Environmental policy stringency and carbon leakages: a case for carbon border adjustment mechanism in the European Union

This study examines the link between the strictness of environmental policies and carbon leakage in the European Union (EU). It utilizes an econometric model to analyse how carbon leakage is influenced by environmental policies and other factors. A comprehensive dataset spanning from 1995 to 2020 for 20 EU member nations is employed. This study is ground-breaking, as it is the first to comprehensively assess the effect of aggregated environmental policies on carbon leakages in the EU. This study employs a range of econometric techniques to ensure the reliability of its findings, including the continuously updated fully modified approach, bias-adjusted ordinary least squares method, and bootstrap panel causality testing. The findings confirm that stringent environmental policies cause greater carbon leakage by increasing the quantity of foreign carbon emissions embodied in EU’s domestic final demand. Specifically, carbon leakage increases within the range 0.051–0.111% as environmental policy stringency rises by 1%. This outcome confirms that direct carbon leakage occurs through the international trade channel as domestic carbon emissions reduction is continuously being offset by greater emissions abroad. Country-specific reactions captured through causality tests further reveal that the predictive powers between environmental policy stringency and carbon leakage is widespread among the sampled EU countries. Thus, our conclusion is that stringent environmental policies put the region at a disadvantage in the international markets. The main recommendation therefore is that ample justification exists for the introduction of carbon border adjustment mechanism, as the positives associated with its imposition are likely to outweigh the negatives.