Unilateral Climate Policy and Foreign Direct Investment with Firm and Country Heterogeneity

We analyse the effects of unilateral climate policy in a two-country two-firm model, with endogenous plant location and heterogeneity in both country size and firm’s characteristics. The effectiveness of unilateral climate policy is shown to depend on the joint effect of country and firm heterogeneity, and on their impact on equilibrium location choice. For being effective and not leading to production relocation in the long-run, unilateral climate policy should be moderate, implemented by a sufficiently larger area and complemented by mechanisms promoting the international transfer of clean technologies. The model indicates that the smaller area cannot take the lead in global climate mitigation for a protracted time period. Finally, when the local community is not environmentally concerned, the unilateral policy unambiguously makes the society worse off.