International Agreements and Cooperation Design Considerations: Carbon Leakage

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Carbon leakage describes a phenomenon in which carbon emission policies in one country increase the cost of production to the point that production relocates—is ‘leaked’—to another location with less stringent regulations.  Since the location of carbon emissions is irrelevant in the context of climate change, this geographical transfer undermines the environmental benefits of the first country's policies.  Carbon leakage is the expected consequence of unilateral emission reductions by one country, region, or other entity that does not embrace the entire international community.  When one country sets a strict cap on emissions, carbon-intensive production is expected to shift to other countries without (or with less stringent) caps, thereby undermining the environmental benefits the first country hoped to obtain.  This collective action problem is at the heart of the international climate debate.

The potential for carbon leakage is closely linked to concerns over international competitiveness.  To the extent that businesses (which employ citizens, earn foreign exchange, and are sometimes politically interconnected) can demonstrate a credible threat to move elsewhere if a country imposes climate regulations, policymakers will be deterred from imposing such regulations.  Even with strict regulation, if the businesses can simply relocate, the resulting carbon leakage will undercut any environmental benefits.  However, an important issue is the extent to which restrictions on international capital flows and other impediments to the free flow of production influence whether businesses actually follow through in relocating.

Other issues involving carbon leakage include: (1) how and to what extent various policy instruments can protect domestic industries and prevent the risk of carbon leakage; (2) whether a truly global agreement is required to avoid widespread carbon leakage; (3) whether leakage will be proportional, or whether and under what circumstances the rise in emissions in the second country will be less (or, possibly, more) than the reductions in the first country; (4) to what extent carbon leakage undermines the incentive to innovate, especially in carbon-intensive industries; and (5) whether trade rules will help prevent, or instead exacerbate, carbon leakage.