What can done to mitigate potential increases in greenhouse gas emissions outside the EU that arise from implementation of the EU’s own climate policies? A new research report by Christoph Böhringer (Carl von Ossietzky University of Oldenburg), Knut Einar Rosendahl (Norwegian University of Life Sciences) and Halvor Storrøsten (Statistics Norway) provides some answers to the problem of ‘carbon leakage’, which risks destroying European jobs, making climate policy less effective and potentially raising global emissions. 

Their study shows that imposing consumption taxes on goods produced by European industries that are ‘emissions-intensive and trade-exposed’ (EITE) constitutes an important instrument for hedging against carbon leakage. They conclude that supplementing the current policy of ‘output-based allocation’ of free emissions allowances to EITE industries with consumption taxes can render unilateral emissions abatement strategies more cost-effective.

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A major challenge for policy-makers aiming to cut greenhouse gas emissions is ‘carbon leakage’ through relocation of ‘emissions-intensive and trade-exposed’ (EITE) industries to other regions. This study examines the climate policy of the European Union and shows that imposing consumption taxes on EITE goods constitutes an important instrument in climate policy design to hedge against carbon leakage and renders unilateral emissions abatement strategies more cost-effective.

The authors address three questions:

• What is carbon leakage and why is it a problem?
• What has been done in the EU to mitigate carbon leakage?
• How can consumption taxes on EITE goods improve EU climate policy?

In the case of EU, carbon leakage is defined as an increase in emissions outside the EU due to the implementation of climate policies within the EU. For example, a company located in Germany may decide to move production to India to avoid paying for its emissions. This would destroy jobs in the EU but also make EU climate policy less effective. Relocation even runs the risk of increasing emissions if production were to shift from the EU to a less efficient plant abroad.

To mitigate carbon leakage, EU grants large amounts of free emissions allowances to EITE industries in proportion to the individual installation’s volume of production – what is known as ‘output-based allocation’ (OBA).

Economic research indicates that implementing OBA tends to reduce leakage and improve competitiveness, compared with carbon pricing alone. But this comes with a negative side effect, as OBA simultaneously may lead to excessive use of EITE goods. The explanation is that OBA works as an implicit subsidy to EITE production.

The adverse effects of OBA for overall cost-effectiveness of unilateral abatement action can become large if the leakage exposure of subsidised industries is limited. In policy practice, actual leakage exposure of industries is difficult to assess. Hence, the free allocation may become too generous, which has been shown to be the case in the EU.

This study shows that supplementing OBA with a tax on domestic intermediate and final consumption of EITE goods improves economic welfare, both from a regional and global perspective, since such a consumption tax attenuates undesired changes in relative prices caused by OBA. Under certain conditions, the authors find that it is optimal to implement consumption taxes that are equivalent in value to the OBA rates.

The researchers show the validity of their theoretical results with an applied general equilibrium analysis based on empirical data. Their simulations for EU climate policy design suggest that imposing consumption taxes as a supplement to OBA yields unambiguously positive welfare effects for the EU.

The extent of the welfare gains is negatively correlated with the exposure to carbon leakage: if leakage exposure is lower than assumed, the welfare gains are quite substantial. If instead leakage exposure is as high as assumed by many policy-makers (or even higher), consumption taxes are less advantageous but do no harm either.

Administrative costs of implementing consumption taxes are likely to be moderate, as the size of the tax of a specific good should correspond to the OBA rate for this particular good – that is, information that is already used in current legislation.

The researchers conclude that supplementing output-based allocation with consumption taxes is a policy-relevant option to improve on EU climate policy design against carbon leakage.

‘Smart hedging against carbon leakage’

Authors:

Christoph Böhringer (Carl von Ossietzky University of Oldenburg)

Knut Einar Rosendahl (Norwegian University of Life Sciences)

Halvor Storrøsten (Statistics Norway)