Can globalization outweigh free-riding?

We analyze the relationship between trade and the environment in a vertically integrated world economy, an international market structure that deserves further scrutiny given its empirical relevance. Next to the traditional free-riding incentive, we find that the stringency of environmental policy is influenced by terms-of-trade externalities and spillback externalities, where the latter refers to the lack of an incentive by domestic policymakers to fully internalize the international welfare effects of leakage. Moreover, these externalities are magnified if the degree of vertical integration increases. In our setting, carbon leakage is always negative and we find that globalization, as defined as an increase in (i) trade openness and (ii) the degree of vertical integration, has an ambiguous impact on the responsiveness of pollution to local environmental policy. Finally, stronger input-output linkages can mitigate the negative impact of increased openness to trade on global environmental quality. Globalization ; Trade and Environment ; Carbon leakage ; Climate Policy ; Input-Output