for the disadvantages imposed by the carbon tax, a plausible interpretation in view of the powerful lobbying activities by these industries. Another study on carbon imports estimates that the volume of trade “caused” by KP is small and that close to half of carbon savings due to the KP signature have been offset by increases in nonsignatories.<sup>18</sup> <u>The limits of trade policy to mitigate GHG emissions. In OECD countries, around 70%</u> of national income is produced in services and only 15-25% in manufactures, limiting any effect of trade policies on reduction in emissions. Besides, emission intensities often vary more across countries within an industry than across industries, implying that using trade policy to correct for differences in carbon policies would call for country-directed rather than industry-level measures (Dong and Whalley (2010)). Such measures would be in violation of the MFN treatment at the WTO unless they were part of a Regional Trade Agreement (RTA).<sup>19</sup> Global multi-regional general-equilibrium trade (MR-GE) models have been used extensively to answer several questions on climate mitigation policies: (i) damage estimates necessary to elicit participation in cooperative agreements and required compensation to bring about participation; (ii) emission reductions from carbon taxes and leakage rates from sub-global carbon taxes, and; (iii) the incidence of Border Tax Adjustments (BTAs) to compensate for differences in carbon taxes.<sup>20</sup> In principle, international trade expands the bargaining set for reaching a cooperative climate agreement, but small countries will not participate unless they receive compensation because of the sharing of benefits with non-participants. Cai et al. (2009) analyze the participation decision in a skeleton MR-GE model in which temperature change caused by CO2 emissions related to consumption enter negatively in the consumer’s utility function.<sup>21</sup> In this set-up, lower consumption directly raises welfare as temperature rises less and indirectly as the country’s terms-of-trade improves because of reduced demand for imports. Calibrating the utility function parameters on the Stern (2005) damage estimates, they show that a 10% damage (i.e. reduction in GDP) from a 1% reduction in consumption would be necessary for the US or China to participate if they are linked through trade. In the absence of trade, the 18Drawing on data for 38 countries (26 of which have ratified Kyoto), and 12 sectors over the period 1995-2005, Aichele and Felbermayr (2010) examine the impact of different GHG policies on trade flows and emissions. They estimate that carbon imports are on average 12% higher if the importer has ratified Kyoto and his trading partner not. Confirming previous work, the effect is most important in energy intensive industries, where robust evidence for carbon leakage was found for seven sectors. Their findings suggest that, even though the volume of trade “caused” by Kyoto is rather small, on average about 40% of carbon savings due to the ratification of the Kyoto protocol has been offset by increasing emissions in non-committing countries.

19Dong and Whalley (2010) examine reasons for carbon-motivated RTAs and requirements for WTO compatibility of such agreements (no selective actions against high-emitting countries and the possibility of invoking article XX to avoid covering all trade). Then, these RTAs could include extension of preferences to low-emission products, but also BTAs to offset anti-competitive effects. As under the Montreal Protocol , the RTAs could also include penalties against those who do not join the agreement.

20De Melo and Mathys (2010, appendix) review the results from simulation models, focusing mostly on MR-GE models, all assuming CED product-differentiation by country of origin (the ‘Armington’ assumption) which produces strong terms-of-rade effects of any change in trade policy.

21The utility function is a Cobb-Douglas over goods and over temperature change deviations from a ceiling temperature beyond which all activity ceases. Since production activities are not modeled, damage is calibrated on consumption changes.

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