NBER WORKING PAPER SERIES CARBON MOTIVATED REGIONAL TRADE ARRANGEMENTS: ANALYTICS AND SIMULATIONS. Yan Dong John Whalley

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1 NBER WORKING PAPER SERIES CARBON MOTIVATED REGIONAL TRADE ARRANGEMENTS: ANALYTICS AND SIMULATIONS Yan Dong John Whalley Workng Paper NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambrdge, MA Aprl 2009 We thank the Center for Internatonal Governance Innovaton (CIGI) and the Academc Development Fund, Unversty of Western Ontaro for fnancal support. The vews expressed heren are those of the author(s) and do not necessarly reflect the vews of the Natonal Bureau of Economc Research. NBER workng papers are crculated for dscusson and comment purposes. They have not been peerrevewed or been subject to the revew by the NBER Board of Drectors that accompanes offcal NBER publcatons by Yan Dong and John Whalley. All rghts reserved. Short sectons of text, not to exceed two paragraphs, may be quoted wthout explct permsson provded that full credt, ncludng notce, s gven to the source.

2 Carbon Motvated Regonal Trade Arrangements: Analytcs and Smulatons Yan Dong and John Whalley NBER Workng Paper No Aprl 2009 JEL No. F13,Q54 ABSTRACT Ths paper presents both analytcs and numercal smulaton results relevant to proposals for carbon motvated regonal trade agreements summarzed n Dong & Whalley(2008). Unlke tradtonal regonal trade agreements, by lowng tarffs on partcpant s low carbon emsson and settng penaltes on outsders to force them to jon such agreements, carbon motvated regonal trade agreements reflect an effectve mergng of trade and clmate change regmes, and are rsng n profle as part of the post 2012 Copenhagen UNFCC negotaton. By addng country energy extracton cost functons, we develop a mult-regon general equlbrum structure wth endogenously determned energy supply. We calbrate our model to busness as usual scenaros for the perod Our results show that carbon motvated regonal agreements can reduce global emssons, but the effect s very small and even wth penalty mechansms used, the effects are stll small. Ths supports the basc dea n our prevous polcy paper that trade polcy s lkely to be a relatvely mnor consderaton n clmate change contanment. Yan Dong Insttute of World Economcs and Poltcs Chnese Academy of Socal Scences 15th Floor of CASS Buldng No.5 Janguomen Ne Avenue Bejng, Chna, John Whalley Department of Economcs Socal Scence Centre Unversty of Western Ontaro London, Ontaro N6A 5C2 CANADA and NBER

3 1. Introducton Ths paper presents both analytcs and numercal smulaton results relevant to recent debate on carbon motvated regonal trade agreements (see Chatham House (2007) and Dong & Whalley (2008)). Proposals whch crculate nclude explctly lowerng or elmnatng tarffs among partes to a regonal agreement on low carbon ntensve and products used n low carbon technologes,border adjustments on trade wth partes outsde the area based on dfferental emssons content of, and the use of trade sanctons aganst countres outsde the area to enforce complance wth emssons reducton targets set for them. Such proposals reflect an effectve mergng of trade and clmate change regmes, and are rsng n profle as part of the post 2012 Copenhagen UNFCC negotatons (See Walsh & Whalley (2008), and Lockwood & Whalley(2008)). Here we dscuss carbon motvated regonal agreements n terms smlar to customs unon and regonal trade agreements based lterature (See Vner(1950)). We note that agreements wth lower wthn-regon barrers on low carbon ntensve products need not reduce emssons globally f emssons ntenstes of producton dffer sharply wthn and nsde the regon. Ths reflects the dfferental mpact of trade creaton and trade dverson on emssons. We also note that unlke conventonal customs unon lterature the welfare effects of a regonal agreement now also nclude welfare mpacts on clmate change from emssons changes. We use a mult-regon general equlbrum structure n whch countres produce commodtes of varyng emssons ntenstes usng substtutable fossl fuel based energy and non-energy nputs. Commodtes are dfferentated by country of orgn followng Armngton (1969). Preferences are defned over both consumpton of and clmate change, wth lower utlty from hgher global temperature change. Unlke n conventonal trade models n whch there s a fxed endowment of factor nputs for each country, here we model energy supply globally as ntegrated wth a sngle global market and prce, and there beng a supply functon for each country reflectng ncreasng extracton costs. We do not separately dfferentate - 3 -

4 between fossl and non fossl fuels, but n a further model extenson we could do so. We model the extracton cost functon n constant elastcty form to yeld a specfcaton consstent wth alternatve values of the supply elastcty of energy. We then treat emssons n each country as fxed coeffcent n energy use, and n ths way ncorporate endogenety of emssons levels. Global emssons levels can thus rse or fall under any gven regonal trade agreement. Ths dffers from other equlbrum structures, (see OECD(1993),Bhattacharyya(1996) and Wng(2004) ) n whch the energy endowment s fxed (perfectly nelastc supply). We next turn to numercal smulaton, and usng a number of data sources construct a benchmark global equlbrum data set based on data for Ths covers producton, consumpton and trade for each of a number of regons (US, EU, Chna, ROW) whch we then project forward usng average growth rates for the perod In our statc equlbrum model we thus treat the thrty year perod as a sngle perod. The data set also contans estmates of energy use by sector and emssons for 2006 whch are growth rate projected forward for perod We calbrate our model to ths data set usng lterature based estmates of key elastctes. Results from our analyss support the conjecture made verbally n our prevous polcy paper (see Dong & Whalley (2008) ) that carbon motvated trade polces such as carbon free trade areas can only have a relatvely small role n reducng carbon emssons. Carbon motvated regonal agreements may ncrease world welfare, but the effects on partcpatng countres may be negatve or postve, when wth penaltes, the effect of carbon motvated trade polces on carbon emssons s stll small. Though the carbon motvated regonal agreements wll have larger effects wth emssons of hgh and low emssons ntenstes countres nvolved, the effects are stll small

