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๐Ÿ’ฐ Carbon Pricing
Managing ImpactsLesson 1 of 65 min readCarbon Tax Guide Ch 7.2; ETS Handbook Step 5

Understanding Carbon Leakage

Understanding Carbon Leakage

One of the most persistent concerns about carbon pricing is carbon leakage: the risk that emissions reductions in one jurisdiction are offset by increases elsewhere. This lesson explains what leakage is, how it happens, and how significant a problem it really is.

What Is Carbon Leakage?

Carbon leakage occurs when carbon pricing in one jurisdiction causes emissions to increase in another, reducing the net global climate benefit.

The basic dynamic:

  1. A country imposes carbon pricing
  2. Domestic production becomes more expensive
  3. Some production shifts to countries without carbon pricing
  4. Emissions occur in the new location instead
  5. Global emissions may be unchanged or even increase

Leakage is like squeezing a balloon. Press on one side (carbon pricing) and the air (emissions) bulges out the other side (unregulated jurisdictions). The total air in the balloon does not change; it just moves.

Types of Leakage

Leakage can occur through several channels:

Production leakage

Facilities relocate to avoid carbon costs. An aluminum smelter closes in Europe and reopens in Southeast Asia.

Investment leakage

New investment goes to unregulated jurisdictions. A planned cement plant is built in Africa instead of Europe.

Market share leakage

Domestic producers lose market share to imports. European steel is displaced by imports from countries without carbon pricing.

Resource leakage

Reduced demand for fossil fuels in one region lowers global prices, increasing consumption elsewhere.

Not all types of leakage are equally important. Production leakage (actual facility closures) is rare. Market share leakage (imports replacing domestic production) is more common but often gradual.

How Significant Is Leakage?

The empirical evidence on leakage is more reassuring than many assume:

What research shows:

  • Actual production relocation due to carbon pricing has been rare
  • Most studies find small or no leakage effects from existing policies
  • Carbon costs are typically small relative to other location factors
  • Labor, infrastructure, and market access matter more for location decisions

Why leakage is often overestimated:

  • Industry has incentive to exaggerate the threat for political purposes
  • Theoretical risk is higher than realized risk
  • Other factors constrain relocation (skilled labor, supply chains, infrastructure)
  • Many industries are not actually trade-exposed

Multiple studies have examined whether carbon pricing causes leakage:

EU ETS studies:

  • Most find no statistically significant evidence of production relocation
  • Some find small effects on imports in specific sectors
  • Overall, EU industrial production has not declined due to carbon costs

California cap-and-trade:

  • No evidence of significant leakage to other states
  • Manufacturing employment stable
  • Some effects possible in highly mobile sectors

Nordic carbon taxes:

  • Decades of experience with high carbon taxes
  • No evidence of industrial flight to lower-tax jurisdictions
  • Manufacturing remains competitive

Why the gap between fear and evidence?

  1. Carbon costs are small relative to total production costs (typically 1-5%)
  2. Relocation is expensive and risky
  3. Skilled labor and infrastructure are not easily replicated
  4. Supply chain proximity matters
  5. Existing facilities have sunk costs

But caution is warranted:

  • Studies examine relatively modest carbon prices
  • Higher prices might have larger effects
  • Some sectors (aluminum, cement, steel) are more vulnerable
  • Forward-looking decisions (new investment) may differ from backward-looking (existing facilities)

Factors That Affect Leakage Risk

Not all industries are equally at risk. Key factors include:

Carbon intensity

Higher carbon costs as a share of production costs means greater leakage risk.

Trade exposure

Industries that compete with imports or export significantly face more leakage risk.

Product transportability

Commodities that ship easily face more risk than products consumed locally.

Capital mobility

Industries with mobile capital face more risk than those with fixed infrastructure.

IndustryCarbon intensityTrade exposureLeakage risk
CementHighModerate (heavy to transport)Moderate
SteelHighHighHigh
AluminumVery highVery highVery high
ChemicalsModerate-highHighHigh
RefiningHighModerateModerate
PaperModerateModerateModerate
ElectricityVariesLow (not traded)Low
ServicesLowVariesLow

Calculating Leakage Exposure

Many jurisdictions use quantitative measures to identify leakage-exposed sectors:

Carbon cost indicator

Carbon cost / Gross Value Added

Measures how significant carbon costs are relative to economic value created.

Trade intensity

(Exports + Imports) / (Production + Imports)

Measures how exposed the sector is to international trade.

Combined assessment

Sectors with both high carbon costs and high trade intensity are considered leakage-exposed and may receive special treatment.

EU ETS leakage assessment:

The EU classifies sectors as at risk of carbon leakage based on:

Quantitative criteria:

  • Carbon cost intensity > 30% of GVA, AND
  • Trade intensity > 10%

OR

  • Carbon cost intensity > 5% of GVA AND trade intensity > 30%

Sectors on the carbon leakage list receive:

  • 100% free allocation at benchmark
  • Protection from full auctioning

About 40 sectors are currently on the EU carbon leakage list.

Leakage vs Competitiveness

Leakage and competitiveness are related but distinct concerns:

Competitiveness:

  • Domestic producers facing higher costs
  • May lose market share, profitability, or employment
  • Concern even without actual emissions relocation

Leakage:

  • Emissions actually increase elsewhere
  • Undermines environmental benefit
  • Only occurs if production actually moves

A domestic industry can lose competitiveness without causing leakage if the lost production is not replaced by foreign production. Conversely, leakage requires both lost domestic production AND replacement by foreign production.

Why Leakage Matters

Even if leakage is small in practice, it matters for several reasons:

Environmental integrity

If emissions just move rather than disappear, climate policy has failed.

Political sustainability

Fear of leakage undermines support for carbon pricing. Industries cite leakage risk to oppose policy.

Fairness

If some countries price carbon and others do not, responsible actors are penalized.

Long-term concern

Higher carbon prices in the future may create larger leakage pressures.

The Good News

Several factors limit leakage in practice:

Increasing carbon pricing coverage

As more countries adopt carbon pricing, there are fewer places to leak to.

Border adjustments

Mechanisms like the EU CBAM reduce leakage incentives by pricing imports.

Technology spillovers

Clean technologies developed due to carbon pricing eventually spread globally.

Complementary policies

Industrial policy and competitiveness measures can reduce leakage pressure.

Looking Ahead

Understanding leakage risk is the first step. The next lesson examines how to assess competitiveness risks systematically, identifying which sectors and activities warrant protection.

Knowledge Check

1.What is the foundation of any carbon pricing system's integrity?

2.What are the three components of MRV?

3.What is continuous emissions monitoring (CEMS)?

4.Why is third-party verification important?

5.What is the typical MRV approach for small emitters?