Understanding Carbon Leakage
One of the most persistent concerns about carbon pricing is carbon leakage: the risk that emissions reductions in one jurisdiction are offset by increases elsewhere. This lesson explains what leakage is, how it happens, and how significant a problem it really is.
What Is Carbon Leakage?
Carbon leakage occurs when carbon pricing in one jurisdiction causes emissions to increase in another, reducing the net global climate benefit.
The basic dynamic:
- A country imposes carbon pricing
- Domestic production becomes more expensive
- Some production shifts to countries without carbon pricing
- Emissions occur in the new location instead
- Global emissions may be unchanged or even increase
Leakage is like squeezing a balloon. Press on one side (carbon pricing) and the air (emissions) bulges out the other side (unregulated jurisdictions). The total air in the balloon does not change; it just moves.
Types of Leakage
Leakage can occur through several channels:
Production leakage
Facilities relocate to avoid carbon costs. An aluminum smelter closes in Europe and reopens in Southeast Asia.
Investment leakage
New investment goes to unregulated jurisdictions. A planned cement plant is built in Africa instead of Europe.
Market share leakage
Domestic producers lose market share to imports. European steel is displaced by imports from countries without carbon pricing.
Resource leakage
Reduced demand for fossil fuels in one region lowers global prices, increasing consumption elsewhere.
Not all types of leakage are equally important. Production leakage (actual facility closures) is rare. Market share leakage (imports replacing domestic production) is more common but often gradual.
How Significant Is Leakage?
The empirical evidence on leakage is more reassuring than many assume:
What research shows:
- Actual production relocation due to carbon pricing has been rare
- Most studies find small or no leakage effects from existing policies
- Carbon costs are typically small relative to other location factors
- Labor, infrastructure, and market access matter more for location decisions
Why leakage is often overestimated:
- Industry has incentive to exaggerate the threat for political purposes
- Theoretical risk is higher than realized risk
- Other factors constrain relocation (skilled labor, supply chains, infrastructure)
- Many industries are not actually trade-exposed
Multiple studies have examined whether carbon pricing causes leakage:
EU ETS studies:
- Most find no statistically significant evidence of production relocation
- Some find small effects on imports in specific sectors
- Overall, EU industrial production has not declined due to carbon costs
California cap-and-trade:
- No evidence of significant leakage to other states
- Manufacturing employment stable
- Some effects possible in highly mobile sectors
Nordic carbon taxes:
- Decades of experience with high carbon taxes
- No evidence of industrial flight to lower-tax jurisdictions
- Manufacturing remains competitive
Why the gap between fear and evidence?
- Carbon costs are small relative to total production costs (typically 1-5%)
- Relocation is expensive and risky
- Skilled labor and infrastructure are not easily replicated
- Supply chain proximity matters
- Existing facilities have sunk costs
But caution is warranted:
- Studies examine relatively modest carbon prices
- Higher prices might have larger effects
- Some sectors (aluminum, cement, steel) are more vulnerable
- Forward-looking decisions (new investment) may differ from backward-looking (existing facilities)
Factors That Affect Leakage Risk
Not all industries are equally at risk. Key factors include:
Carbon intensity
Higher carbon costs as a share of production costs means greater leakage risk.
Trade exposure
Industries that compete with imports or export significantly face more leakage risk.
Product transportability
Commodities that ship easily face more risk than products consumed locally.
Capital mobility
Industries with mobile capital face more risk than those with fixed infrastructure.
| Industry | Carbon intensity | Trade exposure | Leakage risk |
|---|---|---|---|
| Cement | High | Moderate (heavy to transport) | Moderate |
| Steel | High | High | High |
| Aluminum | Very high | Very high | Very high |
| Chemicals | Moderate-high | High | High |
| Refining | High | Moderate | Moderate |
| Paper | Moderate | Moderate | Moderate |
| Electricity | Varies | Low (not traded) | Low |
| Services | Low | Varies | Low |
Calculating Leakage Exposure
Many jurisdictions use quantitative measures to identify leakage-exposed sectors:
Carbon cost indicator
Carbon cost / Gross Value Added
Measures how significant carbon costs are relative to economic value created.
Trade intensity
(Exports + Imports) / (Production + Imports)
Measures how exposed the sector is to international trade.
Combined assessment
Sectors with both high carbon costs and high trade intensity are considered leakage-exposed and may receive special treatment.
EU ETS leakage assessment:
The EU classifies sectors as at risk of carbon leakage based on:
Quantitative criteria:
- Carbon cost intensity > 30% of GVA, AND
- Trade intensity > 10%
OR
- Carbon cost intensity > 5% of GVA AND trade intensity > 30%
Sectors on the carbon leakage list receive:
- 100% free allocation at benchmark
- Protection from full auctioning
About 40 sectors are currently on the EU carbon leakage list.
Leakage vs Competitiveness
Leakage and competitiveness are related but distinct concerns:
Competitiveness:
- Domestic producers facing higher costs
- May lose market share, profitability, or employment
- Concern even without actual emissions relocation
Leakage:
- Emissions actually increase elsewhere
- Undermines environmental benefit
- Only occurs if production actually moves
A domestic industry can lose competitiveness without causing leakage if the lost production is not replaced by foreign production. Conversely, leakage requires both lost domestic production AND replacement by foreign production.
Why Leakage Matters
Even if leakage is small in practice, it matters for several reasons:
Environmental integrity
If emissions just move rather than disappear, climate policy has failed.
Political sustainability
Fear of leakage undermines support for carbon pricing. Industries cite leakage risk to oppose policy.
Fairness
If some countries price carbon and others do not, responsible actors are penalized.
Long-term concern
Higher carbon prices in the future may create larger leakage pressures.
The Good News
Several factors limit leakage in practice:
Increasing carbon pricing coverage
As more countries adopt carbon pricing, there are fewer places to leak to.
Border adjustments
Mechanisms like the EU CBAM reduce leakage incentives by pricing imports.
Technology spillovers
Clean technologies developed due to carbon pricing eventually spread globally.
Complementary policies
Industrial policy and competitiveness measures can reduce leakage pressure.
Looking Ahead
Understanding leakage risk is the first step. The next lesson examines how to assess competitiveness risks systematically, identifying which sectors and activities warrant protection.