Environmental Protection for Sale: Strategic Green Industrial Policy and Climate Finance

Abstract

Industrial policy has long been criticized as subject to protectionist interests; accordingly, subsidies to domestic producers face disciplines under World Trade Organization agreements, without exceptions for environmental purposes. Now green industrial policy is gaining popularity as governments search for low-carbon solutions that also provide jobs at home. The strategic trade literature has largely ignored the issue of market failures related to green goods. I consider the market for a new environmental good (like low-carbon technology) whose downstream consumption provides external benefits (like reduced emissions). Governments may have some preference for supporting domestic production, such as by interest-group lobbying, introducing a political distortion in their objective function. I examine the national incentives and global rationales for offering production (upstream) and deployment (downstream) subsidies in producer countries, allowing that some of the downstream market may lie in nonregulating third-party countries. Restraints on upstream subsidies erode global welfare when environmental externalities are large enough relative to political distortions. Climate finance is an effective alternative if political distortions are large and governments do not undervalue carbon costs. Numerical simulations of the case of renewable energy indicate that a modest social cost of carbon can imply benefits from allowing upstream subsidies.

Appendices

Appendix: Analytical Results

To avoid tedious algebraic manipulations, the optimal and Nash solutions are solved in Mathematica using the linear functional forms, and the results are reported here. To provide core intuition without unnecessary complications, the reported results generally assume symmetric producer countries. The notebook file with proofs is available from the author upon request.

No Downstream Externality

Proof of Proposition  1(b)

We can simplify the expressions for the welfare derivations with our functional forms and solve for the Nash equilibrium. The effect of the third-party market is best seen with the assumption of symmetry across the producing countries: that is, $m_1 =m_2 =(1-m_3 )/2.$

When $\omega >0$, the symmetric Nash solution is

$$\begin{aligned} \eta _i^{\mathrm {Nash}} (0,\omega )= & {} m_3 \frac{hb(a-c+w)}{Z}>0 \\ \gamma _i^{\mathrm {Nash}} (0,\omega )= & {} -\eta _i^{\mathrm {Nash}} +\omega \end{aligned}$$

where $Z=(b+h)^{2}+m_3 h(2(b+h)-hm_3 )$

Furthermore, $\gamma ^{\mathrm {Nash}} >0$ if

$$\begin{aligned} \omega >m_3 \frac{hb(a-c)}{Z}. \end{aligned}$$

Thus, the larger the third-party market share, the higher is this threshold for wanting a positive upstream subsidy.

When $v_i =0$, and $\omega =0,$ the symmetric Nash solution yields

$$\begin{aligned} \eta _i^{\mathrm {Nash}} (0,0)= & {} m_3 \frac{hb(a-c)}{Z}>0 \\ \gamma _i^{\mathrm {Nash}} (0,0)= & {} -\eta _i^{\mathrm {Nash}} <0 \end{aligned}$$

Thus, we see the tax/subsidy shift is strictly increasing in $m_3$. It is also increasing in h, at least initially. Furthermore, when $m_3 =0$ and $\omega =0,$ symmetric countries have no subsidies in equilibrium.

1.1 Discussion of Asymmetric Firms

For this case of $m_3 =0$ and $\omega =0,$ with no third-party region, the asymmetric Nash solution yields

$$\begin{aligned} \gamma _1^{\mathrm {Nash}}= & {} -\eta _1^{\mathrm {Nash}} =\frac{(a-c)bh\Delta _m }{2(b+h)(b+h+h\Delta _m )}=\eta _2^{\mathrm {Nash}} =-\gamma _2^{\mathrm {Nash}} \\ Y^{\mathrm {Nash}}-Y^{*}= & {} -\frac{(a-c)bh\Delta _m ^{2}}{2(b+h)(b+h+h\Delta _m )^{2}}<0 \end{aligned}$$

where $\Delta _m =m_1 -m_2$ is the extent to which region 1 has a larger market share.

Downstream Externality

For the proof of optimal strategies without and with an externality, we derive the analytical solutions in Mathematica and report simplified results here.

