Nationally and Internationally Optimal Climate Policies: External Balances versus Environmental Preferences

This article compares nationally optimal to internationally optimal (Pareto efficient) emission permit levels in a two-country overlapping generations model with national emission permit systems and the environment as a global public good. When each government maximizes its steady state economic and environmental welfare and one country is a net foreign creditor and the other one a net foreign debtor, it is nationally optimal for the creditor country with sufficiently high environmental preferences to chose a stricter permit level than the debtor country. However, the resulting Nash equilibrium permit levels are not Pareto efficient. Depending on the direction and strength of the countries' differences in external balances and environmental preferences, Pareto efficiency mandates that their permit levels are either adjusted in opposite directions or reduced in both. (JEL codes: F59; Q54; D62).