Carbon leakage: has Europe scored an own goal?

Posted by Robert Milnes, Consultant - Economics & Emissions Trading on 17 May 2012

Climate policy increasingly involves putting a price on environmental impacts. This can be done by creating a market through politically influenced targets or by estimating the monetary cost of the damage which companies cause to the environment. A pioneering example is the EU Emissions Trading System (EU ETS), which has created a market for carbon, targeting the big emitters in Europe. In principle it is quite simple, the European Commission supplies an amount of carbon credits which politicians agree is Europe’s share of what the global skies can tolerate, and companies buy them up. The more companies emit, the more demand there is for the credits and so the carbon price rises. The idea is that as the carbon price rises, big emitters start thinking about new technologies to reduce emissions to avoid paying the carbon price. Sounds OK?

 

Well, it’s not OK according to many industries caught by the scheme. The EU ETS has been created by the EU and whilst carbon markets exist elsewhere, rarely are they equivalent to the EU ETS. It follows that EU firms are often disadvantaged by this bold scheme compared to foreign firms whose governments have not implemented similar measures for fear of losing competitiveness.

 

This problem of an uneven political landscape for climate change manifests itself in one topical issue: carbon leakage. If the cost of buying your carbon credits increases production costs and forces your output down, foreign suppliers may soak up the demand causing carbon leakage. The term refers to the CO2 emissions which no longer occur in the region under climate policy, but haven’t gone away – they’ve simply leaked elsewhere. Seeing as climate change is a global problem, claims of carbon leakage can seriously undermine climate policies.

 

Is it happening? Well, quite possibly, but read the figures in the press and reports with care. For some of the worst hit sectors carbon leakage rates of 50%-70% are banded around, but this doesn’t mean that 50%-70% of the industry’s emissions have leaked elsewhere. Carbon leakage is gauged as the amount of leaked emissions as a percentage of the total abated emissions within a climate policy zone, so is not as drastic as it first sounds. For example, if a sector reduces its emissions by 200 MtCO2, but 100 MtCO2 of the reduction is in fact due to production seeping elsewhere, the carbon leakage rate would be 50%.

 

Studies on actual evidence are hard to come by because of the complex factors at play when companies make production and location decisions. Was the reduction in output purely due to the climate policy, or was it more down to labour costs and growing markets? Can’t they pass the climate costs on to their consumers? Where have emissions leaked to? For these reasons we often rely on models to predict the effects, and as always, these are underpinned by assumptions.

 

Still, most model assumptions seem to make sense and there is some agreement on carbon leakage rates caused by the EU ETS of around 5% - 30%, although it varies widely between sectors. The upper end estimates occur where production outside the EU is less efficient than that inside the EU and therefore has a disproportionate effect, in fact, it is possible that there would be a net increase in emissions, a kind of own goal for the climate policy team!

 

Of course, it’s not just emissions we should be concerned about. Dips in production affect jobs and the jobs which rely on those jobs. Climate policy can also divert foreign direct investment and affect the balance of imports to exports, which are big macroeconomic players. It is fair to say though that it is the carbon leakage part which is the main headache for climate policy thinkers, because it fundamentally undermines the aims of the policy.

 

AEA and CE Delft looked into the cumulative impact of all the main climate policies which affect EU and UK companies for the UK Department for Business, Innovation and Skills. It gives conclusions for each affected sector and what the main influences on carbon leakage are. You can find the report, The Cumulative Impact of Climate Policy on UK Businesses (2012), here.