Leakage in Climate Policy Discourse

The concept of leakage plays an important role in climate policy discussions and design. Leakage generally is shorthand for carbon leakage, which, even if intuitively understood as referring to greenhouse gas (GHG) emissions, can be defined in several ways. Leakage can also refer to production or investment, in which case industrial competitiveness is the more salient concern. The two concepts are often treated as overlapping, as this allows for environmental justification of policy measures that aim to protect competitiveness.Different types of leakage have different impacts and implications for policymaking. They require (and deserve) different policy responses to mitigate their adverse effects. This issue brief discusses how the concept of leakage affects climate policymaking and policy design and suggests distinguishing among types of leakage.As countries decarbonize their industries at different speeds, and as new close-to-carbon-neutral (or net-zero-compatible) industrial goods enter the market, the range of carbon intensities in traded industrial goods will be wider than ever, and the prospect of leakage may increase as well. Net-zero-compatible goods can be generally understood as technologies and activities that can continue well beyond the point where a jurisdiction has achieved net-zero emissions—or indefinitely—either by no longer emitting at all or by emitting in sufficiently limited quantities such that the residual emissions can be offset by carbon removal. The latter inevitably depends on political choices and constraints. It is helpful to distinguish among different types of leakage that may potentially arise so that any mitigating policy measures are effectively designed. Four types of leakage are discussed in Section 2.The intuition behind carbon leakage is that by enacting climate policy through pricing or regulation in one country, and thereby raising the costs of emitting GHGs, producers will move at least some of their production elsewhere to a region with lower carbon constraints, thereby offsetting the environmental gain while also undermining economic performance—a potential lose-lose outcome. A closer look at the various elements of potential leakage can be instructive.The worst case of carbon leakage involves a scenario in which emissions elsewhere increase by more than they are reduced in the region increasing its carbon constraints. However, a scenario in which emissions decrease by 100 metric tons in country A, only to rise by 95 tons in country B, is unlikely to be attractive to policymakers, even if there is a net environmental benefit.Things get trickier if the amount of leakage is further reduced but not zero. If emissions increase elsewhere by 20 or 30 tons in country B, the leakage effect is undermining the efficiency of the policy considerably, but the environmental impact can still be considered significant. However, if the policy discourse is squarely focused on the absolute amount of leakage, such a policy could still be rendered politically infeasible.To disentangle the political motivations in dealing with carbon leakage, it can also be instructive to look at the language of what should be done about it, such as risk, avoidance, or mitigation.Assessing whether carbon leakage has, in fact, occurred is not an easy task. Ex ante modeling usually tends to result in higher rates of leakage than empirical ex post studies reveal (Felbermayr and Peterson 2020; Caron 2022). In some cases, pass-through rates are used, with the lack of pass-through ability being considered evidence of risk of leakage. Attribution and causality add to the challenge. If climate policies—and carbon pricing, specifically—create a risk of leakage, it is usually assumed that this is linked to higher production costs and higher costs for energy inputs. However, energy prices can fluctuate for many reasons, and the final costs to (industrial) consumers depend on many factors, of which carbon and energy costs are only one. Shifts in production or investment can also occur for many reasons, some of which are orthogonal to policy, such as growing demand in other regions.Fully preventing or avoiding leakage, let alone claims of purported leakage, is therefore challenging. An element of discourse and narrative framing will remain in policy debates. Some policymakers instead talk about the risk of carbon leakage and the need to mitigate this risk. This leads to a need to define risk. Some combination of trade intensity (imports and exports divided by turnover) and emissions intensity (GHG emissions per volumetric metric ton of product) is generally used, although the ability to pass through costs is an alternative. By using the word risk, policymakers create a fair bit of latitude to act. By focusing on risk mitigation, some level of actually observed leakage might be seen as policy failure. On the other hand, focusing on risk is less precise and allows policymakers to argue that more protections, to further mitigate risk, are desirable.In these circumstances, vague assertions of leakage concerns can justify a great many policy interventions, some of which arguably go beyond legitimate climate policy effectiveness considerations. Protectionism, mercantilism, and geopolitical strife are resurgent today, with industrial policy in vogue again, while multilateral institutions such as the World Trade Organization are weakened (Elkerbout et al. 2024).With industrial competitiveness being threatened across Western countries—especially through competition with China and increasing hard security risks—policies to safeguard or boost competitiveness may become still more popular, as will the temptation to justify such measures by referring to leakage risks. Despite this new geopolitical background, increasingly ambitious climate policy is poised to continue apace. As new low-carbon producers (or production) enter the market, they will have to compete with incumbents domestically and abroad. This gives rise to a new type of competitiveness challenge. Trade and trade policy, moreover, lie at the core of any concern about leakage and competitiveness as the vehicle for carbon embedded in commercial exchange.