Japan's Reaction to the Eu's Carbon Pricing Policy – an Economic-Environmental Analysis

Abstract

The European Commission’s proposal for a Carbon Border Adjustment Mechanism (CBAM) to strengthen the existing Emissions Trading System (ETS) is a policy initiative that has the potential to impact carbon emissions outside of the EU. The question is whether CBAM does indeed provide an incentive to third countries to change their production technology or even to strengthen their domestic carbon pricing policy. We develop a theoretical framework and numerical simulation to investigate this question and consider Japan’s potential responses to the mechanism. Does Japan stand to gain the most from 1) Cooperating with the EU and introducing its own ETS, 2) Staying neutral with no policy response to CBAM, or 3) Contesting CBAM and introducing ‘retaliatory tariffs’ on certain European imports? We evaluate these three scenarios using a two-country stylised model of Japan and the EU as well as a numerical CGE simulation. In this numerical simulation, we introduce a sophisticated carbon pricing structure to accurately mimic the EU’s ETS and the proposed CBAM. The stylised model and the numerical simulation show that CBAM may reduce the world supply of CBAM products and their relative prices, which would worsen Japan’s terms of trade. However, due to Japan’s relatively low carbon intensity for the production of CBAM products, European importers may start importing more CBAM products from Japan and consequently, Japan may gain economic welfare. Lastly, the EU’s CBAM may lead to an increase in Japanese carbon emissions unless Japan increases its domestic carbon price and forms a “carbon club” with the EU.

Keywords: Carbon border adjustment mechanism, international trade, computable general equilibrium modelling, EU, Japan, Carbon Emissions