Phenomenon of Carbon Leakage and The EU’s CBAM

Phenomenon of Carbon Leakage and The EU’s CBAM

What is carbon leakage?

This phenomenon occurs when greenhouse gas emissions (GHG) rise in one country due to emission reductions in another country with stricter regulations and policies. For instance, a country might adopt carbon taxes or a cap-and-trade system to cut GHG emissions. However, companies can evade these additional costs by relocating their production to a country with less stringent regulations, resulting in a spill-over of emissions.

As per the European Commission, "Carbon leakage" denotes the potential scenario wherein businesses might shift production to countries with less stringent emissions regulations due to cost considerations associated with climate policies. Such a shift could result in a rise in their overall emissions.

Because the ETS operates within a specific region, it is susceptible to the diverse emissions policies globally, leading to a reduction in its effectiveness due to carbon leakage. Research from the European Central Bank revealed that companies were relocating their carbon-intensive operations from within Europe to areas outside the EU.

Hence, in December 2022, a tentative agreement was reached between the EU Parliament and EU Council to implement a new mechanism known as the Carbon Border Adjustment Mechanism (CBAM). This mechanism imposes emissions tariffs on imported goods posing a high risk of carbon leakage, originating from non-EU Emissions Trading System (ETS) member countries.

What is the EU Carbon Border Adjustment Mechanism (CBAM)?

As the European Union strengthens its policies and regulations to tackle climate change, the risk of 'carbon leakage' emerges, where EU-based companies shift their carbon-intensive production overseas to countries with less stringent climate policies or no carbon tax. Alternatively, EU products may be replaced by imports with higher carbon footprints.

To address this challenge, the EU introduced the Carbon Border Adjustment Mechanism (CBAM), aiming to place a fair price on carbon emitted during the production of carbon-intensive goods entering the EU. This mechanism also seeks to promote cleaner industrial practices in non-EU countries.

Essentially, CBAM aims to create a level playing field for European producers operating in the EU market, who face financial repercussions for their emissions under the EU ETS, while also fostering global industrial decarbonization.

Officially adopted by the EU Commission on August 17th, 2023, CBAM will undergo a transitional phase from October 1st, 2023, until December 31st, 2025, before coming into full effect on January 1st, 2026.

Stay tuned for our upcoming blog post “Understanding the Functioning of the Carbon Border Adjustment Mechanism."