Addressing the Problem of Carbon Leakage

The Nordic Council of Ministers (NCM) has recently released a new report on the danger of carbon leakage, a consequence of the increasing cost of carbon offsetting. Although the report focuses on the leakage issue from a Scandinavian point of view, this is a problem for all carbon offsetting schemes, and particularly the EU Emissions Trading System (EU ETS) in which the Nordic countries participate. Commencement of the more stringent EU ETS Phase III is likely to increase the risk of carbon leakage since the prices of EU allowances are expected to rise as a result of the switch to auctioning rather than free allocation for the bulk of Phase III allowances.

The phenomenon of carbon leaks appears when an emission reduction policy is being applied as is the case with the EU. In essence, if in a given country or region there is a strict emissions policy, requiring companies to invest in carbon offsetting, businesses may choose to close production in their country of domicile and relocate to a country with less rigid climate legislation. This industry migration can mean that reduced CO2 emissions in one region may be replaced by increased emissions somewhere else. This occurrence is known as carbon leakage.

Scandinavian countries in particular face the problem of carbon leaks, considered as they are to be among the frontrunners in the global climate change mitigation effort. The NCM report, released on 28 February 2012 and entitled “Carbon Leakage from a Nordic Perspective”, identifies 25 sectors of the economy in the Nordic countries with a high risk of carbon leakage. Included are steel and iron, chemicals and the fishing industry. According to the report, if energy prices go substantially higher in the Nordic region, such energy-intensive industries will risk losing market share to foreign competitors.

Among the actions recommended in the report is the introduction of various types of support measures with the purpose of decreasing the competitive disadvantage caused by increased carbon pricing. One such option is introducing higher transportation costs, which can act as a brake to carbon leakage. The report asserts that, for example, the imposition of a carbon cost on international shipping could reduce carbon leakage risks and in addition lead to reduced shipping emissions.

The European Commission has also recognised the problem of carbon leakage in its EU ETS-related legislation, with sectors deemed to be exposed to a significant risk of carbon leakage supposedly receiving more free carbon permits than sectors where carbon leakage is less likely to occur. The risk for leakage is defined according to benchmarks for each sectoral product.

While at present the majority of EUAs are allocated gratis, the EU ETS will undergo a fundamental change with its third trading period scheduled to start in 2013. In accordance with the revision of the Emissions Trading Directive agreed on in 2008, the European Commission has made it clear that auctioning of allowances will become the rule rather than the exception.

Additionally, the Commission recently published a paper exploring the costs of increasing the EU’s 2020 greenhouse gas emission reduction targets from 20 to 30 percent relative to 1990 levels. Although not yet a policy position, the imposition of this more rigid target will generally stimulate companies to invest in carbon offsetting but by the same token will increase the potential for leakage, on account of higher carbon prices stimulated by increased demand.

The Commission paper, entitled “Analysis of options beyond 20% GHG emission reductions: Member States Results”, estimates that stepping up to a 30 percent reduction target will result in extra production costs in the order of one percent due to carbon leakage. According to the Commission paper, the best way to address the problem is effective global action.

Although it’s the EU ETS which provides the context in which the issue of carbon leakage seems most to be discussed, the risk exists wherever a carbon offsetting regime is being applied. Another case in point is the California cap-and-trade system, whose first phase began on 1 January 2012 and which addresses the problem of leakage by issuing allowances free of charge for the first compliance period from 2012 to 2015.

There are different ways to address the problem of carbon leakage, such as facilitating carbon offsetting in endangered industry sectors through the allocation of free allowances. But the most effective and environmentally-beneficial mechanism would be global climate change mitigation action, so obviating the factors which drive carbon leakage.