The effect of carbon taxation on cross-border competition and energy efficiency investments

Carbon taxes increase costs for energy-consuming firms and can impact firms‘ ability to compete with other firms located in regions without that tax. This paper considers the effect of asymmetric carbon taxation when firms are able to adjust their energy efficiency investment levels to reflect the presence of the tax. Using a dynamic model of firm competition, we find that allowing firms to adjust their energy efficiency levels in response to a carbon tax could potentially allow firms to significantly mitigate the competition effects of that carbon tax. In our baseline parameterization, additional energy efficiency investments non-trivially mitigates profit loss for the firm facing the carbon tax as well as spurring adding energy efficiency investments in the non-taxing jurisdiction, thus reducing carbon leakage. This increase in energy efficiency can potentially reduce total energy usage by the firm in the taxing jurisdiction by more than the carbon tax alone. While the quantitative impact of energy efficiency investments on firm competitiveness depends on the nature of the industry, from a policy standpoint, the ability of energy efficiency investments to mitigate cross-border emissions leakage and negative competition effects without policy interventions such as a carbon border tax softens these two common criticisms of unilateral regional carbon taxes.