The Kyoto Protocol and EU Competitiveness

A common fear is that environmental policy will induce relocation of energy-intensive firms. This fear is amplified by the decision of the USA to withdraw from the Kyoto protocol. Moreover, relocation puts the effectiveness of Kyoto into doubt, because of increased carbon leakage. This paper demonstrates that relocation will not occur at a large scale provided that the environmental policy is designed efficiently. To quantify the effects of climate change policies we apply the general equilibrium model WorldScan. Given international trade in emission permits and the USA not ratifying the Kyoto protocol, compliance costs turn out to be modest on average. However, the effects differ across EU countries and impacts for energy-intensive sectors are large, relative to energy-extensive sectors. There is a trade-off between minimizing relocation effects and minimising welfare effects. Specific policies aimed at mitigating the negative effects for energy-intensive sectors introduce inefficiencies leading to higher costs for the economy as a whole. This applies in particular to the EU-proposal for emissions trade. The paper shows that exempting some sectors from a carbon tax raises the costs of climate policy. The paper also addresses an important linkage between climate policy and other ‘energy policies’. The interaction between climate policy and existing energy taxes turns out to be important. Excessive taxes on liquid fuels raise the cost of climate policies and deteriorate EU-competitiveness.