What Can Undermine a Carbon Tax?

Several countries have implemented a carbon tax or cap-and-trade system to establish high carbon prices and create a disincentive for the use of fossil fuels. Essentially, the tax encourages firms to substitute toward low carbon emission energy. Costs also rise for firms down the supply chain that use production inputs with high-emission content, so the total impact of a carbon tax can be large. In practice, however, firms also have an incentive to find an offset to a carbon tax. In this post, based on our recent work, we present evidence of one such adaptation strategy. We show that French firms increased their imports of high-emission inputs from suppliers outside the European Union’s cap-and-trade system, known as the EU Emissions Trading System (EU ETS), reducing the effectiveness of this approach to cutting carbon emissions—an adaptation strategy that leads to “carbon leakage.” To help stop this leakage, the EU is implementing a “carbon tariff” in 2026, which is the topic of a companion post.