Economic assessment of Carbon Leakage and Carbon Border Adjustment

The European Union is the world’s largest importer of virtual CO2-emissions: its net imports of goods and services contain more than 700 million tons of CO2 emitted outside of the EU’s territory. This is more than 20 % of the EU’s own territorial CO2 emissions. Therefore, shifting carbon pricing away from pricing the EU’s territorial emissions to pricing the EU’s CO2-footprint (by means of carbon border adjustment) enhances the reach of European climate policy activities and increases their effectiveness for promoting global abatement activities. The above result relies only on the EU being a net importer of CO2 emissions embodied in international trade. It does not rely on the answer to the question, whether stronger unilateral CO2 mitigation efforts in the EU cause the imports of embodied carbon to increase (direct carbon leakage). Direct carbon leakage refers to the possibility that stringent unilateral CO2 policies in the EU, e.g. in the form of high carbon prices or regulatory measures, might lead to an increase in the carbon imports embodied in trade of goods and services: as European firms’ relative production costs are driven up relative to firms in non-committed foreign countries, domestic production is replaced by imports and domestic emissions are replaced by foreign ones. This compromises the effectiveness of the EU’s climate policies and endangers jobs and value added in exposed sectors. Ex post evaluations of existing carbon policies arrive at mixed conclusions. On the one hand, emission pricing in the EU ETS, so far, is mostly not found to cause direct carbon leakage. On the other hand, studies based on a broader focus of climate policies (not just carbon prices) suggest that measures, e.g., in the context of the Kyoto Protocol, have indeed led to carbon leakage. In countries that have committed to emission targets, imports of goods have gone up by about 5 % and the carbon-intensity of imports has gone up by 8 %. Ex-ante predictions by simulation models indicate that direct leakage is indeed likely. Its size depends on the difference between the EU’s carbon prices and those of its trading partners. On average, studies indicate that about 15 % of domestic emission savings are offset by additional foreign emissions. However, the range of estimates is very large. In most studies, indirect carbon leakage that operates through global markets for fossil fuels, however, is quantitatively more important than direct carbon leakage operating through international markets for goods and services. Ex-ante models show that carbon border adjustment can reduce carbon leakage. In complete setups, it can fully eliminate direct leakage. It does little to reduce leakage through energy markets, or to incentivise countries to engage into more ambitious climate policies. Results depend crucially on the design of the mechanism. Moreover, simulations also show that the adjustment burden is shifted to non-abating countries, many of which are poor and underdeveloped. The note concludes that carbon leakage is an empirically relevant concern. Carbon border adjustments (CBAs) can lower carbon leakage occurring through goods markets. CBAs need to be treated very carefully because they might provoke retaliation by non-committed countries and because they may shift the burden of adjustment to poor countries. In the context of the EU ETS, one promising strategy could be to grant free allocations of emission permits to leakage-prone industries but combine this with a consumption tax, applied to domestic and foreign goods produced by those exempted industries.