Optimal pricing for carbon dioxide removal under inter-regional leakage

TL;DR

This paper derives second-best policy rules for carbon dioxide removal subsidies and taxes in a unilateral climate policy context, accounting for inter-regional leakage and market effects, revealing nuanced differences from first-best solutions.

Contribution

It introduces a novel framework for second-best CDR policy design considering inter-regional leakage and market dynamics, highlighting differences from first-best policies.

Findings

Optimal removal subsidy often exceeds the carbon tax due to lower supply-side leakage.

Net carbon exporters favor larger subsidies to increase producer surplus.

Net importers may set subsidies below taxes when damages are small to capture surplus.

Abstract

Carbon dioxide removal (CDR) moves atmospheric carbon to geological or land-based sinks. In a first-best setting, the optimal use of CDR is achieved by a removal subsidy that equals the optimal carbon tax and marginal damages. We derive second-best policy rules for CDR subsidies and carbon taxes when no global carbon price exists but a national government implements a unilateral climate policy. We find that the optimal carbon tax differs from an optimal CDR subsidy because of carbon leakage and a balance of resource trade effect. First, the optimal removal subsidy tends to be larger than the carbon tax because of lower supply-side leakage on fossil resource markets. Second, net carbon exporters exacerbate this wedge to increase producer surplus of their carbon resource producers, implying even larger removal subsidies. Third, net carbon importers may set their removal subsidy even below their carbon tax when marginal environmental damages are small, to appropriate producer surplus from carbon exporters.