Carbon pricing and cross-border carbon leakage in international transport

Climate change has received a great deal of nervous attention around the world lately. Some countries and regions have introduced carbon pricing such as carbon taxes and emissions trading as countermeasures against global warming. However, there are concerns about cross-border carbon leakage when a country introduces carbon prices. Even if CO2 emissions decrease in this country due to carbon pricing, carbon leakage increases CO2 emissions abroad and in some cases even global emissions. Cross-border carbon leakage undermines a country’s attempt to cope with climate change.

The literature has identified the following three main channels of carbon leakage.

  1. If exporters or importers of carbon-intensive goods introduce carbon pricing, the world market price for fossil fuels falls, which in turn increases fossil fuel consumption and CO2 emissions in other countries (e.g. Bohm 1993, Felder and Rutherford 1993, Kiyono and Ishikawa 2004, 2013 Holle 2005).
  2. Companies are relocating their production facilities from countries with carbon pricing to countries with lax emissions regulations, thereby increasing carbon emissions in the latter (z , 2017).
  3. As carbon-intensive goods producers lose competitiveness in countries with carbon pricing, foreign competitors increase their production, which leads to an increase in their carbon emissions (e.g. Copeland and Taylor 2005, Ishikawa et al. 2012).

International trade and foreign direct investment (FDI) exert an important influence on the channels discussed above. In fact, many studies that analyze the impact of emissions regulations from a global perspective include international trade and foreign direct investment. However, most of these studies do not consider international transport. Those who study the interactions between trade, transport and the environment assume that freight rates are exogenously given without an explicit model of the transport sector (e.g. Cristea 2013, Vöhringer et al. 2013, Shapiro 2016).

In addition, the amount of CO2 emissions caused by international transport itself is too great to ignore. According to the International Maritime Organization, international transport emitted around 920 million tons of CO2 in 2018, surpassing Germany’s national emissions (the sixth highest emission worldwide). The Paris Agreement, which came into force in 2016, did not set specific targets for emissions from international transport. Recently, leaders of several countries and industry associations issued a series of statements on global warming countermeasures related to international transportation:

  • The International Civil Aviation Organization (ICAO) launched the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA) in 2021.
  • In May 2021, the EU announced that international aviation and shipping would be included in the emissions trading system (ETS).
  • In September 2021, the US government announced a goal to reduce aviation-related greenhouse gas emissions by 20% by 2030.
  • In October 2021, the International Air Transport Association adopted a target of virtually zero greenhouse gas emissions by 2050.
  • At COP26, 22 countries sign the Clydebank Declaration to create zero-emission shipping routes.

In a recent article (Higashida et al. 2021) we theoretically analyze the impact of unilateral carbon pricing on CO2 emissions from production, consumption and international transport by explicitly modeling the international transport sector. Our model is based on the endogenous transport cost literature, which has found that the international transport sector is highly concentrated and that transport companies have market power (Hummels et al. 2009). The carriers charge asymmetric freight rates for shipping in different directions on the same trade route, subject to the backhaul issue. The backhaul problem arises when the carrier’s shipping capacity is underutilized due to asymmetries in backhaul trade volume. In particular, the endogenous determination of international transport volumes and prices explains a new mechanism of cross-border and cross-sectoral carbon leakage.

illustration 1 Top 10 deep sea container shipping companies, ranked by deployed capacity and market share, May 2020

source: UNCTAD Review of Marine Transport 2020, Figure 2.9.

figure 2 Interregional Contract Freight Rates, 2018–2020

source: UNCTAD Review of Marine Transport 2020, Table 3.1.

The effectiveness of carbon pricing depends on whether there is a backhaul issue or not.

If the exports from country A to country B (fronthaul) exceed those from country B to country A (backhaul), then the backhaul problem is there. The equilibrium freight rate for exports from B to A is then independent of the marginal costs of shipping (Ishikawa and Tarui 2018). Therefore, although carbon pricing in shipping increases the effective marginal cost of shipping, it has an asymmetric impact on freight rates when the backhaul problem is present. In this situation, carbon pricing in the transport sector reduces fronthaul but does not affect backhaul or associated emissions. We show that a one-sided CO2 pricing of goods consumption is effective. However, carbon pricing of goods production leads to “positive” cross-border carbon leakage: Country A’s carbon pricing for production lowers fronthaul, but increases production in country B and backhaul, thus generating positive cross-border carbon leakage. These changes are conventional, but endogenous freight rate increases mitigate them, meaning carrier behavior weakens cross-border carbon leakage.

