Carbon leakage occurs when companies move their greenhouse gas-emitting production to countries with less strict climate policies to avoid carbon costs. This relocation undermines the environmental effectiveness of the original policy, as it fails to decrease overall global emissions and can harm domestic industrial competitiveness.
Carbon leakage is a critical challenge in global climate policy, describing a situation where stringent environmental regulations in one region cause a rise in greenhouse gas emissions in another. It happens when businesses, particularly in energy-intensive sectors, relocate their operations to jurisdictions with lower or non-existent carbon pricing to reduce costs. The primary concern is that this practice negates the climate benefits of the original policy; instead of reducing total global emissions, it simply shifts them across borders, while potentially leading to job losses and deindustrialization in the environmentally proactive region.
This phenomenon creates a significant dilemma for policymakers and markets like the EU Emissions Trading System (EU ETS). If the price of carbon allowances (like EUAs) becomes too high, it increases operational costs for regulated industries, making them less competitive against foreign counterparts who don't face similar financial burdens.
How Carbon Leakage Occurs
Carbon leakage can manifest in two primary ways:
- Direct Leakage (Production Relocation): This is the most direct form, where a company closes or reduces production in a country with a carbon price and moves its operations to a country without one. For instance, a European cement plant might shut down and open a new facility in a region with no emissions costs.
- Indirect Leakage (Trade and Imports): This form occurs through market dynamics. As carbon costs raise the price of domestic goods, consumers and businesses may switch to cheaper, more carbon-intensive imported alternatives. This increases demand and, consequently, production (and emissions) in the exporting countries with laxer rules.
To combat this, regulatory systems have implemented countermeasures, such as the free allocation of emission allowances to at-risk sectors or, more recently, the introduction of a Carbon Border Adjustment Mechanism (CBAM).
Concrete Examples
Use Case 1: The European Steel Manufacturer
A steel company operating in Germany is subject to the EU ETS and must buy European Union Allowances (EUAs) to cover its CO₂ emissions. As the price of EUAs rises, its production costs increase, making its steel more expensive than steel imported from a country with no carbon tax. To remain competitive, the company might decide to close its German plant and move production to that country, leading to direct carbon leakage.
Use Case 2: Preventing Leakage with CBAM
To solve the problem above, the EU is implementing the Carbon Border Adjustment Mechanism. Under this system, an importer of steel into the EU would be required to buy "CBAM certificates" equivalent to the carbon price they would have paid if the steel had been produced under the EU's rules. This levels the playing field, removes the incentive for the German company to relocate, and ensures that imported goods face the same carbon costs as domestic ones. Learn more about the Carbon Border Adjustment Mechanism (CBAM).
For more official information, you can consult the European Commission's documentation on carbon leakage protection.