Optimal containment and policy differentiation under unilateral climate policy

Without a broad international agreement, climate policy is less effective due to carbon leakage. We investigate whether this negative effect can be addressed by partially containing the policy’s effects to intermediate goods sectors, such as electricity or transportation services. We use a three-sector model to study a policy that taxes emissions caused by intermediate goods production while subsidizing the intermediate good. We characterize the optimal containment policy for combating carbon leakage and show that it complements the concept of policy differentiation.