Carbon taxes lead to downward pressure on fuel export prices.

In the model I assume, realistically, that today not all but only some of the policy-oriented group of countries (the “policy bloc”) have established a climate policy, and in a fully coordinated way. Other fuel-importing countries (the “fringe”) have no policy. They act in an uncoordinated fashion, and each country is small and has no market power. The producer countries as group, and the policy bloc as a group, are however both assumed to behave non-competitively in the fossil fuels markets, so that policies are fully coordinated within each of these two groups. Policies are not coordinated across these two groups. The model is static by focusing on shortrun demand and supply relations. Many further issues are not directly addressed by this paper, in particular, the issue of fossil fuels as exhaustible resources.7 In particular, Sinn’s (2008) “green paradox” argument, that carbon pricing could lead to increased emissions in the short run, is ignored.8

I then show that a tax solution is preferred to a cap-and-trade (c-a-t) solution, for both the policy bloc and the fringe. The difference lies in the response of a monopolistic fuel exporter, setting the fossil fuel export price, to a tax versus the response to a cap. Generally, importers’ demand for fuel will be less elastic when some of these countries set a cap. This effect is stronger when the policy bloc is larger. The demand function will then be less elastic, leading to a higher fuel export price. This hurts both the policy bloc and the fringe.

A focus of this paper is on effects on the fringe of alternative climate policy regimes in the policy bloc. The analysis shows that individual countries in the fringe will fare best when the policy bloc sets a carbon tax, and when the fuel demand from the policy bloc constitutes a large fraction of overall demand. Put otherwise, the smaller the fringe, the more each country in the fringe will benefit from being “free riders” on a carbon tax set by the policy bloc. The reason is that a large policy bloc translates into great market power of this bloc in the fossil fuel markets. The optimal carbon tax is then higher for a larger policy bloc; and it puts more downward pressure on the export price for a given tax. This all translates into a lower fuel export price, which benefits the fringe.

A similar benefit for the fringe, due to a large policy bloc, does not materialize under a cap policy. The fuel export price is then in most cases set higher by exporters when the policy bloc comprises a larger share of total demand, not lower as under a carbon tax.

In the appendix I consider cases where cap set by the policy bloc in the c-a-t case consists of the entire fossil fuel consumption; as is in particular the case when the policy bloc consists of all fuel-importing countries. I show that the equilibrium internal trading price in the bloc’s c-a-t scheme then always equals zero. The best possible solution for the policy bloc is then that achieved in a Stackelberg equilibrium with the policy bloc as leader (setting its cap before the exporter sets its fuel tax). This solution is however still inferior to the tax equilibrium, from the point of view of fuel importers.