5 2. Relevant Lterature and Model Structure 2.1 Lterature Revew Dscusson of both the form and mpact of carbon free trade agreements s related to the long studed customs unon ssue orgnally analyzed by Vner (1950). Vner, the ntator of subsequent customs unon lterature, ponted out that regonal trade agreements do not necessarly result n gans to members, even though blateral tarffs are elmnated by the agreement. He developed what later became known as the trade creaton trade dverson approach to regonal trade agreements to help understand ths ambguty. Followng Vner s work, for many years trade creatng regonal agreements were seen as good, and trade dvertng regonal agreements were seen as bad. Vner s work was also the drvng force behnd later lterature that subsequently sought to set out the condtons under whch regonal trade agreements would ether mprove or worsen welfare. Ths work was stll based on trade creaton trade dverson consderatons, but Meade (1955), Lpsey(1957) and others dscovered that preference consderatons also enter n tryng to make such determnatons. Ths was to lead to Lpsey and Lancaster s (1956) characterzaton of the general theory of the second best, confrmaton that no general customs unon results were possble. Dssatsfacton wth the trade creaton trade dverson dchotomy resulted n Lpsey (1970), Kemp(1969), Rezman(1979) and others tryng to develop other approaches that would yeld clear propostons. The approach known as the terms of trade-volume of trade approach became popular, under whch the mpact of a regonal trade agreement can be summarzed by ts effects on both terms of trade (prces) and trade volumes. Most tradtonal lterature on regonal trade agreements falls nto the tradtonal Vneran framework. In Dong & Whalley(2008), we proposed three dfferent forms of possble carbon motvated regonal trade arrangements. One s regonal trade agreements wth varyng types of trade preferences towards low carbon ntensve products, low carbon new technologes and nputs to low carbon processes beng used to stmulate trade (and - 5 -

6 hence consumpton) n low carbon ntensve products. In ths way they are desgned to contrbute drectly to emssons reducton through changed trade patterns. A second type focuses on the ant-compettve effects on domestc producers when sgnfcant jont emssons reducton commtments are made whch others do not follow. Such commtments rase costs for domestc producers and whether there should be offsets for these relatve cost effects compared to thrd country producers operatng outsde of such arrangements s an ssue, as well as the form they should take. The perceved need for border tax adjustments had already arsen n Europe who saw themselves as gong father and faster on emssons reductons than partner countres. A thrd type of arrangement could be where countres enter nto free trade or other regonal trade agreements and use jont and dscrmnatory carbon motvated trade barrers aganst thrd partes as a way of pressurng countres to jon ther jont envronmental agreement. Ths form of trade arrangement s smlar to that contaned n the Montreal Protocol of Ths paper follows Dong & Whalley (2008), and numercally evaluates the economc effects of type one and type three carbon free trade areas n that paper. In ther smplest form, carbon free trade areas would nvolve free trade n low carbon contanng products among countres jontly commttng to sgnfcant emssons reductons or renewable commtments, and also wth external trade barrers aganst thrd countres that do not follow. Dscusson of both ther form and mpact s related to the long studed customs unon ssue orgnally analyzed by Vner(1950), but now there are also mpacts of carbon prcng/reducton polces on emssons va endogenous energy supply. The paper focuses on two departures from Vneran form, one ncludes clmate change effects n utlty, and the other changes tradtonal free trade areas and Customs Unons to carbon motvated free trade areas and Customs Unons. In carbon free trade agreements, tradtonal zero-tarffs on all changes to structural preferental trade polces settng hgh tarffs on hgh carbon ntensve products and zero tarffs on low carbon ntensve. We also consder a new form of carbon motvated Customs Unons of only settng zero tarffs on low carbon ntensve

