Carbon Leakage

Carbon leakage refers to the situation where efforts to reduce greenhouse gas (GHG) emissions in one country or region inadvertently lead to an increase in emissions elsewhere. This typically occurs when stringent climate policies, such as carbon pricing or emissions regulations, raise production costs in one region, causing industries to relocate their operations to countries with weaker or no climate policies. The result is a shift rather than a reduction in global emissions, undermining the overall effectiveness of climate action.

Concept and Meaning

Carbon leakage arises from the global interconnectedness of trade, production, and investment. When countries impose stricter environmental standards, industries facing higher costs may transfer production to regions where compliance is cheaper, leading to emissions being “leaked” across borders.
For example, if a steel factory in Europe relocates to a developing country with lax environmental rules to avoid carbon taxes, the emissions are not eliminated but merely displaced.
Thus, carbon leakage is an unintended consequence of asymmetric climate policies and highlights the importance of global cooperation in emission reduction efforts.

Causes of Carbon Leakage

Several interrelated factors contribute to carbon leakage:

1. Differences in Climate Policies:
   • Countries with stricter emission regulations face higher production costs, while those with relaxed standards become more attractive for investment.
2. International Trade Dynamics:
   • Export-oriented industries subject to carbon pricing may lose competitiveness, encouraging companies to shift manufacturing abroad.
3. Energy Price Differentials:
   • Regions with lower fossil fuel prices or subsidised energy attract carbon-intensive industries.
4. Investment Flows and Capital Mobility:
   • Investors may redirect capital to countries with lower regulatory costs, increasing emissions in those regions.
5. Market Substitution Effects:
   • Reduced production in one country can lead to higher production in another to meet global demand.

Mechanisms of Carbon Leakage

Carbon leakage can occur through three main mechanisms:

1. Production Relocation: Industries move their operations to countries with weaker emission regulations, directly transferring carbon-intensive activities abroad.
2. Changes in Global Fuel Demand: Reduced fossil fuel use in regulated markets can lower global demand and prices, encouraging increased consumption elsewhere.
3. Trade Substitution: Domestic goods facing higher production costs due to carbon pricing are replaced by imported goods from less regulated countries, increasing global emissions.

Sectors Most Affected

Certain industries are particularly vulnerable to carbon leakage because they are both energy-intensive and trade-exposed. These include:

• Steel and Aluminium Production
• Cement and Lime Manufacturing
• Chemicals and Fertilizers
• Petrochemicals and Refineries
• Paper and Pulp

These sectors rely heavily on fossil fuels and face international competition, making them sensitive to changes in energy and regulatory costs.

Measurement of Carbon Leakage

Quantifying carbon leakage is complex. Economists and environmental agencies use models that simulate trade, production, and energy markets to estimate leakage rates.

• The carbon leakage rate is typically defined as:

  Leakage Rate=Increase in emissions outside the regionReduction in emissions within the region×100\text{Leakage Rate} = \frac{\text{Increase in emissions outside the region}}{\text{Reduction in emissions within the region}} \times 100Leakage Rate=Reduction in emissions within the regionIncrease in emissions outside the region​×100

• For instance, if a region reduces emissions by 100 tonnes but global emissions fall by only 80 tonnes, the leakage rate is 20%.

Examples of Carbon Leakage

1. European Union (EU) Emission Trading System (ETS):
   • The EU’s carbon pricing scheme led to concerns that industries such as steel and cement might relocate to non-EU countries.
   • To address this, the EU introduced free emission allowances and, later, the Carbon Border Adjustment Mechanism (CBAM) to prevent unfair competition.
2. Kyoto Protocol and Developing Nations:
   • Under the Kyoto Protocol, developed countries had binding emission targets, while developing countries did not.
   • This policy asymmetry raised fears that energy-intensive industries might shift to developing nations, increasing emissions there.
3. Outsourcing of Manufacturing:
   • Over the past decades, the shift of manufacturing from industrialised nations to emerging economies has effectively relocated emissions rather than reducing them globally.

Consequences of Carbon Leakage

1. Environmental Consequences:
   • Undermines the global effectiveness of emission reduction efforts.
   • Leads to concentration of pollution in developing or less-regulated regions.
2. Economic Consequences:
   • Reduces competitiveness of domestic industries in countries with strict climate policies.
   • Causes potential job losses and deindustrialisation in developed economies.
3. Political and Diplomatic Implications:
   • Creates tension between developed and developing nations over responsibilities and fairness in climate action.

Strategies to Prevent or Mitigate Carbon Leakage

1. Carbon Border Adjustment Mechanisms (CBAM):
   • Introduced by the European Union, CBAM imposes a carbon price on imports based on their embedded emissions.
   • Ensures a level playing field between domestic and foreign producers.
2. Free Allocation of Emission Allowances:
   • Governments may provide free carbon allowances to industries at risk of leakage to maintain competitiveness.
3. International Climate Cooperation:
   • Coordinated global carbon pricing and emission reduction targets can reduce policy asymmetry.
4. Clean Technology Transfers:
   • Promoting low-carbon technologies in developing countries reduces the incentive for industries to relocate.
5. Sectoral Agreements:
   • Establishing international agreements within specific industries (e.g., steel, cement) ensures uniform emission standards globally.
6. Encouraging Renewable Energy Use:
   • Expanding clean energy access worldwide can lower carbon intensity in manufacturing sectors.

Carbon Border Adjustment Mechanism (CBAM) – A Case Study

The European Union’s CBAM, introduced in 2023, is one of the most significant policy tools to address carbon leakage.

• It applies to imports of carbon-intensive goods such as cement, steel, aluminium, fertilizers, and electricity.
• Importers must pay a charge equivalent to the carbon price that would have been paid if the goods were produced under the EU’s Emission Trading System.
• The mechanism aims to:
  • Prevent carbon leakage.
  • Encourage trading partners to adopt cleaner technologies.
  • Maintain competitiveness of EU industries under strict carbon regulations.