Carbon leakage occurs if, as a response to climate change, different countries or regions introduce different carbon costs into the production of all traded goods and, in response, carbon-intensive producers exit the regions imposing the carbon cost. In other words, producers leave to avoid production costs from going up and hampering their competitive edge. Such an exodus would lead both carbon emissions and economic activity to “leak” out of these regions.

The European Commission has identified 164 sectors – in other words, three-quarters of manufacturing emissions under the EU Emissions Trading Scheme (ETS) – that are at risk of carbon leakage in case of a CO₂ emission price of 30 euros per tonne. In an attempt to minimise the amount of leakage, the European Commission is set to allocate a certain amount of free allowances to these sectors  from 2013.

According to the UK Carbon Trust, however, the EU’s response could be inherently counter-productive.

“If all 164 sectors were granted free allowances to compensate them for the risk of carbon leakage, the economic incentives to invest in low carbon manufacturing would be greatly weakened”, reads the report.

In fact, the report has found that no free allocation of allowances or protection at all would only drive less than 2% of emissions abroad. Previous studies undertaken by the Carbon Trust show that many sectors in the Commission’s list of 164 sectors would be unlikely to suffer significant leakage in the first place.

The report’s main recommendation is to avoid a widespread, one-size-fits-all free allocation of allowances, instead opting for sector-specific solutions. Generalised responses, says the report, carry serious drawbacks.

“Given the current EU emissions target, granting free allowances to cement, steel and aluminium could increase the carbon price faced by the rest of industry by 10-30%; whilst cement sector profits could rise by £0.7bn – £3.4bn (in Europe) annually without necessarily preventing leakage”, reads the report.

“Adjusting for cost differentials at the border of the carbon pricing zone is more effective and efficient than free allocation, and for some sectors can be made automatically World Trade Organisation compliant”, the report continues.

The report calls for a border mechanism for cement sector and an investment subsidy for aluminium. Further, it recommends free ETS allowances for steel manufacturers, one of the sectors most prone to carbon leakage, in the short term. In the long term, it recommends that the steel sector look towards other options such as import levelling – whereby all importers of the same products must acquire emission allowances on the basis of best available technology (BAT) performance – or global sectoral agreements.

Access the full report here.