7 We argue that agreements wth lower wthn regon barrers on low carbon ntensve products need not reduce emssons globally f emssons ntenstes of producton dffer sharply wthn and outsde the regon. Ths reflects the dfferental mpact of trade creaton and trade dverson on emssons. We also note that unlke conventonal customs unon lterature the welfare effects of a regonal agreement also nclude welfare mpacts on clmate change from emssons changes. 2.2 The Model We present our carbon free trade area model n algebrac form. In ts smplest form, there are three regons, =1,2,3,where regons 1 and 2 form a carbon free trade agreement, although n emprcal mplementaton we can consder more regons. There are two, j=1,2, n producton, good 1 has hgh energy ntensty, and good 2 has low energy ntensty. The model specfes two factors, N a non-energy nput, whch s mmoble across countres, but moble across sectors wthn a country, and E an energy nput whch s moble across both countres and sectors. On the producton sde, we consder a two sectors (a hgh emsson good and a low emssons good), two factors (energy and non energy nputs) structure. We assume producton s CES. The producton functon for each good n each country can be wrtten as Y j = Φ [ a j σ j 1 σ j 1 σ j 1/ σ j σ j 1/ σ j σ j σ j 1 j1 Ej + aj 2 N j ] =country, j=sector (1) where Yj s the output of good j produced n country, pe s the prce of energy, σ j s the elastcty of substtuton between the two nputs. We assume that energy s moble across countres, so that the energy prce n each country (the world prce) s the same. pn s the prce of the non-energy nput n country, prces are P j. Frst order condtons mply the followng: 1 σj 1 σj 1 σj j j j j1 E j1 E j 2 N σj 1 σ j E = Y Φ a p [ a p + a p ] (2) 1 σj 1 σj 1 σj j j j j 2 N j1 E j 2 N σj 1 σ j N = Y Φ a p [ a p + a p ] (3) 1 1 σj 1 σj j j j1 E j2 N 1 1 σj P =Φ [ a p + a p ] (4) - 7 -

8 Unlke tradtonal general equlbrum models whch use a fxed endowment of energy, here, by ntroducng an extracton cost functon for each country nto the model, energy supply now s endogenously determned. The extracton cost functon can be wrtten as K = F + (5) B 3 ( Q ) = B 1 B 2Q where K s the extracton cost n country, and Q s energy extracton n country. We assume the energy market s perfectly compettve, and from the frst-order condtons for the extracton cost functon, we get p and the energy supply elastcty s dk df ( Q ) = = = B B Q (6) B 3 1 E 2 3 dq dq = dk K EQ = 1 B 3 (7) dq Q Dvdng the extracton cost functon by the energy prce, we can calculate the resources that are used n energy extracton. The utlty functon s B 3 K B 1+ B2Q R = = (8) p p E E 1 σ1 1 1 σ1 1 σ1 σ1 σ1 σ1 σ1 σ1 1 C ΔT β U = U( RX, Δ T) = [ γh H + γ L L ] ( ) (9) C Ths utlty functon follows Ca, Rezman & Whalley (2009). RX s composte consumpton, Δ T s temperature change. In ths specfcaton,c can be thought of as the global temperature change at whch all economc actvty ceases (say, 20 ). In ths case, as Δ T approaches C, utlty goes to zero. In ths form, as Δ T goes to zero, there s no welfare mpact of temperature change. For the fnal good demand functons, RX s a two level nested CES functon. Each regon s assumed to maxmze utlty by frst choosng among hgh and low - 8 -

9 emsson, and each regon then chooses usng among domestc and the other country at a second level. RX = f ( X, X, L X, X ) (10) r 2r Each of the four regons maxmzes top level utlty subject to a budget constrant. I s ncome n country. P j X j = j I (11) ncome ncludes non-energy ncome, energy ncome, tarff revenue, and transfers from abroad (fnancng net mport and net energy mport). I = p W + [ p Q K ] + R + TR (12) N N E For country, pn s the prce of non-energy nput, WN s the non-energy endowment, K s the extracton cost of energy, and Q s energy extracton n country. R s tarff revenue, and TR are exogenous transfers between countres (net mport plus net energy mport). These can be zero, but ncorporatng them allows calbraton to unbalanced trade data. tarff) as Fgure 1 shows the structure of two level nested CES utlty functons used. For each good j produced n country, we can defne the seller s prce (net of p j, and allow each country to mpose tarffs at rate t j ( country s tarff on good j mported from country ) on each mported good. Tarffs are set to zero for exports. Internal (gross of tarff ) prces for good j produced n country are thus P = [1 + t ] P (13) j ' j j - 9 -

10 Fgure 1 : Two Level Nested CES Utlty Functons Used for Each Country DEMAND Fnal Demand Functons In each regon, a 2 level CES functonal form s used CES Herarchy Hgh-emsson Consumpton Low-emsson Temperature change D M 1 M 2 M 3 D M 1 M 2 M 3 Level 1 Substtuton between hgh and low emsson composte Level 2 Substtuton between domestc and mport Temperature change n physcal form s assumed to be a functon of energy consumpton, e b ΔT = g( Ej ) = a( Ej ) + c (14) In equlbrum, and factor markets clear. Goods market clearng mples: X j = Y j =1,2,3, j =1,2 (15) Non-energy s only moble across sectors wthn regons and mmoble across regons, so each regon s non-energy consumpton equals ts non-energy endowment. The non-energy clearng condton s: N j = WN =1,2,3 (16) j Energy s moble across countres and so global energy consumpton equals global energy extracton. The energy clearng condton s: j = j E Q =1,2,3 (17)

