Carbon Leakage: The Problem CBAM Solves
Why this lesson matters
Carbon leakage is the central market failure that CBAM was designed to correct. Understanding it precisely - not just intuitively - is the prerequisite for understanding every other design choice in the regulation.
The Core Problem: Unequal Carbon Costs
When the European Union raises the cost of emitting carbon dioxide for its own industries, it creates an asymmetry. EU producers must pay for each tonne of CO₂ they emit through the EU Emissions Trading System (EU ETS), while producers in countries with weaker or no carbon pricing face no equivalent cost. That gap in regulatory burden is not simply an abstract policy concern - it has concrete commercial consequences.
A European steelmaker that must purchase EU ETS allowances at, say, €65 per tonne of CO₂ carries a cost of production that a competitor based in a country with no carbon price does not. In a globally competitive commodity market, this difference can tip purchasing decisions, investment flows, and ultimately production locations.
The Tilted Playing Field
Imagine two runners in a race. One runs uphill - paying a real cost for every step forward. The other runs on flat ground. Both produce the same product (reaching the finish line), but one carries a burden the other does not. Carbon leakage is what happens when the uphill runner simply decides to start at the bottom of the hill instead - moving production abroad to avoid the climb.
Two Channels of Carbon Leakage
The CBAM Regulation (Recital 6) identifies two distinct mechanisms through which carbon leakage occurs:
- Relocation of production: EU-based companies shift manufacturing to countries with less stringent climate policies, where they can produce the same goods at lower total cost. The emissions do not disappear - they simply occur outside the EU, beyond its regulatory reach.
- Import substitution: Even without relocation, EU products can be displaced in the market by cheaper imports from countries where production carries no carbon cost. The EU manufacturer loses market share without moving anywhere - the leakage happens through trade flows rather than investment decisions.
Both channels undermine EU climate policy in the same fundamental way: they allow global emissions to remain the same (or increase) even as the EU reduces its territorial emissions. The EU achieves its domestic targets on paper while the atmosphere sees no net benefit.
Which Sectors Are Most at Risk?
Not all industries face equivalent leakage risk. The European Commission assesses carbon leakage exposure based on two factors: the carbon intensity of production (how much CO₂ is emitted per tonne of output) and the trade intensity of the sector (how much of global supply crosses international borders). Sectors that score high on both dimensions are most vulnerable.
| Sector | Why High Carbon Intensity | Why High Trade Intensity |
|---|---|---|
| Cement | Calcination of limestone releases CO₂ chemically, not just from fuel | Regional trade flows; sea freight makes import viable |
| Steel (iron and steel) | Blast furnace route requires coking coal at high temperatures | Global commodity market with established trade routes |
| Aluminium | Electrolysis is extremely electricity-intensive | Primary aluminium traded globally as a commodity |
| Fertilisers | Ammonia synthesis consumes large quantities of natural gas | Urea and ammonia widely traded internationally |
| Electricity | Fossil fuel generation is CO₂-intensive | Cross-border electricity interconnections enable import |
| Hydrogen | Steam methane reforming is gas-intensive | Emerging global hydrogen trade routes |
How the EU ETS Previously Addressed the Problem
Before CBAM, the EU's primary tool for managing carbon leakage risk was the free allocation of EU ETS allowances to sectors deemed at risk. Under Article 10a of the EU ETS Directive, industries on the carbon leakage list received a portion of their emission allowances at no cost, rather than having to buy them all at auction. This reduced - but did not eliminate - their carbon cost disadvantage relative to non-EU competitors.
Free allocation was always understood as a transitional measure. It dampens the competitive impact of carbon pricing, but it also dilutes the environmental signal: producers who receive free allowances have less financial incentive to invest in decarbonisation technologies. Recital 12 of the CBAM Regulation explicitly links the gradual phase-out of free allocation to the phase-in of CBAM as the preferred long-term solution.
Economists quantify leakage risk using the concept of the carbon leakage rate: for every tonne of CO₂ reduced domestically, how many tonnes are added abroad? A rate of 100% means the domestic reduction is entirely offset by foreign increases - climate policy achieves nothing. A rate of 0% means no leakage occurs.
Empirical estimates vary widely by sector and methodology. Studies suggest that for sectors like steel and cement, leakage rates without protective measures could range from 5% to 30% under moderate carbon prices, rising steeply as prices increase. These ranges drove the political urgency behind CBAM.
The 2021 EU Impact Assessment (SWD(2021) 643) estimated that, under a scenario where the EU increases ambition to 55% emission reductions by 2030 without border measures, carbon leakage risks would intensify materially for key industrial sectors.
Why CBAM Is the Structural Solution
CBAM addresses carbon leakage at its source by ensuring that imports of carbon-intensive goods into the EU carry a carbon cost equivalent to what an EU producer would pay. It does not prevent trade, restrict imports, or impose punitive tariffs. It simply ensures that the carbon cost embedded in a product's production is priced consistently, whether that product was made in Germany or in a country with no carbon pricing at all.
This approach has two simultaneous effects. First, it protects the competitive position of EU producers by levelling the carbon cost playing field. Second, it creates a global incentive for foreign producers to reduce the emissions intensity of their production - because the lower their embedded emissions, the lower their CBAM liability when exporting to the EU.
Concrete Example: Steel from India vs. Germany
Suppose the EU ETS carbon price is €70/tonne CO₂. A German steelmaker producing 1 tonne of steel with 1.8 tCO₂ of direct emissions pays roughly €126 in carbon costs per tonne of steel (ignoring any residual free allocation). An Indian steelmaker producing the same tonne of steel with 2.5 tCO₂ (a less efficient production process) paid nothing in carbon costs before CBAM. Under CBAM, the Indian producer's EU-bound exports now carry a certificate cost calculated on the 2.5 tCO₂ embedded - approximately €175 per tonne of steel. The playing field is substantially levelled, and the Indian producer has a concrete financial incentive to invest in lower-carbon steelmaking.
Key Takeaways
- 1Carbon leakage occurs when EU climate ambition causes production or market share to shift to countries with weaker carbon pricing, so that global emissions are not reduced even as EU territorial emissions fall
- 2Two channels drive leakage: relocation of production facilities abroad, and import substitution of EU goods by cheaper, carbon-intensive imports
- 3Sectors most at risk combine high carbon intensity of production with high trade intensity - cement, steel, aluminium, fertilisers, electricity, and hydrogen
- 4Free allocation of EU ETS allowances was the previous leakage protection tool, but it was transitional and weakened the decarbonisation price signal
- 5CBAM solves the problem structurally by placing an equivalent carbon cost on imports, creating a level playing field and a global incentive for cleaner production