25 April 2018
Carbon Leakage in the Post-Paris Landscape
By Enrica De Cian and Ramiro Parrado
Climate policies are designed to set a price on the external costs of the greenhouse gas (GHG) emissions mostly linked to the use of fossil-fuel-based energy in production processes. Increasing the production costs of pollution-intensive activities is therefore a necessary and desired output1.
Yet heterogeneity in explicit and implicit carbon prices, across both countries and sectors, can create competitiveness distortions, which can induce production to move across jurisdictions, as well as across sectors. This creates, what is known in literature as, “carbon leakage”, the increase in emissions in the unregulated sector or jurisdiction per unit of emissions reduced in the regulated sector or jurisdiction. If production is not able to move, carbon price differentials can induce industries to lobby for preferential treatments, unless policies are designed to explicitly accommodate the interests of business sectors that could be impacted.
While a few exceptions of neutral carbon taxes have been implemented in a few jurisdictions, such as in British Columbia and Sweden, preferential rules allocating free allowances to leakage-prone industries has been a key strategy for mitigating political opposition in the EU as well as in Californian cap-and-trade system2. The upshot is that concerns about competitiveness effects and carbon leakage have been shaping the way climate policy has been implemented, with the potential risk of limiting the cost–effectiveness of those policies.
Evidence on Competitiveness Effects and Carbon Leakage
Since 1990, we have been observing large variation in carbon prices, from low values as US$ 1 per tonne of CO2 equivalent (tCO2e) up to US$ 126/tCO2e in Sweden3. Many Scandinavian and European countries have also had very high fuel taxes which, although are not directly designed for responding to the climate threat, act as a climate tax surrogate4.
Though analysis of historical data, several studies have investigated whether environmental regulations and carbon prices have had a negative impact on various competitiveness indicators, such and trade, employment, productivity. Overarching conclusions have not found evidence supporting that hypothesis. With the majority of emissions covered by climate policies are priced at less than 10$/tCO2e5, at this price the costs of environmental regulation is only a small share of total production costs.
When more ambitious policies are simulated using energy-economy models that allow for assessment of counterfactual scenarios (referred to as ex-ante studies), the evidence for carbon leakage is actually quite irrefutable. Understanding why opposite conclusions are reached is a research priority for the scientific community that can have policy implications as well. More research is needed in order to empirically confirm the model assumptions that seem to drive this difference, such as the modelling of trade and industrial structure, of innovation, and international spillovers of technologies and knowledge.
What is interesting to note is that both ex-post studies based on the historical evidence and as well as results from model simulations suggest that climate policy induces significant technological change and innovation6, and that if the policy-induced advancements in technology and knowledge are spread across countries, carbon leakage is actually reduced7, and can become even negative8.
Directions for Future Research
The Paris climate agreement reached in December 2015 represents an unprecedented commitment to address climate change with increasingly ambitious mitigation actions. Of the 162 Nationally Determined Contributions (NDCs) submitted under the Paris Agreement, more than 90 include proposals of carbon-pricing systems9. The large-scale participation to the Paris Agreement might reduce price differentials over time and create a fertile playing field for linking diverse regional, national and sub-national climate policies through a future international agreement10.
In this context, competitiveness concerns need to be assessed and addressed in a different way from the past, where only a handful of countries were committed to fight climate change. In a context of growing policy ambition issues, such as technological change, innovation and spillovers should be the focus of policy action, as they could enable improvements to competitiveness in low carbon industries that would eventually spread to the rest of the economy. Other policy design alternatives could include opening an innovation fund for industry, to further develop low-carbon technologies that reduce carbon leakage risk, when revising EU carbon leakage rules.
Over the course of the COP21RIPPLES project, research teams will examine policy solutions to address leakage and competitiveness concerns related to consumption-based pricing, while paying attention to channels that facilitate negative leakage, such as technology diffusion and innovation.
Enrica De Cian is a Researcher at Fondazione Centro Euro-Mediterraneo sui Cambiamenti Climatici (CMCC)
Ramiro Parrado is a Senior Researcher at Fondazione Centro Euro-Mediterraneo sui Cambiamenti Climatici (CMCC)