Efficient Climate Policy with Internationally Mobile Firms

A major concern in the design of an incomplete climate agreement is thatfirms that use fossil fuels intensively may respond to emission regulationsby relocating their plants from cooperating to non-cooperating countries.This paper analyses how the cooperating countries might deal with the issueof firm delocation through emission taxes, trade provisions and alocalisation subsidy to mobile firms. It is shown that firms should not beinduced to stay in the cooperating countries by lowering emission taxesbelow the Pigouvian tax rate. Incentives to stay should be given partlythrough trade provisions and partly through a localisation subsidy. A secondbest solution without localisation subsidies is also discussed. In thatcase, the efficient emission tax is lower than the Pigouvian tax rate.Finally, the paper discusses the implications of the first best and thesecond best policy regimes for the pattern of firm localisation.