Emissions Leakage, Environmental Policy and Trade Frictions

We develop a two-good general equilibrium model of a small open economy to decompose effects of a unilateral strengthening of environmental policy in a country on pollution emissions in the rest of the world, known as emissions leakage. We show analytically and numerically that the level of emissions leakage crucially depends upon the level of trade frictions in the service sector. In the model, production in the manufacturing sector is associated with pollution emissions and production in the service sector is clean. We solve for the amount of leakage from a small strengthening in environmental regulation. In a special case with free trade in manufacturing and no trade in services there is no leakage. Allowing for trade in services, we analytically solve for three effects of environmental regulation on emissions leakage: income, output and terms of trade. The income effect generates negative leakage while the output and terms of trade effects generate positive leakage. We solve for the relationship between trade frictions in the service sector and leakage, and show that at lower levels of service sector trade friction, leakage from a small strengthening of environmental regulation decreases (increases) if services are imported (exported). Finally, we calibrate the model to the Canadian economy to estimate relative sizes of these effects. We find that leakage is about eighteen percent lower when using trade friction levels estimated from the literature rather than assuming no trade frictions in services.