Carbon Border Adjustment and Strategic Environmental Quality: Quality Backfire and Market Contraction

Abstract

We develop a two-stage game with vertically differentiated products and endogenous environmental quality to study unilateral carbon pricing and the Carbon Border Adjustment Mechanism (CBAM). A home EU firm and a foreign exporter choose environmental quality, then compete in prices. Under unilateral pricing, only the home firm is taxed, so the foreign exporter’s quality choice responds only indirectly through competition, not a direct tax-saving motive. CBAM corrects this by taxing imports, too. We show that this correction can defeat itself: the same charge that incentivizes upgrading also contracts the foreign firm’s margin and market share, and once the carbon price exceeds a parameter-dependent threshold, this contraction can dominate, leaving the firm choosing lower quality under CBAM than under unilateral pricing. We analytically show that, sufficiently close to free trade, the foreign firm’s equilibrium quality is higher under CBAM than under unilateral pricing, so quality backfire is a finite-carbon-price equilibrium reversal rather than a local artifact, and numerically show that the reversal occurs over a substantial part of the admissible parameter region and survives several robustness checks. A second channel, where CBAM narrows the quality gap, could increase aggregate emissions, but the backfire is not realized in our calibration. The results provide a game-theoretic explanation of how border carbon policies shape strategic quality competition in carbon-intensive trade.