What can we do about carbon leakage?

Part 5 in our Putting a price on carbon series

In this installment of our series on carbon pricing, we take a closer look at carbon leakage — an issue that emerges from differences in carbon prices in an integrated global economy.

1 What is carbon leakage?

Carbon leakage is a term to describe the escape of emissions from one production or consumption site to another. It results from the differences in climate regulation or carbon prices between different jurisdictions — cities, states, countries, or regions.

It stems from consumers’ and producers’ inclination to prefer goods from locations or production in places with less strict rules or smaller carbon prices, making them cheaper. Carbon leakage comes via two different channels: a direct and an indirect one.

2 What is direct carbon leakage?

Direct carbon leakage relates to shifts of emissions due to shifts in production and investment. Assume that country A puts a higher price on carbon than country B. As a result, consumers from country A demand more imports from country B, driving up the production and emissions in B and driving it down in A.

In the long run, companies from country A might even choose to set up new production sites in country B, thus further accelerating this trend. If this process produces a net carbon reduction or increase depends largely on the carbon efficiency of the production technology in countries A and B.

Small and open economies, such as Ireland or Denmark, are usually prone to direct carbon leakage since foreign trade makes up a relatively large share of their economic activity.

3 What is indirect carbon leakage?

Indirect leakage is the more subtle and often overlooked channel of carbon leakage. As a result of higher carbon prices in country A, production in country A goes down.

Therefore, also energy consumption goes down, for example, in fossil fuels. If country A has a rather big economy, the decline in demand will also drive down prices on the world energy market. Therefore, indirect carbon leakage is more common in countries like the US or China.

As a result of falling energy prices, it becomes cheaper for all other countries to consume fossil fuels, thus driving up their demand and emissions in these countries. However, prices are likely to surge back quickly because of this increase in demand.

4 What is the carbon leakage rate?

The concept of a carbon leakage rate was introduced to measure the scope of carbon leakage. Assume that the rise in carbon prices in country A results in reducing A’s emissions by 100 tons of carbon. As a result of carbon leakage, the emissions in the rest of the world rise by 15 tons.

Then, the carbon leakage rate for this increase in carbon prices is 15 percent, meaning that 15 percent of the emissions saved in country A have escaped to other countries. So, the net saving of global carbon emissions stands at only 85 tons.

5 What is the scope of carbon leakage?

The empirical evidence on the scope of carbon leakage is ambiguous. Different calculations range from 5 to 30 percent for developed economies. They are particularly prone to leakage since they can usually afford higher carbon prices or stricter climate standards than developing countries.

The size of leakage also depends on the costs of trade, most importantly tariffs and transportation, the intensity of competition between firms in a market or sector, and the options of substitution for the goods whose price has increased.

6 Why is carbon leakage a growing problem?

Today’s relatively low leakage rates are primarily a result of low and often symbolic carbon prices. Except for a couple of European economies, carbon prices are currently below 20 dollars per ton of carbon.

However, with the climate emergency increasing and developed countries setting more ambitious emission targets, price difference and carbon leakage rates are likely to rise. The ultimate challenge will be to keep leakage rates below 100 percent to ensure that the positive effects of climate measures in one country are not more than offset by the negative side-effects in other countries.

7 What can we do about carbon leakage?

The ultimate remedy is, of course, a global carbon price. It would create a level-playing field of environmental costs and eliminate carbon leakage altogether. However, it would put a heavy burden on developing countries and specific industries and is therefore unlikely to be implemented.

A second-best or interim solution could be a carbon border adjustment mechanism (CBAM). Countries with high carbon prices could levy an import tax, which depends on the carbon intensity of the good and the carbon price level of the trading partner.

This would help reduce leakage and increase the competitiveness of industries hit hard by high carbon prices.

Our next blog post will present the findings from our study on how different carbon pricing schemes, including a global carbon price and a European carbon border adjustment mechanism, playout — for global emissions, national incomes, and leakage rates.

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