11 3. Data and Parameterzaton We buld a model compatble benchmark general equlbrum data set whch we use n calbraton. Our base case assumes a sngle 30 year perod, forward projectng a busness as usual scenaro for trade, producton, and consumpton data (as well as energy use) for a 2 good (energy / non energy ntensve), 2 factor (energy nputs, other nputs) structure for 4 regons (Chna, US, EU, ROW). We forward project 2006 data usng average growth rates, for the perod In Table 1-1 GDP data s from the World Bank s WDI database. The hghemsson sector reflects manufacturng ndustry. The low-emsson sector ncludes servce and agrcultural sectors. For Table 1-2, trade data s taken from the UNCOMTRADE database, F.o.b. export values as reported by exportng countres are used. Snce data on EU s exports to Chna and US n 2006 were not avalable at the tme of model executon, we use the mport data of Chna and the US from the EU nstead. Snce Chna s growth rates s hgh relatve to other regons,to keep trade balance n the data, we use Chna s growth rate for Chna s mports and exports, whle for other data, we use the mport country s growth rate n our projectons, tarff data s from the WTO Statstcal Database. In Table 1-3, energy data for 2005 s calculated from IEA energy statstcs. The unt of account of the IEA statstcs data s thousand of tonnes of ol equvalent, whch we adjust to bllon US dollars, (1 toe=7.33 barrel of ol equvalent, ol prce (average)=$ 50.64/per barrel). In 2005, the energy balances for world were crude ol mports of Ktoe, whle exports were Ktoe, comparable wth world crude ol trade balance. The extracton cost s calculated usng the IEA trade balance table. In the data presented n Table 1-4, adjustments are made to consumpton by calculatng GDP mnus exports. There are also some small dfferences n classfcatons between the underlyng consumpton, producton and tarff rate data. Table 1-5 gves energy consumpton data from IEA statstcs

12 Table 1 Data Sources n Model Calbraton Table GDP by Sector by Regon (Bllon $) Chna EU-27 US ROW Hgh Low Hgh Low Hgh Low Hgh Low GDP by sector GDP Source: World Bank s WDI database Table Blateral Trade Data (Bllon $) Exports by (Bllon $) Chna EU-27 US ROW World Imports by Chna EU-27 US ROW World Hgh Low Total Hgh Low Total Hgh Low Total Hgh Low Total Hgh Low Total Source: UNCOMTRADE database Extracton Table Energy Balance Data (Bllon $) Import Export Net Import Extracton cost Consumpton Hgh emsson sector nput Low Emsson sector nput Chna Eu US ROW World Source: IEA energy statstcs

13 Table 1-4 : Consumpton of Domestc Goods ( ) (Bllon $) Consumpton of domestc Hgh energy ntensty Low energy ntensty Chna EU US ROW Table 1-5 Energy Consumpton (Bllon US $) Year Chna EU-27 US ROW World Source: Internatonal Energy Agency: Key World Energy Statstcs, As for elastctes, n the central case, model analyses elastcty parameters are used as follows: for all countres the producton elastcty s 0.5, the extracton / energy supply elastcty s 0.5, the consumpton elastcty, that s the substtuton elastcty between hgh and low emsson n consumpton s equal to 0.5, and the trade elastcty,that s the substtuton elastcty between domestc and mported s equal to 2. The substtuton elastctes between domestc and mported commodtes follows the rule of two, as dscussed n Hertel al. (2009). Ths rule was frst proposed by Jomn et al.(1991) and later tested by Lu, Arndt,and Hertel(2002) n a back-castng exercse wth a smplfed verson of the GTAP model. The model Global 2100 uses a captal and labour nest aganst energy wth a substtuton elastcty of 0.4 (see Manne and Rchels, 1992), Kemfert(1998) studed the case of Germany, and the substtuton elastctes n all sectors between composte of captal and labor, tradng off aganst energy was We thus use the settng of 0.5 as the substtuton elastcty between energy and non-energy nputs

14 Usng the data for 2006,2036, and 2056 n table 1-5, and assumng the temperature change at these three ponts to be 0,2, and 5 respectvely, we can solve for the values of parameters a,b,and c n equaton (14) as b 0 = a ( ) + c 2 b = a ( ) + c b 5 = a ( ) + c Solvng these equatons for the parameters a,b,and c yelds values of , and 0. Substtutng these values n the temperature equaton yelds ΔT = g( E j ) = 0.001( Ej ) (18) Assumng a temperature change ΔT of 5 between 2006 and 2056 (consstent wth Stern(2002)), Table 2 reports the calbrated preference parameters n equaton (9) under alternatve damage assumptons. If we assumed half temperature change, at these three ponts to be 0,1, and 2.5 respectvely, we can solve for the values of parameters a,b,and c, , and 0. If we double temperature change, temperature change at these three ponts wll be 0,4, and 10 respectvely, and the values of parameters a,b,and c are , , and 0. The specfcaton C can be thought of the global temperature change at whch all economc actvty ceases (say 20 ). In ths case, as ΔT approaches C utlty goes to zero. In ths form, as ΔT goes to zero there s no welfare mpact of temperature change. As dscussed n Ca et al.(2009), the share parameter β reflects the assumed severty of damage from temperature change, whch we later (n Table 7) calbrate to varous damage estmates from busness as usual global temperature change scenaros reported by Stern(2006) and Mendelson(2007). Table 2 also reports remanng parameter values n producton, preferences and extracton cost functons generated by calbraton. These are ndependent of the assumed utlty damage due to temperature change

