Welfare-optimal policy response to border carbon adjustments: An emerging economy perspective

Abstract

We develop a Melitz-style model of asymmetric countries to analyse how a trading partner's border carbon adjustment affects the welfare costs of raising a domestic carbon price in the exposed country. By examining how a unilateral increase in emissions taxes affects endogenous productivity cut-offs, we show that a border carbon adjustment reduces these costs through a reversal of the partner's export cut-off, thereby expanding imported consumption. This welfare-smoothing effect depends on structural asymmetries such as energy intensity, productivity dispersion, and average productivity, and interacts with conventional tariff policy. Extending the model with environmental damages, we show that a border carbon adjustment raises the exposed country's welfare-optimal carbon price, generating a policy alignment plateau between trading partners. Calibrating the model to India using firm-level data, we quantify these mechanisms in a three-region extension and show that the EU Carbon Border Adjustment Mechanism can effectively reduce India's relative welfare costs of carbon price convergence.