with David Weisbach and Michael Wang

We consider climate policy by a country called Home in a world with international trade in energy and in manufactured goods produced with energy and labor. Assuming that Home's trading partner Foreign is passive, we derive an optimal unilateral policy to confront the global externality from manufacturing's combustion of carbon-based energy.  Our solution strategy combines techniques from Markusen (1975) and from Costinot, Donaldson, Vogel, and Werning (2015). We interpret the optimal policy as a particular set of taxes and subsidies. The key features are: (i) Home institutes a carbon tax equal to its damages from emissions, raising the cost of energy for its manufacturers relative to the price received by its energy extractors; (ii) this Pigouvian tax is the sum of an extraction tax and a production tax on the use of energy; (iii) a border adjustment on the energy content of imported manufactured goods, equal to the production tax, leaves Home's consumption decisions undistorted; (iv) the mix between the extraction and production tax is optimized to reduce carbon leakage and to improve Home's terms of trade; (v) energy taxes are not removed at the border for exports, but instead Home subsidizes exports of goods in which its comparative advantage is weak while taxing those where its comparative advantage is strong; (vi) Home expands exports of manufactures on the extensive margin, potentially even exporting goods that it also imports.  A novel feature of the optimal policy is how Home exploits international trade in manufactured goods to expand the reach of its climate policy. Through its tax policy Home indirectly controls how energy is used in producing both its imports and its exports.

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