15 Table 2 Calbrated Parameters under Alternatve Damage Assumptons A. Assumed Changes n Preference Parameters Assumed Utlty Loss Utlty Relatve to No damage β 1% % % % % % % % B. Parameters n CES producton functons technology coeffcent shares on energy shares on non-energy hgh emsson Chna EU US ROW low emsson hgh emsson low emsson hgh emsson low emsson hgh emsson low emsson C. Parameters n Nested CES Utlty functons Chna EU US ROW Shares of consumpton of hgh emsson domestc and mport Chna-H EU-H US-H ROW-H Shares of consumpton of low emsson domestc and mport Chna-L EU-L US-L ROW-L Chna EU US ROW Shares of hgh and low emsson composte hgh emsson low emsson hgh emsson low emsson hgh emsson low emsson hgh emsson low emsson D. Parameters n Extracton functons Constant Parameter Coeffcent parameter

16 4. Model Experments and Results for Carbon Motvated Regonal Trade Agreements We have used our calbrated model to smulate the mpacts of carbon motvated regonal trade agreements on emssons and welfare. Followng Dong & Whalley (2008), we analyze the frst type of carbon motvated regonal agreement (lower tarffs on low carbon ntensve ) and the thrd types of carbon motvated regonal agreements(added penaltes on thrd partes). Results are presented n Table 3 to Table 8. These experments confrmed the conjectures n our prevous polcy paper (see Dong & Whalley (2008)), that whle carbon motvated regonal agreements can reduce global carbon emssons, the effect on carbon emssons s small. Carbon motvated regonal agreements may ncrease world welfare, but the effects on partcpatng countres may be negatve or postve. When we consder thrd party penaltes, the effects of carbon motvated trade polces on carbon emssons are stll small. Even though carbon motvated regonal agreements wll have larger effects on emssons when hgh and low emssons countres are nvolved compared to more unform emssons levels, the effects are stll small. In Tables 3,4,5, usng central case model specfcatons, we analyze four groupngs of regonal trade agreements, these are EU-US, EU-Chna, US-Chna, and EU-US-Chna. In each group, there are two sub forms. One s carbon free trade agreements, whch elmnates nteror tarffs on low carbon ntensve, and keep tarffs on hgh carbon ntensve unchanged. The other s carbon motvated customs unons, besdes wthn regon tarff reductons as n carbon free trade agreements, we assume a common 5% external tarff on low carbon motvated. Totally we analyze eght knds of carbon motvated regonal trade agreements n our central case analyses. Table 3 reports the mpacts of carbon motvated trade arrangements on welfare and emssons. Most carbon motvated trade arrangements wll reduce global emssons, but the effect s small. In Table 3-1, the global emssons are reduced n seven cases; the excepton beng n the US-Chna carbon CU case. The bggest reducton s from a EU-US-Chna carbon FTA, % (very small change), and smallest reducton s from a EU-US carbon FTA, %, Snce Chna has much

17 hgher emssons ntensty than the EU or the US, the carbon FTAs that nvolve Chna wll have larger effects. We can also compare carbon FTAs and carbon CUs. In case 1 and case 4, EU-US, EU-US-Chna, snce Chna and ROW are respectvely outsde the agreement and both of these two regons have a hgher emsson ntensty than the nsders (measured n average emssons ntensty across sectors), carbon CUs has more mpact than carbon FTAs n these two scenaros. In cases 2 and 3, EU-Chna, US-Chna, the outsde countres have lower emssons levels than nsders (average level). In ths case carbon FTAs have more mpacts on emssons than a carbon CU. A carbon CU has a larger role than a carbon FTA n reducng carbon emssons when the outsder has hgher emsson ntensty than nsders. Table 3-1 also reports separate effects on country s emssons. The EU ncreases emssons n most cases, snce EU s carbon ntensty s low, and ncreased trade ncreases producton n other member countres who have a relatve hgher carbon ntensty. For Chna, partcpatng n the carbon free trade areas wll decrease Chna s carbon emssons, such that EU-Chna carbon FTA, US-Chna carbon FTA, EU-US-Chna FTA wll decrease Chna s emssons %, %, %. For US, n most cases, partcpatng n carbon FTAs and CUs wll reduce t s carbon emssons. In Table 3-2, for welfare analyss, we use Hcksan CV and EV measures capturng the effects of temperature change. ΔU U U CV = = C ΔT C ΔT C C β 0 β ( ) ( ) (19) ΔU U U EV = = C ΔT C ΔT C C β 1 β ( ) ( ) (20) In Table 3-2, snce the temperature change s small, ΔT0 Δ T1, and CV and EV measures from equatons (19) and (20) are smlar. We only focus on the CV measure. For the global economy, n most cases (except a US-Chna carbon FTA), carbon motvated regonal trade agreements are welfare mprovng. And comparng carbon FTA and CU, n case 1, snce the outsder has hgher carbon emssons, the total welfare ncrease s small, for a EU-US FTA, when reducng the tarff on outsder s low carbon to a 5% CET, A EU-US CU however, seems to mprove global

18 welfare more. In cases 2,3 and 4, the hgh emsson country Chna s nvolved n the carbon arrangement, so a carbon CU s more powerful than carbon FTAs n ncreasng global welfare. For nsders, n EU-US FTA/CU, EU-Chna FTA/CU, EU-US-Chna FTA/EU, the EU wll beneft most from these arrangements, n US-Chna CU, Chna wll beneft most. For outsders, n all cases, outsders ncrease welfare n carbon FTAs, but lose n a carbon CU. Table 3-1 Impacts of Carbon Motvated Trade Agreements on Emssons(Energy Use) (% Change Based on 2006 Data) Carbon FTA/CU % Change n Emssons Chna EU US Row Total 1 EU-US FTA % % % % % EU-US CU ( 5 % CET) % % % % % 2 EU-Chna FTA % % % % % EU-Chna CU( 5 % CET) % % % % % 3 US-Chna FTA % % % % % US-Chna CU (5 % CET) % % % % % 4 EU-US-Chna FTA % % % % % EU-US-Chna CU ( 5 % CET) % % % % %

