The impacts of carbon leakage can be bothenvironmental and socio-economic. Carbon leakage is caused by “asymmetricalclimate policies” (Marcu A, 2013, pg. 5). What is meant by this is thatpolicies that have a price for carbon emissions in one region, while anotherregion has no, or a more relaxed, climate policy and price causes carbonleakage. This is because if carbon emission policies of a country raise thecost of local emission, then another country with a more relaxed carbonemissions policy would have a comparative advantage.
Carbon Leakage increasesfirms cost by attempting to make firms internalise the negative externalitiesthey cause i.e. the pollution they produce. This leads to increases in costscausing firms to move to regions with more relaxed carbon emission policieswith cheaper costs. Rather than incentivising firm cleaner production andinnovation, the carbon-pricing could lead firms to move abroad as there arecheaper forms of production (because climate and emission policies are notcurrently universal policies). Due to this, it is clearly arguable that by notacknowledging carbon leakage, carbon emission policies can lead to innovationfailure as firms will simply move to another country with a more relaxedclimate policy and pollute more in other regions. A possible solution for thisis that policies that aim to tackle carbon leakage need to be universal or facethe potential of carbon emission policies failing to be implementedcorrectly. One system that is aiming to reduce carbon leakageis the European Union Emissions Trading System (EU ETS).
This is achieved bysetting carbon prices, such as the ‘cap-and-trade’. The EU ETS has a ‘cap andtrade’ system which aims to reduce not only regional but also global carbonemissions (reference). The EU ETS setsan aggregate emissions limit of particular greenhouse gases that can be emittedby the EU participants who are involved and covered by the system. The cap isreduced over time so that in total, emissions too will fall over time. What is meant by this is that the EU ETS aimsto cap the overall level of emissions allowed to be produced by setting anaggregate emission limit. Within that limit, participants in the system areable to buy and sell permits as they need it. These permits are the trading’currency’ of the system. The gradual cap on the total number of permitscreates scarcity for these allowances in the market.
This scarcity ofallowances means that the allowances will increase in price as there is lesssupply of them. This high price for the scarce allowances incentivises firms toproduce fewer carbon emissions in order to reduce their need for the permits.However, if the demand for a firm’s goods remains the same, production may moveabroad to a cheaper country with lower emission standards, and global emissionswill not be reduced – they may even potentially increase. The risk of carbonleakage to some extent weakens the environmental outcomes; while at the sametime can lead to a decline in domestic production with a decrease inemployment. This could be a major socio-economic issue as if firms move anddecide to invest abroad to reduce their costs, the amount job opportunitieswould decrease for citizens living in a region with high carbon emission costs.
The climate is a global public good and thus needsglobal collaboration in maintaining it. Due to this, initially the bestapproach to tackling carbon emissions would appear to organising all countries topay equivalent carbon emission costs– similar to the EU ETS, but a globalversion. However, evident from the climate negotiations in Copenhagen (2009),it is clear as to how difficult it can be to get all 180 countries to agree toequal and simultaneous action. It is increasingly clear that the climate issueand regional and national climate policies cannot wait for global action if we aimto solve the climate problem.
Yet differential action generates concerns thatcarbon intensive producers might move outside of regions imposing a carboncost, causing carbon emissions and economic activity to ‘leak’ outside of theseregions. However, theEU ETS currently “operates in 31countries (all 28 EU countries plus Iceland, Liechtenstein and Norway)” (Climate Action – EuropeanCommission, 2018). Despite the EU ETS not having allcountries as participants to its scheme, it is clear that the EU ETS isattempting to reduce carbon leakage as by increasing the number of countriesthat participate in the scheme it is evident that it acknowledges that carbonleakage is more than a regional or national issue – it is a global issue.However, if all countries takeinto consideration carbon leakage whilst designing climate policies, as morecountries implement climate policies such as carbon pricing, carbon leakagesmay reduce and potentially may even disappear. If it carbon leakage does arise,it can have the possibility of having detrimental environmental and socio-economicconsequences. Carbon leakage could undermine a carbon-pricing policy’senvironmental objective by causing emissions to increase in regions beyond thereach of the policy.
The opportunity cost between preventing carbon leakage andthe other uses of the fiscal resources can help balance political interests.For instance, if public citizens understand that there is a relationshipbetween the help provided to firms to reduce the risk of carbon leakage and thefiscal resources available for other uses, including to support households, itmay help decision makers make more balanced decisions. In addition to this,actions being made to address carbon leakage usually involve the use of fiscalresources that could be used for other purposes e.g. to compensate householdsor other general uses of revenue.
This trade-off often requires to some extenta level of political judgment providing the incentive for different intereststo persuade decision makers.