Conversely, when fronthaul equals backhaul (i.e., the backhaul issue is absent), we find that both cross-border and cross-sector carbon leakage caused by carbon pricing can be “negative”. In other words, carbon pricing can be extraordinarily effective, as carbon pricing for a sector in a trading country can reduce emissions not only from the target sector but also from other sectors, including those in other trading countries. For example, carbon prices for shipping increase freight rates for both directions, leading to a decrease in both fronthaul and backhaul. As a result, not only the transport company’s emissions can decrease, but also those of the manufacturing companies, which means that negative “cross-sectoral” carbon leakage can occur. This observation identifies a new source of carbon leakage due to endogenous transportation costs. We also show that absent the backhaul problem, any carbon pricing is effective as global greenhouse gas emissions are bound to decrease.

Our analysis also shows that carbon pricing in international transport may not reduce total trade-related emissions if we consider the interplay between endogenous transport costs and manufacturers’ foreign direct investment decisions. Confronted with a manufacturer who may engage in horizontal direct investment (i.e. in local production), the freight forwarder can strategically deter him, since transport demand falls when horizontal direct investment does not trigger trade in intermediate goods. Furthermore, even if the freight forwarder accepts such FDI, he prefers FDI with a single foreign factory to FDI with two factories (one domestic and one foreign factory) because there is no demand for international transportation with two factories. Thus, the freight forwarder has an incentive to induce foreign direct investment in individual plants. These strategic moves by the airline also have an impact on global emissions.

These results flow from our theoretical framework, which addresses the interactions between trade, transport and the environment by explicitly considering the transport sector. They point to another benefit of comprehensively regulating emissions from production (or consumption) and transport.

We argue that it is important to understand the market environment of the international transport sector when designing carbon pricing. In particular, the backhaul problem affects not only the efficiency of transport, but also the effectiveness of carbon pricing. The effectiveness of carbon pricing will increase if measures can be taken to address the backhaul problem at the same time as carbon pricing.

Editor’s note: The main research on which this column is based appeared first as a discussion paper of the Research Institute of Economy, Trade and Industry (RIETI) in Japan.

references

Bohm, P (1993), “Incomplete International Cooperation to Reduce Carbon Emissions: Alternative Policies”, Journal of Environmental Economics and Management 24(3): 258-271.

Copeland, BR and MS Taylor (2005), “Free Trade and Global Warming: A Trade Theoretical View of the Kyoto Protocol”, Journal of Environmental Economics and Management 49(2): 205-234.

Felder, S. and TF Rutherford (1993), “Unilateral CO2 Reductions and Carbon Leakage: The Consequences of International Trade in Oil and Commodities”, Journal of Environmental Economics and Management 25(2): 162-176.

Higashida, K., J. Ishikawa, and N. Tarui (2021), “carry carbon? Negative and positive carbon leakage in international transport“, RIETI Discussion Paper Series 21-E-102.

Hoel, M (2005), “The Triple Inefficiency of Uncoordinated Environmental Policies”, Scandinavian business journal 107(1): 157-173.

Hummels D, V Lugovskyy and A Skiba (2009), “The trade-reducing effects of market power in international shipping“, Journal of Development Economics 89:84-97.

Ishikawa, J., K. Kiyono and M. Yomogida (2012), “Is Emissions Trading Beneficial?”, Japanese economic report 63(2): 185-203.

Ishikawa J & T Okubo (2011) Environmental product standards in north-south trade. Review of Development Economics 15(3): 458-473.

Ishikawa, J. and T. Okubo (2016), “Greenhouse gas emission controls and international carbon leakage through trade liberalization”, international economy 19:1-22.

Ishikawa, J. and T. Okubo (2017), “Greenhouse gas emission controls and fixed locations in north-south trade”, Environmental and Resource Economics 67(4): 637-660.

Ishikawa, J. and N. Tarui (2018), “Backhaul backhaul problems: trade and industrial policies with endogenous transport costs”, Journal of International Business 111:81-98.

Kayalica, M.O. and S. Lahiri (2005), “Strategic Environmental Policy in the Presence of Foreign Direct Investment”, Environmental and Resource Economics 30(1): 1-21.

Kiyono, K. and J. Ishikawa (2004), “Strategic emissions tax-quota non-equivalence under international carbon waste”, in S. Katayama and HW Ursprung (eds.), International economic policy in a globalized worldd, Springer, Berlin, Heidelberg.

Kiyono, K. and J. Ishikawa (2013), “Environmental Management Policy under International Carbon Leakage”, International Economic Review 54(3): 1057-1083.

Markusen, JR, ER Morey and ND Olewiler (1993), “Environmental policies in endogenous market structures and plant locations”, Journal of Environmental Economics and Management 24(1): 69-86.

Markusen, JR, ER Morey and ND Olewiler (1995), “Competition in regional environmental policies at endogenous plant sites”, Journal of Public Economy 56(1): 55-77.

Zeng, DZ and L Zhao (2009), “Pollution havens and industrial agglomeration”, Journal of Environmental Economics and Management 58(2): 141-153.

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