19 Table 3-2 Impacts of Carbon Motvated Trade Agreements on Welfare ( n bllon $) Carbon FTA Change n Welfare by Regon (CV) Change n Welfare by Regon (EV) Chna EU US Row Total Chna EU US Row Total EU-US FTA EU-US CU ( 5 % CET) EU-Chna FTA EU-Chna CU( 5 % CET) US-Chna FTA US-Chna CU (5 % CET) EU-US-Chna FTA EU-US-Chna CU ( 5 % CET)

20 In Table 4, we compare the welfare effects of carbon based regonal trade agreements and tradtonal trade agreements, also calbratng a non clmate change tradtonal trade model to the same trade, producton and consumpton data for Ths allows us to compare the welfare mpacts of smlar tarff arrangements wth and wthout clmate change consderatons. There are four country cases where the sgn change from a negatve CV (n tradtonal carbon regonal agreements) to a postve CV (n carbon based regonal agreement). The four cases are: n EU-US FTA, the welfare of EU, and total welfare, n US-Chna CU, the welfare of US and n EU-US-Chna CU, the welfare of Chna. That suggests carbon motvated regonal trade agreements ncrease welfare for partcpatng countres over conventonal regonal agreements. In Table 4, comparng mpacts on total welfare, n most cases, carbon motvated regonal trade agreements reduce welfare compared to tradtonal regonal trade agreements. In the 6 cases(all except EU-US FTA/ CU),snce these carbon regonal trade agreements have no tarff preferences towards hgh energy ntensve, whch wll reduce the consumpton of such knd of, the negatve consumpton effect s bgger than the postve temperature effect, so the total welfare effect s negatve. In Table 4, we also consder the welfare change of ndvdual countres, and for the ROW. All 8 cases show welfare reductons under a carbon regonal trade agreements compared to tradtonal trade agreements whch means that carbon motvated regonal trade agreements offer more ncentves for the outsders to jon envronmental trade agreements. For Chna, only under a EU-US FTA/CU does Chna s welfare reduce under carbon free trade agreements. For EU, as an outsder the EU faces losses n US-Chna carbon regonal trade agreements compared to tradtonal trade agreements. But when consderng US, there s some change n EU-US FTA/EU cases where the US loses n carbon agreements compared to tradtonal agreements

21 Table 4 Comparng Conventonal CU / FTA Analyss and Carbon Based Regonal Trade Agreement Analyss(bllon $) Carbon FTA/CU Carbon Based Regonal Agreement Analyss : Change n Welfare by Regon (CV) Conventonal Regonal Agreements Analyss : Change n Welfare by Regon (EV) Chna EU US Row Total Chna EU US Row Total EU-US FTA EU-US CU ( 5 % CET) EU-Chna FTA EU-Chna CU( 5 % CET) US-Chna FTA US-Chna CU (5 % CET) EU-US-Chna FTA EU-US-Chna CU ( 5 % CET)

22 In Table 5, we analyze the mpacts of carbon based regonal trade agreements on trade flows and producton. In nearly all eght cases, carbon FTA/CU wll ncrease nsder s mports, except n the case of EU-Chna carbon FTA for Chna, and the EU-US-Chna FTA for Chna. For outsders the results are that carbon FTAs wll ncrease outsder s mports, but a carbon CU (5% CET) wll reduce outsder s mports. Table 5 also reports the mpacts on producton n nearly all cases. Chna, US, Row ncrease low energy ntensve, producton, and reduce hgh energy ntensve producton, except n an EU-US FTA(Chna producton), a US-Chna CU (Chna,ROW Producton), a EU-Chna FTA(US producton). As for the EU, except for US-Chna a FTA/CU ncreases low energy ntensve producton, and reduces hgh energy ntensve producton. In all other cases,the EU reduces low energy ntensve producton and ncreases hgh energy ntensve producton. That means that hgh emsson countres wll tend to produce more low energy ntensve, and less hgh energy ntensve, no matter whether they are outsders or nsders. For a low emsson country (EU), when t s an outsder, t wll tend to produce more low energy ntensve, and less hgh energy ntensve, and when t s an nsder, vce versa. That means f carbon regonal trade agreements are sgned between hgh emsson countres, t wll be more forceful n reducng carbon emssons

23 Table 5 Impacts of Carbon Based Regonal Trade Agreements on Trade Flows and Producton % Change n Value of Imports Emssons ntensve good % Change n Producton Emssons non ntensve good Chna EU US Row Chna EU US Row Chna EU US Row EU-US FTA % % % % % % % % % % % % EU-US CU ( 5 % CET) % % % % % % % % % % % % EU-Chna FTA % % % % % % % % % % % % EU-Chna CU( 5 % CET) % % % % % % % % % % % % US-Chna FTA % % % % % % % % % % % % US-Chna CU (5 % CET) % % % % % % % % % % % % EU-US-Chna FTA % % % % % % % % % % % % EU-US-Chna CU (5 % CET) % % % % % % % % % % % %

