Measures Against Carbon Leakage: Combining Output-Based Allocation with Consumption Taxes

Countries with ambitious climate targets are concerned about carbon leakage to other countries. A common measure against leakage is output-based allocation of emissions allowances, whose effectiveness could be enhanced by consumption taxes levied on the carbon intensity of goods. We combine theoretical and numerical analysis to derive optimal combinations of output-based allocation and consumption taxes, where “optimal” means from a regional or global welfare perspective. Different assumptions on the stringency of emissions reduction targets, the coverage of emissions in regulated sectors, and their trade exposure are considered. A key analytical finding is that output-based allocation and consumption taxes are complements rather than substitutes. A key numerical finding is that the output-based allocation and consumption tax should be set at almost the same rate and increase substantially with the stringency of the emissions reduction targets. Another key finding is that inclusion of Scope 2 emissions is crucial for the optimal policy.