The economics of carbon leakage mitigation policies

Carbon leakage occurs when carbon-priced low-emission domestic products are replaced with high-emissions foreign products. In a trade model with endogenous emissions abatement, we investigate the impact of three policies aimed at mitigating carbon leakage: free emission allowances, Carbon Border Adjustment Mechanism (CBAM) and export rebates. Providing allowances for free does not alter the incentives to abate carbon emissions, but fosters the entry of more carbon intensive producers. It levels the “playing field” both domestically and internationally, and may even reverse the carbon leakage. In contrast, the CBAM levels the playing field only domestically, which may lead to an autarky equilibrium. To reverse the carbon leakage, the CBAM should be complemented with other policies, such as export rebates. The optimality of these policies depends on the geographical scope of carbon emissions. With trade-adjusted emissions, the CBAM is always welfare enhancing, while free allowances alone are not. We then formally characterize the optimal combination of the three policies. Lastly, we calibrate the model to simulate the effects of the CBAM recently proposed by the European Union. The policy, when accompanied with either free allowances or export rebates, reverses the carbon leakage in the cement and steel sectors, and increases welfare in almost all sectors