Emissions
Carbon leakage explained
Carbon leakage happens when climate policy in one place causes emissions to rise somewhere else. It is one of the most cited worries in climate policy, and one of the hardest to measure.
Climate change is a global problem, but climate policy is mostly made by individual countries or groups of countries. When one jurisdiction raises the cost of emitting carbon and others do not, some emissions may simply move. That shift is called carbon leakage, and it matters for two reasons: it reduces the environmental benefit of the original policy, and it can mean lost jobs and investment for the country that acted first.
A working definition
Carbon leakage is usually described as the increase in emissions outside a jurisdiction that results from that jurisdiction’s climate policy. Economists often express it as a leakage rate: the increase in emissions abroad divided by the reduction achieved at home. A leakage rate of zero means the domestic cut is a genuine global cut. A rate of 100 percent would mean the policy achieved nothing for the climate.
The channels
Leakage is not a single mechanism. Three channels are commonly distinguished.
The competitiveness channel
If domestic producers face higher costs, foreign producers without those costs may win market share at home and abroad. Production, and its emissions, shifts towards them. This is the channel most people have in mind when they talk about leakage, and it is the main concern for heavy industry.
The investment channel
Over a longer period, companies deciding where to build new plants may favour locations with lower carbon costs. Even if no existing factory closes, future capacity may be built elsewhere.
The energy market channel
When a large group of countries reduces its demand for coal, oil and gas, world prices for those fuels can fall. Lower prices make fossil fuels cheaper for everyone else, which can increase consumption and emissions in countries without strong climate policies. This channel works through global markets and is difficult for any single country to counteract with trade measures.
Which sectors are exposed?
The risk is not spread evenly. It is concentrated in activities that are both:
- emission-intensive, meaning carbon costs are a significant share of production costs, and
- trade-exposed, meaning products are traded internationally and buyers can switch suppliers easily.
Typical examples include iron and steel, cement and lime, aluminium, basic chemicals, fertilisers, refining, pulp and paper, and glass. Cement is an interesting case: it is very emission-intensive but heavy and costly to transport, which historically limited trade over long distances, although sea transport can change that for coastal markets.
Most other sectors, from services to most manufacturing, have relatively low exposure, because energy and carbon costs are a small part of their total costs.
The pollution haven debate
A related, older question asks whether countries with lax environmental regulations gain a comparative advantage in polluting industries. Two ideas are often distinguished:
- The pollution haven effect: stricter environmental rules raise costs and, at the margin, shift some trade and investment in polluting industries towards places with weaker rules.
- The pollution haven hypothesis: a stronger claim that differences in environmental regulation are a main driver of where polluting industries locate.
Research has generally found more support for the first than for the second. For most industries, environmental compliance costs are modest compared with labour, capital, access to markets, infrastructure, skills and political stability. These other factors tend to dominate location decisions. Effects that do appear are concentrated in the most pollution- and energy-intensive activities, which is consistent with the sector pattern above.
Why leakage is hard to measure
Estimates of carbon leakage vary widely, and there are good reasons for that.
| Difficulty | Why it matters |
|---|---|
| Counterfactuals | We cannot observe what would have happened without the policy, so leakage must be inferred or modelled. |
| Many causes at once | Trade and investment shift for many reasons: exchange rates, demand, technology, wages, trade policy. |
| Low carbon prices in the past | Where carbon prices were low or heavy industry received free allowances, little leakage would be expected, which says less about higher prices. |
| Model assumptions | Model-based estimates depend on assumptions about how easily products and fuels can be substituted. |
The honest summary is that leakage is a real risk for a limited set of sectors, that its size depends heavily on carbon price levels and policy design, and that it is easier to model than to observe directly.
Production versus consumption
Leakage connects to a broader accounting question. Most national emissions inventories count emissions produced on a country’s territory. An alternative view counts emissions embodied in what a country consumes, including imports. A country can reduce its territorial emissions while its consumption-based footprint stays the same or grows, if it imports more carbon-intensive goods. Not all of that difference is leakage caused by climate policy, since trade patterns change for many reasons, but the two perspectives together give a fuller picture.
Policy responses
Governments have tried several approaches, often in combination.
- Free allocation of emission allowances. Exposed industries receive some allowances free of charge, often based on benchmarks for efficient production. This protects competitiveness but weakens the incentive to switch to cleaner products and raises questions of fairness.
- Border carbon adjustments. A carbon charge on imports, sometimes with relief for exports, so that domestic and foreign goods face a similar carbon cost. See our explainer on border carbon adjustment.
- Output-based rebates and subsidies. Revenues are returned to firms in proportion to their output, keeping marginal production costs lower.
- Product standards. Rules on the carbon intensity of products sold in a market, applied equally to domestic and imported goods.
- International cooperation. Sectoral agreements, coordinated carbon prices or minimum carbon prices among major emitters, sometimes described as climate clubs, aim to reduce the price differences that cause leakage in the first place.
Each option has costs. Free allocation is simple but blunt. Border adjustments are more targeted but complex and politically sensitive. International cooperation addresses the root cause but is slow to negotiate.
The bottom line
Carbon leakage is a useful concept because it reminds us that national climate policies operate in a connected world economy. It is also easily overstated: the risk is concentrated, the evidence is mixed, and the policy response should be proportionate. Understanding which channel is at work, and in which sector, is the first step to choosing the right tool.