Proof of Proposition 3

Although the value of an individual subsidy is a complicated expression, without relying on the symmetry assumptions, with our functional forms, $\eta _i^{\mathrm {Nash}} +\gamma _i^{\mathrm {Nash}} =u_i v_i +\omega$.

For example of the individual subsidies, when $v_i =v,i=\{1,2\},$and $\mu _i =\mu ,\,\forall i,$ the symmetric Nash solution yields

$$\begin{aligned} \eta _i^{\mathrm {Nash}} (v)= & {} \eta _i^{\mathrm {Nash}} (0)+\frac{vub(b+h(1+m_3 ))}{Z}>0 \\ \gamma _i^{\mathrm {Nash}} (v)= & {} \gamma _i^{\mathrm {Nash}} (0)+vu-\frac{vub(b+h(1+m_3 ))}{Z}<0 \end{aligned}$$

Proof of Proposition 4

This result essentially requires $\mu _3 >0$ and $m_3 >0.$ We show the result for the case of symmetric producer countries that value the externality at the global value (that is, $v_2 =v_1 =v_G$ and $m_1 =m_2 =(1-m_3 )/2)$, and when the marginal external benefit is the same across countries $(\mu _i =\mu \,\forall i)$, so the location of deployment does not matter. The difference in global deployment is a function of the difference between the Nash and globally optimal upstream subsidies, as well as the political distortion:

$$\begin{aligned} Y^{\mathrm {Nash}}-Y^{*}=\frac{m_3 (\gamma ^{Nash}-\gamma ^{*})}{b+h}+\frac{(1-m_3 )}{b+h}\omega \end{aligned}$$

If $\omega =0,$ then $\gamma ^{\textit{Nash}}<\gamma ^{*}$ and $Y^{\textit{Nash}}<Y^{*}$. If the political distortion is large enough, deployment may be even higher with the Nash equilibrium among strategic countries. However, if $\mu _3 >\mu$, there is the additional problem that strategic countries deploy too little abroad, reducing the external benefits achieved under the Nash equilibrium.

Contributions to Climate Finance

Proof of Proposition 5

If the planner cannot use upstream subsidies, the optimal contributions, split equally, are

$$\begin{aligned} f_i ^{*}=\frac{\mu _3 v_G }{2} \end{aligned}$$

and the optimal downstream subsidies in producing countries remain the same.

Proof of Proposition 6

In the unconstrained (subscript u) symmetric Nash equilibrium with $v = 0$,

$$\begin{aligned} \eta _u^{\textit{Nash}}= & {} -m_3 \frac{bh(a-c+\omega )}{Z_2 }<0 \\ \gamma _u^{\textit{Nash}}= & {} \omega -\eta _u^{\textit{Nash}} >0 \\ f_u^{\textit{Nash}}= & {} -\frac{b(b+h)(a-c+\omega )}{Z_2 }<0 \\ \end{aligned}$$

where $Z_2 =\left( {3(b+h)-hm_3 } \right) \left( {b+h-hm_3 } \right) >0$.

Proof of Proposition 7

In the restricted (subscript r) symmetric Nash equilibrium with $\mu _i =\mu ,\,\forall i$,

$$\begin{aligned} \eta _r^{\textit{Nash}}= & {} \frac{-m_3 bh(a-c)+\left( {3(b+h)-2hm_3 } \right) (\omega +2\mu )}{Z_2 } \\ f_r^{\textit{Nash}}= & {} \frac{-b(2b+h)(a-c)+b\left( {b+2h-hm_3 } \right) (\omega +2\mu )}{Z_2 } \\= & {} \eta _r^{\textit{Nash}} -\frac{b(a-c+\omega +2\mu )}{3(b+h)-hm_3 } \\ \end{aligned}$$

If $\mu _3 \ne \mu ,\quad f_r^{\textit{Nash}} >\eta _r^{\textit{Nash}}$ if

$$\begin{aligned} \mu _3 >\mu +\frac{b(a-c+\omega +2v\mu )}{v(b+h+hm_3 )} \end{aligned}$$