Domestic Carbon Pricing Coordination Under CBAM: Resource Reallocation, Green Innovation, and Policy Synergy

Abstract

CBAM is reshaping the external conditions under which open economies pursue decarbonization, raising new questions about how domestic carbon pricing can remain effective while supporting sustainability. We develop an environmental DSGE model for a small open economy with a cleaner green sector and an emissions-intensive brown sector, an endogenous green innovation margin, and a banking sector that prices sector-specific transition risk through credit spreads. Carbon pricing affects the economy through relative prices and resource reallocation, while CBAM acts as an export-revenue wedge that weakens cash flows in exposed activities and tightens financing conditions. In the baseline, a coordinated increase in the domestic effective carbon price cuts emissions quickly and shifts investment toward the green sector, with aggregate activity recovering as reallocation proceeds. Under CBAM, the near-term contraction is deeper, and the spread spikes more, but endogenous green innovation and a policy mix that combines targeted green credit support with macroprudential measures deliver a smoother adjustment and the largest welfare gains. The results suggest that coherent policy packages linking carbon pricing, innovation support, and financial stability are central to managing the transition in an open economy.