24 In Table 6-1, we report senstvty results for elastctes and other key model parameters for carbon based regonal trade agreements analyss. If we choose the case of a EU-US-Chna carbon FTA, decreasng trade elastctes ncreases the global emssons mpact of the agreement. The outsder ncreases emssons, and for the nsder, Chna emssons ncreases, whle EU and US reduce emssons. Decreasng producton elastctes, all nsders wll reduce emssons, but for outsders, the result s not clear. Reducng extracton elastctes, all regons ncrease emssons. Wth a combned reducton of trade elastctes, producton elastctes and extractons elastctes together, total emssons ncrease, and outsders stll ncrease emssons, and for the nsders, EU and US emssons fall whle the Chna ncreases emssons. In Table 6-2, when consderng welfare nputs, lower trade elastctes wll ncrease all regons welfare mpacts, and a fall n producton elastctes ncreases the welfare of EU,US and ROW and decreases the welfare of the Chna and total welfare. Also a fall n extracton elastctes wll ncrease the welfare of EU, US, Row, and decrease the welfare of the Chna and total welfare. Wth a combned reducton of trade elastctes, producton elastctes and extractons elastctes together, all regons welfare mpacts of trade agreements wll ncrease. Table 6-1 Senstvty of Carbon Based Regonal Trade Agreements Analyss to Elastctes and Other Key Model Parameters (% change based on 2005 data) EU-US-Chna FTA % Change n emssons Chna EU US Row Total 1. Base Case ( Table 3-1) trade elastctes n all regons % % % % % 3 Half trade elastctes n all regons % % % % % 4 Double producton substtuton elastctes n all regons % % % % % 5 Half producton substtuton elastctes n all regons % % % % % 6 Double the extractons elastctes n all regons % % % % % 7 Half the extractons elastctes n all regons % % % % % 8 2,4, and 6 together % % % % % 9 3,5,and 7 together % % % % %

25 Table 6-2 Senstvty of Carbon Based Regonal Trade Agreements Analyss to Elastctes and Other Key Model Parameters (bllon $) EU-US-Chna FTA CV EV Chna EU US Row Total Chna EU US Row Total 1 Base Case ( Table 3-2) trade elastctes n all regons Half trade elastctes n all regons Double producton substtuton elastctes n all regons Half producton substtuton elastctes n all regons Double the extractons elastctes n all regons Half the extractons elastctes n all regons ,4, and 6 together ,5,and 7 together

26 Table 7 Senstvty of Results to Key Parameters n the Envronmental Component of Modelng Structure (bllon $) EU-US-Chna FTA (CV) EU- Chna FTA( CV) Chna EU US Row Total Chna EU US Row Total 1 Base Case ( Table 3-2) 2 Halve damage estmated to calbrate preferences towards temperature change 3 Double damage estmated to calbrate preferences towards temperature change Halve temperature change for BAU scenaro Double temperature change for BAU scenaro

27 Table 7 reports senstvty analyss of key parameters n the envronmental component of the modelng structure. We choose two cases, EU-US-Chna FTA and EU-Chna FTA, both cases show that f we ncrease damage cost estmates, the welfare mpacts wll ncrease. And also f we ncrease temperature change,the welfare mpacts of agreements wll ncrease wth ncreasng temperature change. In Table 8,we analyze the mpacts of carbon based regonal trade agreements on emssons and welfare wth trade penaltes on thrd partes. Results show that ncreasng penaltes on outsders effectvely decreases the emssons of outsders, but ncrease the emsson of nsders, and also ncrease the world total emssons. The EU-US FTA nvolves zero tarff on low emsson, ncreasng domestc producton (and consumpton) of hgh emsson. Imports from Chna of hgh emsson fall, and emssons rse n the EU and the US. Interestngly, there are peaks for the mpled emssons reducton as a functon of external penalty rates, suggestng an optmal external tarff n terms of maxmzng emssons reducton. Table 8 Impacts on Emssons of Carbon Based Regonal Trade Agreements wth Penaltes (bllon $) EU-US FTA % Change n Emssons Chna EU US Row Total 1 FTA wthout penalty % % % % % 2 15% external rate on hgh emsson % % % % % 3 30% external rate on hgh emsson % % % % % 4 50% external rate on hgh emsson % % % % % 5 100% external rate on hgh emsson % % % % % 6 150% external rate on hgh emsson % % % % % 7 200% external rate on hgh emsson % % % % % 8 15% external rate on all % % % % % 9 30% external rate on all % % % % % 10 50% external rate on all % % % % % % external rate on all % % % % % % external rate on all % % % % % % external rate on all % % % % %

