Existing studies of the impact of carbon pricing on carbon emissions typically ignore the role played by international transportation. This column provides a framework to assess the importance of this sector for carbon leakage across borders and across sectors. The authors identify the importance of asymmetric trade volumes on shipping routes, and the interplay between transportation costs and foreign direct investment choices, in determining the amount of carbon leakage. This shows the need to understand the market environment when designing carbon pricing policies.
Climate change has recently been receiving significant and nervous attention from around the world. Some countries and regions have adopted carbon pricing such as carbon taxes and emissions trading as countermeasures against global warming. However, there is a concern about cross-border carbon leakage when a country introduces carbon pricing. Even if carbon emissions decrease in that country as a result of carbon pricing, carbon leakage increases carbon emissions abroad, and in some cases even increases global emissions. Cross-border carbon leakage undermines a country's attempt to deal with climate change.
The literature has identified the following three main channels of carbon leakage.
- When carbon-intensive goods exporters or importers introduce carbon pricing, the world price of fossil fuels falls, which in turn increases fossil fuel consumption and carbon emissions in other countries (e.g. Bohm 1993, Felder and Rutherford 1993, Kiyono and Ishikawa 2004, 2013, Hoel 2005).
- Firms shift their production plants from countries with carbon pricing to countries with lax emission regulations, thereby increasing carbon emissions in the latter (e.g. Markusen et al. 1993, 1995, Kayalica and Lahiri 2005, Zeng and Zhao 2009, Ishikawa and Okubo 2011, 2016, 2017).
- As carbon-intensive goods producers in countries with carbon pricing lose their competitiveness, foreign rivals increase their production, leading to an increase in their carbon emissions (e.g. Copeland and Taylor 2005, Ishikawa et al. 2012).
International trade and foreign direct investment (FDI) exert an important influence on the channels explained above. In fact, many studies that analyse the effects of emission regulations from a global perspective incorporate international trade and FDI. However, most of those studies do not consider international transport. Those that address the interaction between trade, transport, and the environment assume that the freight rates are exogenously given without an explicit model of the transport sector (e.g. Cristea 2013, Vöhringer et al. 2013, Shapiro 2016).
Furthermore, the amount of carbon emissions created by international transportation itself is too large to ignore. According to the International Maritime Organisation, international transport emitted approximately 920 million tonnes of CO2 in 2018, surpassing Germany's national emissions (the sixth-highest emission in the world). The Paris Agreement, which came into effect in 2016, did not set specific targets for emissions from international transportation. Recently, leaders of several countries and industry associations delivered a series of statements regarding global warming countermeasures related to international transport:
- The International Civil Aviation Organization (ICAO) started the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA) in 2021.
- In May 2021, the EU announced that international aviation and shipping will be included in the Emissions Trading System (ETS).
- In September 2021, the US government announced a goal to reduce aviation-related global warming gas emissions by 20% by 2030.
- In October 2021, the International Air Transport Association adopted a target of virtually zero global warming gas emissions in 2050.
- At COP26, 22 countries sign the Clydebank Declaration to create zero-emission shipping routes.
In a recent paper (Higashida et al. 2021), we theoretically analyse the effect of unilateral carbon pricing on carbon emissions from production, consumption, and international transport by explicitly modelling the international transport sector. Our model is based on the endogenous transport cost literature, which has found that the international transport sector is highly concentrated, with transport firms having market power (Hummels et al. 2009). The transport firms charge asymmetric freight rates on shipping in different directions on the same trade route subject to the backhaul problem. The backhaul problem arises when the transport firm's shipping capacity is not utilised at the maximum level on the backhaul because of asymmetry in trade volumes. Notably, endogenous determination of international transport volumes and prices explains a new mechanism of cross-border and cross-sector carbon leakage.
The effectiveness of carbon pricing depends on the presence or absence of a backhaul problem.
If the exports from country A to country B (the fronthaul) exceed those from country B to country A (the backhaul), the backhaul problem is present. The equilibrium freight rate on exports from B to A is then independent of the marginal costs of shipping (Ishikawa and Tarui 2018). Therefore, even though carbon pricing in shipping raises the effective marginal costs of shipping, it affects the freight rates in an asymmetric manner when the backhaul problem is present. Under this situation, carbon pricing on the transport sector reduces the fronthaul but affects neither the backhaul nor the associated emissions. We show that unilateral carbon pricing on goods consumption is effective. However, carbon pricing on goods production results in ‘positive’ cross-border carbon leakage: country A's carbon pricing on production lowers the fronthaul but increases the production in country B and the backhaul, and hence generates positive cross-border carbon leakage. These changes are conventional, but the endogenous increase in the freight rate mitigates them, meaning the behaviour of transport firms weakens cross-border carbon leakage.
By contrast, if the fronthaul equals the backhaul (i.e. the backhaul problem is absent), we find that both cross-border and cross-sector carbon leakage caused by carbon pricing can be ‘negative.' In other words, carbon pricing can be exceptionally effective because carbon pricing on a sector in a trading country may reduce emissions not only from the target sector but also from other sectors including those in other trading countries. For example, carbon pricing on shipping increases freight rates for both directions, leading to the decrease in both fronthaul and backhaul. Thus, emissions not only from the transport firm but also from the manufacturing firms can decrease, implying that negative ‘cross-sector’ carbon leakage can occur. This observation identifies a new source of carbon leakage due to endogenous transport costs. We also show that if the backhaul problem is absent, any carbon pricing is effective because the global greenhouse gas emissions necessarily decrease.
Our analysis also indicates that carbon pricing on international transport may not reduce overall trade-related emissions once we consider the interplay between endogenous transport costs and manufacturers' decisions on FDI. Faced with a manufacturer that may engage in horizontal FDI (i.e. in local production), the carrier may deter it strategically because the demand for transport decreases if horizontal FDI does not induce any trade in intermediate inputs. Moreover, even if the carrier accommodates such FDI, it prefers FDI with a single foreign plant to FDI with two plants (a domestic and foreign plant) because there is no demand for international transport with two-plant FDI. Thus, the carrier has an incentive to induce single-plant FDI. These strategic moves by the carrier also affect the global emissions.
These findings follow from our theoretical framework, which addresses the interlinkage between trade, transport, and environment by considering the transport sector explicitly. They indicate another benefit of comprehensive regulation of emissions from both production (or consumption) and transport.
We argue that it is important to understand the market environment of the international transport sector when designing carbon pricing. In particular, the backhaul problem impairs not only the efficiency of transportation but also the effectiveness of carbon pricing. The effectiveness of carbon pricing will increase if policies can be taken to eliminate the backhaul problem at the same time as carbon pricing.
Editors' note: The main research on which this column is based first appeared as a Discussion Paper of the Research Institute of Economy, Trade and Industry (RIETI) of Japan.