The economics of carbon leakage mitigation policies

In a trade model with endogenous emissions abatement, we investigate the impact of three policy instruments aimed at mitigating carbon leakage: free emission allowances, Carbon Border Adjustment Mechanism (CBAM) and CBAM with export rebates. We show that providing allowances for free does not alter the incentives to abate carbon emissions, but fosters the entry of more carbon intensive producers. It levels the “playing field” both domestically and internationally, and it may even reverse the carbon leakage. In contrast, the CBAM levels the playing field only domestically, and it may lead to an autarky equilibrium. To reverse the carbon leakage, the CBAM must be complemented with export rebates. We further show that the CBAM increases welfare for any share of free allowances, and identify the optimal share of free allowances with or without CBAM. Finally, we perform a calibration exercise on cement and steel sectors to simulate the effects of the CBAM recently adopted by the European Union. Our model predicts a scenario with reverse carbon leakage and significant welfare gains for both sectors.