Carbon leakage

Putting a price on greenhouse gas emissions runs the risk of “carbon leakage”, which occurs when companies move production to markets with less onerous environmental regulations. Governments seek to avoid carbon leakage through free allocation, tax-free allowances, and exemptions. But such measures mean that companies are not as incentivized to cut their emissions, running counter to climate targets.

Climate policies such as carbon pricing impose costs on companies to spur decarbonization. This increases the risk that domestic companies relocate to countries where they would face lower environmental costs. Such a move would shift those companies’ carbon emissions offshore, weakening the impact of the carbon price and reducing the original country’s economic competitiveness. Governments with a carbon price have sought to mitigate this risk in various ways. In some carbon markets, such as China’s emissions trading programs, participants receive a share of their emission allowances as free allocation, while some taxes, like those in Canada and South Africa, include exemptions or reduced tariffs for certain sectors.

In the EU Emissions Trading System, the European Commission has devised a list of sectors at significant risk of carbon leakage. The amount of free allocation for each participant is calculated based on production quantity and a benchmark value for that product in terms of emissions per metric ton. The EU has been steadily decreasing the volume of free allocation, and sectors less exposed to carbon leakage will see free allocation phased out after 2026, from a maximum of 30% to zero by 2030.

Governments around the world are starting to consider emissions linked to imported goods. Markets like the EU, Japan and US have much higher emissions embedded in imports than those produced domestically. This has raised the question of carbon import tariffs. More information on such mechanisms can be found in the dedicated factsheet.