Inefficient environmental instruments and the gains from trade

The primary result from the trade and environment literature is that countries never lose from trade liberalization as long as they implement optimal pollution targets or if they hold emissions constant. These results are derived in models where the regulators use efficient instruments such as tradable permits or emission taxes. Regulators, however, continue to prefer command and control instruments. I show that regulation under these inefficient instruments (such as design standards or concentration standards) can lead to net losses under trade liberalization even if emissions are optimally adjusted for trade. Furthermore, holding the line on emissions need not guarantee welfare improvements either. The problem is that institutional distortions, the excess costs of inefficient instruments, can rise with trade and offset the material gains from trade. Hence the presumption that we can achieve gains from trade by considering only the level of emissions fails to recognize that the mode of regulation also matters.