Carbon leakage can havemany causes. For instance, if the carbon emission policy of a country raisesthe cost of local emission, then another country with a more relaxed policywould have a comparative advantage. Carbon Leakage increases firms cost byattempting to make firms internalise the negative externalities they cause, thepollution they produce. This leads increase in costs cause firms to move toregions with more relaxed carbon emission policies with cheaper costs. Ratherthan incentivising firm innovation, the carbon emission costs could lead firmsto move abroad as there are cheaper forms of production because climate andemission policies are not universal policies.

Due to this, it is clearlyarguable that by not acknowledging carbon leakage, carbon emission policies canlead to innovation failure as firms will simply move to another country with amore relaxed climate policy and pollute more in other region. A possiblesolution for this is that policies that aim to tackle carbon leakage need to beuniversal or face the potential of carbon emission policies failing to beimplemented correctly. TheEU ETS has a ‘cap and trade’ system which aims to reduce carbon emissions ingeneral. This aims to cap the overall level of emissions allowed to be producedby setting an aggregate emission limit.

Within that limit, participants in thesystem are able to buy and sell permits as they need it. These permits are thetrading ‘currency’ at the heart of the system. The gradual cap on the totalnumber of permits creates scarcity for these allowances in the market. Thisscarcity in permits means that the permits tend to be higher in price and thusincentivises firms to produce less carbon emissions in order to reduce theirneed for the permits. However, if the demand for afirm’s goods remains the same, production may move offshore to a cheapercountry with lower emission standards, and global emissions will not bereduced.

Arguments that the risk ofleakage undermines the environmental outcomes, while at the same time leadingto a decline in domestic production with potential job losses, can weakensupport for the introduction of carbon pricing. In addition, measures toaddress carbon leakage normally involve the use of fiscal resources (explicitor implicit) that could be used for other purposes (to compensate households orother affected groups, or other general uses of revenue). This trade-off oftenrequires a degree of political judgment providing the incentive for differentinterests to persuade decision makers. Pollution permits would fallin price as a result of carbon leakage meaning firms do not pay the full costof pollution and also do not have to internalise the cost of the negativeexternality they have caused. The EU ETSworks on the ‘cap and trade’ principle. A cap is set onthe total amount of certain greenhouse gases that can be emitted byinstallations covered by the system. The cap is reduced over time so that total emissions fall. 

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