<p>The World Trade Organization (WTO) permitted subsidies for environmental protection in the past; however, such subsidies are subject to countervailing duties under the current rules. We examine the policy game with production subsidies and countervailing duties on environmental goods to clarify the effects of permitting retaliation. The consumption of environmental goods generates transboundary positive externalities, while their production requires dirty intermediate goods that cause local pollution. We find that retaliation by the home government with an import tariff, including a countervailing duty, may fail to deter the foreign government from subsidizing environmental goods. Compared with the case of no retaliation, both countries’ environments may deteriorate in the policy game because home retaliation reduces the consumption of foreign-firm-made environmental goods with high environmental performance. We consider the trade policy game with retaliation and find that the optimal foreign policy can be an export subsidy, which sharply differs from the well-known result. As extensions, we discuss the case of imperfect competition and trade in upstream, transboundary pollution associated with upstream production, and an upstream production tax and a downstream consumption subsidy.</p>