Assessing carbon leakage in the EU Emissions Trading System

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Differences in carbon pricing across countries can leave businesses in places with higher carbon costs at a competitive disadvantage, which leads to both economic activity and emissions shifting to countries that are not subject to such constraints. This phenomenon, known as carbon leakage, can hamper the effectiveness of carbon pricing in reducing global emissions and leads to environmental, social, and economic harm in countries with more stringent climate policies. The European Union (EU), like all governments that have established emissions trading systems (ETS), has addressed the risk of carbon leakage by granting energy-intensive, trade-exposed sectors a share of emission allowances for free. However, this approach will face increasing constraints because the number of allowances available for free will decline significantly in line with a revised EU ETS cap, particularly under a more ambitious 2030 reduction target. Many key industrial sectors in Europe could face increasingly high costs for their emissions in the coming decade, which may require new approaches to safeguard competitiveness while driving mitigation.

adelphi is part of a team of researchers asked by the European Commission’s Directorate General for Climate Action to assess the extent to which carbon leakage has occurred during the third phase of the EU ETS (2013-2020) and to identify industrial sectors that may be vulnerable in the coming decade under a stricter reduction target of 50 to 55 percent instead of the current 40 percent. This study in part assesses the effectiveness of free allocation in preventing carbon leakage as well as limitations to this approach going forward, when the number of free allowances will decline significantly in line with a revised EU ETS cap implied by a more ambitious 2030 reduction target.

This fact-finding exercise aims to inform an EU impact assessment on higher climate ambition. A final report consists of both backward- and forward-looking analysis of carbon leakage. It includes factsheets on key industries covering a range of economic and climate metrics during Phase III of the EU ETS, as well as a quantification of potential allowance shortages and an assessment of each sector’s vulnerability to carbon leakage based on factors such as their expected abatement potential and costs during Phase IV.

adelphi drew on its extensive experience with international carbon markets to provide qualitative and quantitative data on carbon pricing, leakage protections, and other climate policies among key EU trading partners. Additionally, adelphi presented policy options to address identified risks of carbon leakage for vulnerable sectors. Specifically, we assessed carbon border adjustments (CBA), consumption charges, a tiered as well as conditional approach to free allocation, and innovation support.