CARBON LEAKAGE: CURRENT CHALLENGES AND POTENTIAL SOLUTIONS

Carbon based emissions are now proven to be a harmful by-product to humans and the environment. An excess of CO2 in the atmosphere, in addition to an increase in the average global temperature with catastrophic consequences already experienced today, affects the health of the individual in several ways: blood acidification, lower cognitive performance, muscular tremor and shortness of breath.               

The question then arises: what is being done to facilitate the ecological transition and reduce the use of carbon?

In this regard, in 2005 the European Union launched the European Trading System (ETS) with the aim of promoting technological change by putting a price on carbon. Over time, the system has led to various achievements: in 2020, the emissions of the sectors of interest where reduced by 22%, compared from levels of 2005, with sustained economic growth of 58%.
Nevertheless, it must be said that these goals concern only those countries that joined the system, leaving the door open to a particular concern known as carbon leakage.


Specifically, carbon leakage is the situation where a decrease in CO2 emission in a regulating country leads to an increase of CO2 emission elsewhere. The phenomenon is explained by two channels:

  • EITE channel(emission-intensive and trade-exposed industries), where tight environmental regulation reduces the competitiveness of industries.
  • Fossil-fuel channel, where a reduction in demand – due to climate policy – causes globalfossil-fuel prices to become depressed. As a result, prices will plummet, increasing the attractiveness for less-strict countries to become more carbon intensive.

The consequences of carbon leakage on market is clearly shown by a graph designed by Carolyn Fischer in Options for avoiding carbon leakage.

Two aspects can be extracted:

Where ROW = Rest of the world. As a result of carbon pricing by a coalition, the price of fossil fuel falls and the demand shifts inwards. However, the reduction in prices reduces the consumption in regulated countries but rises in ROW.
  • A loss in competitiveness of emission-intensive industries in the single country or bloc of countries where environmental standards are higher;
  • A gain in competitiveness of emission-intensive industries in those countries with laxer environmental regulations. Hence, those countries welcome all the companies that decide to reallocate their activities.

How to deal with carbon leakage?

Identifying carbon leakage is not easy. Empirical studies demonstrated that a reduction of100 units of CO2 in a regulatted country leads to an increase of 5-30 units of CO2 in non-regulating countries.
However, many variables must be considered (economic crises, internal policies of each country, technological progress, etc.) if we want to arrive at a figure that is as reliable as possible. In this regard, there are several hypotheses that could be analysed to avoid this wasteful transfer of CO2 emissions

1.INTERNATIONAL TECHNOLOGY SPILLOVER

We know that production processes are one the key contributors of CO2 emissions. However, we also know that these production processes differ from country to country for various reasons, such as investment, human development, policies to preserve national environmental resources, etc. Considering the multiple disparities among countries, we understand that it would be utopian to think that it would be easy to force environmental standards at a global level.

On the other hand, we could help those countries where green technologies are still far from being taken seriously, through investments and export and, thus, diffusion of such green models.

With respect to this topic, the degree of substitutability of non-renewable resource is fundamental when talking about sustainability, as it explains how relative intensity of production factors changes as relative prices changes. In fact, as the non-renewable resource becomes scarcer, their prices increases. Here, there would be two options:

  • Where the elasticity is high, meaning that there are several ways of substituting the finite resource, small changes in relative input prices will determine a large change in the quantities of inputs used. The concern of resource scarcity will be solved by the ability of the economy to replace the scarce resource by the reproducible substitute.
  • Where the elasticity is low, resource scarcity has more serious side-effects, as substitution possibilities are more limited.

Strong backstop technology – a technology capable of solving the problem of scarcity rent through the development of new sustainable ideas (ex. hybrid cars) – is the key the make consumption socially optimal.

Nowadays, several initiatives have been presented, such as the Energy Efficiency Programms, with the goal to improve the energy efficiency of high-emitting industries, or InnovFin, created in 2014 to facilitate the financing of innovative research projects through soft loans for companies dealing with new technologies. Not to be underestimated is the European Green Deal, whose aim is to mobilise around 1,000 billion euro to finance the European green transition over the next ten years, and 100 billion of euro to implement a fair transition to help those regions that will be most affected by such change.

2. OUTPUT-BASED REBATING

EITE sectors are included in the carbon pricing system, but receive discounts based on their production, according to a benchmark. For instance, Europe focused on low-emission companies, setting a benchmark of 10%. The discount would work as a production incentive for such companies. However, there is still the question of consumer response, as they would have less incentive to buy less-intensive goods. The risk would be to lose a segment of those who are more inclined to buy cleaner products. At the moment, this remains the most twisted way to go.

3. BORDEN CARBON ADJUSTMENT

THE BCA consists of the introduction of import taxes at the expense of countries producing high-emissions goods. The measure would lead to an increase in the goods produced by the EITE sectors, thereby discouraging the consumption. This hypothesis was taken up by the European Citizens’ Initiative with its proposal “A price for carbon to fight climate change” According to this proposals, the price of the goods involved should rise over the years in order to stimulate the technological and infrastructural transition necessary to orient the habits and consumption of citizens, the public sector and European companies towards renewable energy sources.

Many would be the incentives of such a policy:

  • An increase in revenue estimated at around 225 billion euro.
  • Public finance would be forces to move towards a carbon-free and socially equitable economy, using part of the revenue to relieve the tax burden on low-income households, and the remainder to support the transition of the production system towards more sustainable models.

At the moment, the BCA seems to be on the right track, mainly because it was included by the Commission as one of the points of the European Green Deal, which states as follows: “as long as many international partners do not share the same ambition as the EU, there is a risk of carbon leakage”, and therefore “the Commission will propose a carbon border adjustment mechanism, for selected sectors, to reduce the risk of carbon leakage”.

The only big loophole that is yet to be resolved is the search for compatibility between the BCA and WTO rules. In fact, Art.1 of GATT contains one of the main principles of the organization – and one of the biggest problems for BCA – namely the “most-favoured-nation principle”, according to which a country is not allowed to discriminate those products imported from different countries and/or producers if the goods in question are considered “like”.

As it pertains to this topic, there are still many doubts and many experts trying to find a solution. Among the various papers, I recommend one by Alexander Krenek titles, “How to implement a WTO-compatible full borden carbon adjustment as an important part of the European Green Deal”, with analyses from an economic and legal point of view, the various GATT articles and principles, with their interpretations.

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