Unilateral climate policy and optimal containtment in an open economy

In the absence of a broad international agreement, national climate policies are less efficient, due to carbon leakage, and more costly, due to causing unemployment and a loss of competitiveness on international markets. As, in many countries, a substantial fraction of emissions results from the production of intermediate goods, such as electricity or transportation services, we investigate whether the above negative side-effects can be addressed by a policy mix that (partially) contains the effects of climate policy to the intermediate goods sector. We use a four-sector general equilibrium model to study a policy mix that consists of taxing emissions and subsidizing the intermediate good. We show that such containment is a second-best approach to combat carbon leakage and to maintain a favorable international market position. Also, it can help to reduce climate-policy-induced unemployment.