Exports or foreign direct investment? A multinational firm’s production decision under carbon border adjustment mechanism

Abstract

The Carbon Border Adjustment Mechanism (CBAM) has occurred in the European Union (EU) since October 2023. It aims to reduce carbon leakage from an overseas supplier who exports emission-intensive materials (e.g., steel) to the EU multinational firm (MNF). The MNF competes with the foreign manufacturer and chooses to export products to the overseas market or make foreign direct investment (FDI) for overseas production. In this paper, we build game-theoretical models comprising one overseas supplier, one MNF, and one foreign manufacturer and analyze the MNF’s production decision (exports or FDI) under the CBAM. Our findings indicate that the CBAM certificate price changes the MNF’s production decision. When the CBAM certificate price is sufficiently high (low), the MNF will be more likely to make FDI (exports) as the CBAM certificate price increases. Implementing the CBAM effectively reduces European carbon leakage and global carbon emissions. Such effectiveness increases with the CBAM certificate price. Moreover, an all-win situation in the EU market could be achieved in Case FDI when the unit manufacturing cost in the EU is moderate, and such an outcome is more likely to be realized with the increased CBAM certificate price when the CBAM certificate price is high. Based on real data from the European Energy Exchange, our simulation results suggest that the MNF in the cement and aluminum (steel) industries should prioritize importing materials with lower carbon emission intensity when engaging in FDI (exports) to align with the European 2030 Climate Target Plan.

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