Carbon Leakage Mechanisms

The EU imposes a carbon price of roughly 60 euros per tonne on steel production. India does not. If a European steelmaker moves production to India to avoid the carbon cost, global emissions are unchanged but European industry has shrunk. This is carbon leakage: climate policy that shifts production rather than reducing pollution.

Carbon leakage occurs through two channels. The competitiveness channel drives energy-intensive production to jurisdictions with weaker carbon pricing. European aluminum smelters, cement plants, and chemical producers face 5-15% cost increases from EU ETS allowances that competitors in Turkey, Egypt, or Southeast Asia do not bear. The investment channel redirects new capacity: when a company decides where to build the next plant, jurisdictions without carbon costs become more attractive. Leakage through investment is harder to measure but potentially larger, because it shapes industrial geography for decades.

Quantifying the risk. Studies estimate leakage rates for energy-intensive industries at 5-25%, meaning 5-25% of domestic emission reductions are offset by increases abroad. Cement and steel show the highest rates because they are globally traded commodities with thin margins.

Does leakage invalidate carbon pricing?

No, but it demands a policy response. Free allocation of ETS allowances to exposed industries reduces leakage but also weakens the price signal. Border carbon adjustments (like the EU's CBAM) charge imports the same carbon cost domestic producers face, equalizing the competitive playing field. The choice between free allocation and border adjustment defines the current frontier of carbon pricing policy.

---