What is carbon leakage in the EU ETS?

Carbon leakage happens when stringent climate policies in one region lead to increased emissions in regions with looser regulations, as industries relocate to avoid compliance costs. Academic research estimates that this can increase global emissions by 0.5 to 3 tons for every 10 tons reduced thanks to climate regulations. Causes for carbon leakage include regulatory disparities, trade exposure, and cost competitiveness, particularly affecting sectors like steel and cement. There is a correlation between the EU Emissions Trading System (EU ETS) and carbon leakage in Europe, especially in energy-intensive industries, with multiple studies confirming this connection. To combat this phenomenon and preserve European industrial competitiveness, the EU introduced the Carbon Border Adjustment Mechanism (CBAM) in 2023 - it imposes equivalent carbon pricing on imports to prevent unfair competition and incentivize global climate policy alignment. The CBAM is estimated to reduce carbon leakage by 19%.

• What is the definition of carbon leakage?
• What are the causes of Carbon Leakage?
• Does the EU ETS cause carbon leakage? 
• Fighting carbon leakage in the EU thanks to the Carbon Border Adjustment Mechanism  

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What is the definition of carbon leakage?

Carbon leakage happens when stringent climate policies in one region lead to an increase in carbon emissions in other regions where the environmental regulations are less strict. Essentially, industries relocate their operations to countries with looser environmental standards to avoid compliance costs - thus, this increases CO2 at one place and offsets the emissions reductions achieved elsewhere. According to academics, (Branger and Quirion (2014) and Carbone and Rivers (2017)), for every 10 tons of carbon avoided in a country thanks to climate policies, CO2 increases by 0.5 to 3 tons in the rest of the world.

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What are the causes of carbon leakage?

Carbon leakage because of regulatory disparities

Differences in climate policies and carbon pricing mechanisms across regions create incentives for businesses to relocate to jurisdictions with lower compliance costs. Below you can see a graph showing the large scope of prices and coverage of carbon pricing mechanisms across the world, providing incentives for businesses to optimize their operations according to the existing carbon prices.

A graph showing the price and scope of coverage of domestic emissions of several ETS across the world

Carbon leakage because of trade exposure

Industries that are highly exposed to international trade are particularly susceptible to carbon leakage. The most concerned are steel and cement manufacturing as they face intense global competition and may relocate operations to evade strict regulations. The 2024 report on carbon leakage risks and the CBAM by the ERCST shows that in the past few years, there has been a rising trend in exported volumes by certain sectors, as a response to carbon pricing in the bloc. 

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Carbon leakage because of cost competitiveness

Companies may also relocate to countries with lower labor and energy costs, along with weaker environmental regulations, to maintain their cost competitiveness. It is therefore hard to distinguish the motivations and ways to tackle carbon leakage - an industry’s carbon intensive activities relocating because of salary expenses should not be treated in the same way as carbon leakage as a result of ambitious cap-and-trade schemes. 

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Does the EU ETS cause carbon leakage? 

The link between the EU ETS and carbon leakage

The EU ETS is the largest emissions trading system globally and plays a crucial role in Europe's efforts to combat climate change. However, concerns about carbon leakage have been a central issue within the EU ETS framework. Many academic papers have studied the question (Chan, Li, and Zhang (2013), Dechezleprˆetre, Gennaioli, Martin, Muˆuls, and Stoerk (2019), aus dem Moore, Großkurth, and Themann (2019)) showing that there is indeed a link between the EU cap-and-trade and industrial relocation. This is especially the case for the energy-intensive sectors where the relocations due to carbon costs have been the highest, as per the EU commission supported association Eurochambres. 

Assessing the carbon leakage importance by academics and institutions 

Carbon leakage has been a longstanding concern among academic and institutional representatives. President of the EU Commission Ursula von der Leyen highlighted the significance of carbon leakage risk, introducing the concept of a Carbon Border Adjustment Mechanism (CBAM) for the first time in her political guidelines in 2019. Subsequently, in 2021, it emerged as a central topic for the European Parliament, which published a resolution addressing the issue. Also since 2021, academics like Marcu, the founder and executive director of the ERCST, have been evaluating carbon leakage matters by assessing and quantifying their expected effectiveness.

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Fighting carbon leakage in the EU thanks to the Carbon Border Adjustment Mechanism  

A reminder on the CBAM, a tool against carbon leakage

The Carbon Border Adjustment Mechanism (CBAM) is a policy tool proposed by the European Union to address carbon leakage concerns. It aims to ensure that imported goods are subject to similar carbon pricing as those produced within the EU, thus preventing unfair competition for domestic industries. Essentially, the CBAM seeks to incentivize global partners to align with the EU's climate goals by encouraging the adoption of comparable carbon pricing mechanisms. It has been introduced in 2023 and will gradually cover larger percentages of the carbon intensity of imported goods. 

Is the CBAM effective in fighting carbon leakage? 

The CBAM came into effect only in May 2023, meaning its impact is yet to be fully gauged and evaluated in the years to come. However, a paper published in 2023 estimates that within a broad framework, including various policy schemes like carbon pricing and revenue usage, the CBAM could potentially reduce carbon leakage by 19%.

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Main takeaways

• Carbon leakage occurs when strict climate policies in one region lead to increased emissions in regions with looser regulations due to industry relocation.
• Academic research estimates that for every 10 tons of carbon avoided through climate policies, global emissions may increase by 0.5 to 3 tons elsewhere.
• Causes of carbon leakage include regulatory disparities, trade exposure, and cost competitiveness, particularly affecting steel and cement sectors.
• The EU introduced the Carbon Border Adjustment Mechanism (CBAM) in 2023 to impose equivalent carbon pricing on imports and prevent unfair competition.
• CBAM aims to align global climate policies with the EU's goals by encouraging the adoption of similar carbon pricing mechanisms worldwide.
• The CBAM's effectiveness in reducing carbon leakage is estimated to be 19%, though its full impact will be assessed in the coming years.

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