On the efficiency of green trade policy

The paper derives conditions for second best environmental policy when there are foreign countries which fail to implement appropriate environmental regulations. It is shown that in such cases, efficiency in the global economy will not be achieved unless domestic environmental regulations are supplemented by trade provisions. The result is independent of whether environmental problems are local or international. Furthermore, when trade provisions are implemented, efficiency requires that domestic environmental taxes are fixed at the Pigouvian tax rate. The results imply that there is an economic rationale for regulating the trade between signatories and non-signatories of international environmental agreements. Efficient trade regulations will either take the form of trade restrictions or trade promotions, depending on whether the environmental problem is created by production or consumption activities, and whether the net import of the relevant commodity is positive or negative. It is argued that an efficient climate agreement, signed by a group of fuel-importing countries (e.g., the OECD countries), should include a subsidy on the import of fossil fuels.