Carbon leakage provides an efficiency argument for unilateral climate policy to differentiate emission prices in favor of emission-intensive and trade-exposed sectors. At the same time, differential emission pricing can be (mis-)used as a beggar-thy-neighbor policy to exploit terms of trade....

We build a two regions general equilibrium model with cross-border pollution and either international or only inter-regional capital mobility. To control pollution each region uses public pollution abatement and issues either intra-regionally or inter-regionally tradable emission permits. We...