Does the EU ETS provoke carbon leakage?
Summary
Carbon leakage, where companies relocate to avoid stringent climate policies, undermines emissions reduction efforts. The EU ETS combats this through free allowance allocation and the Carbon Border Adjustment Mechanism (CBAM), ensuring fair carbon pricing and encouraging global climate policy alignment for responsible investment. These sustainable finance policies aim to support investing in sustainable development and reduce the risk for impact companies.
The opposite of a first mover advantage? Being a pioneer in climate policies can be challenging - carbon leakage occurs when companies relocate to regions with less stringent climate policies for financial reasons. The good news is that the European Union Emissions Trading Scheme (EU ETS) improvements are actively combating this phenomenon.
What is carbon leakage?
Carbon leakage occurs when strict climate policies in one region lead to increased emissions in regions with looser regulations. This phenomenon happens as industries relocate to avoid higher compliance costs associated with stringent environmental policies. The result is a net increase in global carbon emissions, undermining the efforts of regions with more stringent regulations. For every 10 tons of carbon emissions reduced in these regions, it is estimated that 0.5 to 3 tons can increase elsewhere due to carbon leakage.
Sectors at risk of carbon leakage
Certain sectors within the EU ETS are particularly vulnerable to carbon leakage due to their high energy consumption and significant exposure to international trade. These sectors include steel, cement, aluminum, and chemicals. Even if there can be several reasons for such companies to relocate (for example to regions with lower labor costs), the biggest relocation risk engendering carbon leakage is driven by the cost of carbon markets compliance.
Carbon leakage in the EU ETS, empirically
Many academic and institutional studies have documented the actual presence of carbon leakage linked to the EU ETS. Research shows that energy-intensive industries, in particular, have shown a propensity to relocate production outside of the EU to avoid compliance costs. Such papers are confirming that carbon leakage is not just a macroeconomic theory, but a real-life potential risk for the EU’s cap-and-trade system.
The EU ETS improvements to combat carbon leakage
A first strategy of the EU ETS to address carbon leakage and preserve the competitiveness of European firms, is the allocation of free European Union Allowances (EUAs) to sectors at high risk of carbon leakage. These free allocations help mitigate the additional costs incurred by these sectors due to carbon pricing. Another important mechanism is the introduction of the Carbon Border Adjustment Mechanism (CBAM) in 2023. It aims to level the playing field by imposing a carbon price on imports equivalent to that faced by EU producers. This makes sure that imported goods are subject to similar carbon costs. The CBAM also incentivizes non-EU countries to adopt comparable carbon pricing mechanisms, thus contributing to global climate policy alignment.
There is no such thing as too ambitious climate policies given the urgency of the climate crisis. Fighting climate change should be a collective effort, and the EU ETS ensures the economic viability of the current system while achieving effective decarbonization.
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