Climate Policy Uncertainty, Environmental Regulatory Arbitrage, and Internal Carbon Leakage in the European Union: Fourier ARDL and Causality Analyses

We argue that climate policy uncertainty can lead to a unique type of regulatory arbitrage whereby domestic firms respond to fluctuations between lax and stringent environmental regulations by relocating their production processes to jurisdictions with minimal environmental policies that could affect their profitability. The presence of uncertainty-driven environmental regulatory arbitrage may consequently contribute to the emergence of regions or countries that act as havens. This phenomenon could intensify internal carbon leakage, especially in economies with ambitious climate targets, as efforts to manage the risks associated with uncertain policies involuntarily result in increased carbon emissions elsewhere. Over time, this could lead to a rise in emissions displacement due to higher imports from abroad. To back up our claim with empirical evidence, we specifically study the internal carbon leakage in the EU15 countries resulting from the climate policy uncertainty. The analysis covers the period 1990–2022. A battery of econometric techniques is adopted—Fourier and conventional unit root tests, cointegration testing within the Fourier ARDL framework, short and long-run estimations within the Fourier ARDL framework, as well as Fourier Granger causality testing. By employing this battery of testing methodologies, we ensure robustness and thus the credibility of the study findings. Overall, after controlling for the effects of ecological innovation, environmental policy stringency, and the real GDP, we find that increases in climate policy uncertainty raise internal carbon leakage contemporaneously and that internal carbon leakage declines as climate policy uncertainty dies out over time in the long along with the short term. Furthermore, causality results reveal that climate policy uncertainty is a significant predictor of internal carbon leakage into the European Union. This study therefore identifies climate policy uncertainty as a potential source of idiosyncratic and systemic risk that aggravates internal carbon leakage as European Union products get replaced by more carbon-intensive imports.