Environmental Policy Instruments Response to Trade Shocks

How do environmental policy instruments respond to trade shocks? Emerging studies show that the surge of low-cost exports from China has led to downward pressure on the price of traded goods (Kamin, Marazzi, and Schindler, 2006; Amiti and Freund,2010; Mandel, 2013). China's entry into the world economy has led to a big movement in the terms of trade and an increase in imports in much of the rest of the world. We ask how such fluctuations in the terms of trade affect the choice of environmental policy instruments. The existing literature that evaluates environmental policy instruments' merits under uncertainty employs a closed-economy framework. This limits their ability to address this question. We analyze the properties of environmental policy instruments under uncertainties for an economy open to international trade and capital flows. We document the economic responses to environmental regulation under uncertain economic growth and unanticipated import surges. To do so, we develop a small open economy (SOE) dynamic stochastic general equilibrium (DSGE) model that incorporates three environmental policy instruments which are certainty equivalent in emissions: cap-and-trade, pollution tax, and an emission intensity standard, which sets an allowed emissions level per unit of output. We introduce exogenous temporary productivity shocks to simulate uncertain economic growth and an exogenous temporary terms-of-trade shock to simulate an unanticipated import surge. We then compare the effects on key macroeconomic variables -welfare, pollution levels, outputs, consumption, investment, supply of labor and trade flows -in the economy across cap-and-trade, pollution tax, and emissions intensity standard policy instruments. Our results suggest that cap-and-trade policies reduce the business cycle's intensity relative to a pollution tax or intensity target. This is consistent with the findings of Fischer and Springborn (2011); Annicchiarico and Dio (2015) in closed economy models. Allowing the regulated economy to access global product and investment markets does not affect the key findings of the existing literature. More interestingly for a terms of trade shock all three policy instruments have a similar impact on key economic variables like consumption and employment. The cap-and-trade policy is most effective in reducing the surge in imports. In this way cap-and-trade policies can act as an unintended trade barrier, reducing the severity of import competition during times when it is most intense.