The implication of this is that on aggregate developed countries will wish to purchase carbon offsets from developing countries in a cap and trade regime where quotas for developed countries are below baseline emissions.

# _Unilateral action and leakage_

One key concern in any carbon regime that excludes major carbon emitters is that production of carbon intense goods will move to countries with no (or a lower) price on carbon. Burniaux and Oliveira Martins (2000) provide a succinct discussion of the main channels of leakage—distinguishing between non-energy and energy markets. On the non-energy side, one of the key channels of course is that the higher cost of production in countries with a carbon tax will lead to a competitive disadvantage and shift production to lower cost countries. The degree of leakage will therefore depend on the tradability of non-energy goods (reflected by the so-called Armington elasticity in most trade models) and on capital mobility. Leakage would increase with tradability as the rise in domestic costs would lead to large substitution effects with rising imports and declining exports. The role of capital mobility is less clear cut and could potentially go in reverse direction (though is closely linked to the Armington elasticity). A drop in international energy prices (particularly oil), could potentially lead to a real exchange rate appreciation for Annex I countries and a capital inflow.

As regards the energy market, the degree of leakage will depend on two effects—how much energy prices drop in non-Annex I countries thus leading to increased energy demand and emissions and the degree of inter-fuel substitution. The energy channels are essentially of three kinds. First there is role of ‘carbon’ supply elasticities. As the price of oil drops internationally, there would be a relative switch to oil away from coal in nonAnnex I countries. All else equal, this would tend to reduce leakage as coal is more intensive in carbon. The lower the supply elasticity of oil, the greater the price drop of oil, and the higher the supply elasticity of coal, the more its price is invariant to demand changes and the combination of these two effects would minimize leakage. This would be moderated to some extent by the degree of tradability of coal. A low supply elasticity of coal linked with a highly integrated coal market would induce Annex I coal producers to export considerable volumes to non-Annex I countries. For a variety of reasons, including logistical, this is an unlikely outcome. Another channel is inter-fuel substitutability. Here two effects can offset or reinforce each other—overall demand effect versus substitution effects.

# Numerical analysis

It is difficult to undertake systematic sensitivity analysis with a full-blown CGE model. An alternative approach is to reduce the model to some core set of relations that capture the essence of the full model and that is amenable to systematic sensitivity analysis. This is the approach taken by Burniaux and Oliviera Martins, which we have attempted to replicate though with some modifications. We have re-constructed their model, but have converted it to a model in levels rather than linearized in percent deviation. Second, we have calibrated the model to the same database as the ENVISAGE model with a 2004 base instead of the 1985 database. Third, rather than replicate their pair-wise sensitivity 33