Measuring and Mitigating Leakage Risk

When a policy regulating greenhouse gas emissions applies to only a subset of emitting sources (i.e. the policy is ``incomplete"), a policy-induced shift in economic activity to exempt (or less stringently regulated) sources can substantially undermine policy effectiveness via emissions ``leakage". Under existing climate change policies, output-based rebating of compliance costs is the preferred means of mitigating this leakage risk. These implicit production subsidies have potentially significant implications for both economic efficiency and the distribution of policy impacts, so it is important to carefully target this leakage mitigation to those industries truly at leakage risk. We provide a theoretically sound basis for deriving industry-specific, output-based subsidies under different policy objective functions and market structures. Key components include industry-level measures of emissions intensity, industry-level measures of import and export intensity, and industry-level measures of how domestic output, import flows, and export flows respond to changes in relative energy prices. Using rich transaction and firm-level data from the U.S. Census, we estimate these components and calibrate industry-specific, output-based subsidies for manufacturing sectors in the United States. We assess the efficiency and distributional implications of implementing a domestic carbon policy with and without these leakage mitigation provisions.