When governments want to cut carbon emissions, they typically rely on one of two tools: a carbon tax, which makes pollution directly more expensive, or an emissions trading system (ETS), which sets a cap on total emissions and allows firms to buy and sell permits. Both approaches put a price on carbon. But our new research shows that they do not work equally well in every context — and that applying the same policy tool across very different economies may produce weaker climate outcomes, or even shift emissions across borders rather than reduce them overall.
The Hidden Problem: Emissions Do Not Always Stay Put
One of the central challenges in climate policy is that emissions reductions in one country do not always translate neatly into lower global emissions. When carbon rules become more stringent, firms may adjust by reorganizing production, relying more heavily on foreign inputs, or shifting some activities to countries with weaker regulations. In such cases, emissions may be displaced across borders rather than eliminated. Economists refer to this broader risk as carbon leakage, and it remains one of the most difficult problems in global climate policy.
This raises an important question for policymakers: when countries tighten carbon rules, do they actually reduce global emissions, or do they partly shift emissions elsewhere through international supply chains? And does the answer depend on which policy instrument they use?
What We Found
Using a multi-country dataset spanning two decades, we examined not only emissions produced at home, but also emissions embodied in trade and in global value chains. This allowed us to trace how environmental policies affected the balance between domestic and foreign sources of emissions embedded in production.
To capture policy ambition, we used the OECD’s Environmental Policy Stringency Index, which provides a comparable measure of how strict climate-related policies are across countries.
A clear pattern emerged. ETS tends to be more effective in richer economies with stronger institutional capacity, whereas carbon taxes appear to work better in developing economies. That pattern does not hold identically in every case, but it is broadly consistent across different regional and sectoral settings.
What makes this finding especially important is that much of the public debate still treats carbon pricing as an abstract choice between two instruments. Our research suggests that this is the wrong starting point. The more important question is whether a country has the institutional capacity, industrial structure, and policy environment needed to make a given instrument work. In other words, climate policy design is not just about choosing between a tax and a market. It is about matching the instrument to the context in which it will be used.
Why the Gap?
The answer lies in institutions. An ETS is not just a policy target; it is a system that depends on functioning markets, credible monitoring, legal enforcement, and administrative capacity. Those conditions are much more common in advanced economies than in developing ones.
That is why ETS tends to work better where regulatory systems are already mature. In those economies, firms can adapt within a stable framework, and emissions cuts are more likely to be real rather than displaced abroad through supply chains.
In developing economies, the same policy can be less effective. Without the necessary institutional foundation, firms may respond not by cutting emissions, but by shifting production structures, increasing reliance on foreign inputs, or moving emissions-intensive activities elsewhere.
A carbon tax is simpler. It does not depend on a trading market, and it gives firms a clearer and more predictable cost signal. For governments still building regulatory capacity, that simplicity can make a major difference.
We also find that rigid non-market regulations such as emissions limits are often less effective than market-based tools, and in some cases may worsen leakage risks by giving firms fewer flexible ways to adjust.
A Roadmap for Developing Countries
For countries at earlier stages of development, the policy lesson is not that they should avoid carbon pricing altogether, but that they may need to begin with a simpler instrument and build institutional capacity over time.
A carbon tax is generally easier to administer. It does not require a permit market, and it provides a more direct and predictable signal to firms. That can give governments time to strengthen the monitoring systems, enforcement capacity, and administrative infrastructure that a well-functioning ETS eventually requires.
Our findings also suggest that carbon pricing alone may not be enough in many developing and transition economies. Investment in clean technology — including renewable energy, green innovation, and energy-efficiency improvements — can play an important complementary role. This appears to be especially relevant in parts of Asia and Eastern Europe, where institutional and industrial conditions make decarbonization more difficult.
International support matters too. Wealthier countries and multilateral organizations can help developing economies build this capacity not only through climate finance, but also through technical assistance and knowledge sharing.
The Bottom Line
Public debate often treats carbon pricing as a simple choice between two policy options. Our research suggests that the real challenge is not choosing between instruments in the abstract, but matching them to national conditions. The effectiveness of carbon pricing depends heavily on a country’s institutions, its economic structure, and its stage of development.
Designing effective climate policy means meeting countries where they are, not where we wish they were. A carbon price that works in Paris may not work in Jakarta. Getting this right is not just a matter of economic efficiency. It is a matter of whether global emissions actually fall, or whether they are simply displaced across borders and along supply chains.
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