“The Optimal Design of Climate Agreements”

How can we design a climate agreement that implements the optimal climate policy? In the presence of inequality, trade leakage effects and policy constraints, the lack of climate cooperation and free-riding incentives are exacerbated. Through the lens of an Integrated Assessment Model (IAM) with heterogeneous countries and bilateral trade, I study the taxation of carbon when countries can deviate and exit climate agreements. Participation constraints create a policy tradeoff between an intensive margin — a “climate club” with few countries implementing  large emission reductions — and an extensive margin — accommodating a larger set of countries at the cost of lowering the carbon tax. As in Nordhaus (2015), trade sanctions for non-participants are crucial to ensure the stability of the coalition. I solve for the optimal design of the club, and despite complete freedom in policy instruments — carbon tax and tariffs — one cannot achieve the world’s optimal policy with complete participation. It can be beneficial to leave several fossil fuels producing and developing countries outside of the climate agreement. I explore how transfers, as proposed in the COP’s loss and damage fund, can increase abatement and welfare by mitigating the adverse redistributive effects of climate change and carbon taxation.