28 5. Concludng Remarks We buld on an earler polcy pece by Dong & Whalley(2008) and develop a mult-regon general equlbrum model calbrated to a sngle perod data set reflectng a busness as usual scenaro between 2006 and We use ths to evaluate the mpacts of both carbon motvated free trade agreements and customs unons on trade, emssons and welfare. Our results confrm the wdely held vew that as a mechansm for reducng carbon emssons trade polcy would seem to only offer quanttatvely small and ndrect effects, snce t s economc growth more so than trade and ts composton that seemngly fuels growng emssons. Results from model analyss show that carbon motvated trade arrangements may reduce global carbon emssons. And as conjectured by Dong & Whalley(2008), the effect of such agreements on emssons are relatvely small comparng carbon FTAs and carbon CU, carbon CUs seem more powerful than carbon FTAs n terms of emssons mpacts when outsders have hgher emsson ntenstes than nsders. For welfare analyss, most carbon RTAs are welfare mprovng. When ncludng hgh emsson countres n the agreements, carbon based CUs are more effectve than carbon FTAs. Comparng carbon RTAs to tradtonal RTAs, snce carbon RTAs do not elmnate tarffs on hgh emsson, the negatve consumpton effect s bgger than the postve temperature effects, so the total welfare effect s negatve. Carbon RTAs also gve a much bgger ncentve than tradtonal RTAs for the outsder to jon agreements. In most cases, carbon based RTAs wll ncrease nsder s mports, For outsders, the mpacts on mports are unclear: carbon based RTAs wll ncrease the producton of low energy ntensve, and reduce the producton of hgh energy ntensve ; Fnally even wth trade penaltes on thrd partes there are stll not large effects n terms of carbon emssons reductons As the global debate on a new Post 2012 clmate change regme moves forward to the 2009 Copenhagen UNFCCC negotaton, trade and clmate ssues wll lkely lnk promnently. These results seemngly support the general argument that as a way of addressng clmate change, trade polcy has only small mpacts

29 References Bhattacharyya, S.C.(1996) Appled General Equlbrum Models for Energy Studes: A Survey, Energy Economcs,Vol18 (1996),pp Ca,Y,Z, R.Rezman and J. Whalley(2009) Internatonal Trade and the Negotablty of Global Clmate Change Agreements, NBER Workng Paper No.14711, Issued n Feb Chatham House (2007) Changng Clmates: Interdependences on Energy and Clmate Securty for Chna and Europe, Antony Froggatt, Bernce Lee, Chatham House Report. Cooke,R.(2007) The elastcty of ol producton and consumpton, Energy Bulletn, Archved Mar Dong,Y. & J. Whalley (2008) Carbon, Trade Polcy, and Carbon Free Trade Areas, NBER Workng Paper No.14431, Issued n October Hertel, T., R. McDougall, B.Narayanan and A.H. Aguar(2009) GTAP 7 Data Base Documentaton - Chapter 14: Behavoral Parameters, access at https://www.gtap.agecon.purdue.edu/resources/download/4184.pdf Jomn, P., J.F. Zetsch, R. McDougall, A. Welsh, S. Brown, J.Hambley and J. Kelly(1991) SALTER: A General Equlbrum Model of the World Economy, Vol. 1. Model Structure, Data Base, and Parameters. Canberra, Australa: Industry Commsson. Kemfert,C.(1998) Estmated Substtuton Elastctes of a Nested CES Producton Functon Approach for Germany. Energy Economcs 20 3, pp Kemp M. and H. Wan (1976) An Elementary Proposton Concernng the Formaton of Customs Unons. Journal of Internatonal Economcs 6,pp Lpsey,R.G. & Kelvn Lancaster(1956) The General Theory of Second Best, The Revew of Economc Studes, Vol. 24, No. 1. ( ), pp Lpsey, R. G. (1957) The Theory of Customs Unons: Trade Dverson and Welfare, Economca 24, pp Lpsey, R. G. (1970), The Theory of Customs Unons: A General Equlbrum Analyss. London: Wedenfeld and Ncholson. Lu, J., Y. Surry, B. Dmaranan and T. Hertel(1998) CDE Calbraton, Chapter 21 n Robert McDougall, Azz Elbehr, and Truong P. Truong. Global Trade, Assstance and Protecton: The GTAP 4 Data Base, Center for Global Trade Analyss, Purdue Unversty, West Lafayette, Indana

30 Lockwood B. & J. Whalley (2008) Carbon Motvated Border Tax Adjustments: Old Wne n Green Bottles? NBER Workng Paper No , Issued n May Manne, A. S. and R. G. Rchels(1999) The Kyoto Protocol: A Cost-Effectve Strategy for Meetng Envronmental Objectves? n The Costs of the Kyoto Protocol: A Mult-Model Evaluaton, John Weyant (ed.), Specal Issue of The Energy Journal. Meade, J.E.(1955) The Theory of Customs Unons. North Holland, Amsterdam. Mendelsohn, Robert, O.(2006) A Crtque of the Stern Report, Regulaton.(Wnter ), pp OECD(1993) GREEN: The Techncal Reference Manual, Economcs Department, OECD Pars, October, Rezman, R. (1979), A 3x3 Model of Customs Unons. Journal of Internatonal Economcs 9,pp Stern,N. (2006) Stern Revew on the Economcs of Clmate Change. (Cambrdge Unv Press, Cambrdge, UK). Vner J. (1950) The Customs Unon Issue, New York: Carnege Endowment for Internatonal Peace. Walsh, S. & J. Whalley (2008) The Global Negotatng Framework for Clmate Change Mtgaton, paper prepared at CESfo conference n Vence July 2008 on European Global Envronmental Negotatons. Wng, I. S.(2004) Computable General Equlbrum Models and Ther Use n Economy-Wde Polcy Analyss, MIT Techncal Note No. 6, September

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