A Regulatory Framework that Would Enable Firms to Compete Internationally without Degrading the Environment

by Benedikt Bruckner 1, Ottmar Edenhofer 1,2,3, Nicolas Koch1,4, Jan Steckel1,5

1 Mercator Research Institute on Global Commons and Climate Change (MCC)

2 Potsdam Institute for Climate Impact Research (PIK)

3 Technical University Berlin

4 Institute of Labor Economics (IZA)

5 Brandenburg University of Technology (BTU) Cottbus-Senftenberg

How to mitigate climate change is one of the dominant topics at the international policy arena. While the IPCC reminds us of the urgency of mitigating emissions, countries have not yet agreed on a common regulatory framework that allows for a level playing field for internationally competing firms while safeguarding the environment. One key problem is that a joint framework needs to avoid leakage, regarding both carbon leakage, i.e. the shift of emissions from countries with ambitious environmental policies to regions with weaker policies, as well as green leakage, i.e. industry resettlement due to more beneficial green policy incentives, such as subsidies, in other regions.

Carbon leakage can occur through three major channels. First, lower demand for fossil fuel in regions with strict climate policy will reduce world market prices. This could trigger increased consumption in other regions1,2. Second, climate policies increase production cost of carbon intensive processes, which might lead to a reallocation of production processes to countries with less stringent climate policies1,2. Third, in light of emission reduction policies in other countries the most favorable action for an individual country is to increase emissions2,3. On the other hand, climate policy can also induce industrial relocation. Such green leakage can occur if firms relocate to regions attracting green investments by the introduction of generous subsidies for low-carbon technologies, a concern often raised in the context of the Inflation Reduction Act in the United States.

Both forms of leakage could be avoided by coordinating a global carbon price. It is unlikely, though, that the world will see an international carbon price anytime soon. While domestic carbon pricing mechanisms are already in place, amongst others in China, the EU and New Zealand4, it is unlikely that a carbon price at relevant magnitudes will be adopted by the United States2 or in emerging economies any time soon. In the United States, the introduction of new taxes seems to be politically impossible, in the context of developing and emerging countries, there are still questions how a carbon price needs to be designed to be effective in the respective market environments. Highly regulated energy markets5 as well as a potential backlashes on deforestation6 might impede the effectiveness of pricing instruments.

To prevent leakage in the absence of a global carbon price, two major paradigms seem to compete. On the one hand, the European Union has adopted the Green Deal, strengthening the domestic Emission Trading System (ETS) and establishing long-term emission reduction goals. To safeguard domestic industries and to reduce carbon leakage, the EU introduced the EU Carbon Border Adjustment Mechanism (CBAM). It requires importers of iron and steel, fertilizers, electricity, aluminium, cement and hydrogen to pay the price difference of the price on carbon in the country of production and the weekly price set by the EU ETS. As a response to the EU CBAM, countries might opt to put a price on carbon to keep the revenues. As a result, the EU CBAM could work as a self-expanding climate club7. On the other hand, the Inflation Reduction Act (IRA) proposed by the US last year focuses on preventing green leakage by providing substantial tax incentives and other subsidies for investments in low-carbon technologies. A price instrument, at least on the national level, is not in place.

Evaluating the two routes from a trade policy perspective is arguably complicated. Domestic BCAs are an effective measure against free-riders8 and can be designed in a way that conforms to WTO rules1,9,10. Green subsidies as proposed in the US IRA are likely at odds with WTO trade law and were already heavily criticized by the EU as being protectionist11. Both measures are likely perceived as protectionist by competitors and might lead to negative reactions, e.g. through trade sanctions or tariffs1,10. To avoid green leakage, countries might engage in a race for the highest subsidies. BCAs would theoretically incentivize other countries and regions to increase their climate policy efforts, e.g. by increasing carbon pricing. However, they would also shift the burden of mitigation to developing countries1,12,13 and would worsen terms of trade for already disadvantaged countries10,14. Some of these concerns might be alleviated by recycling revenues from BCAs to developing countries13, but they can still trigger tensions and fierce international debates.

Thus far, there is little empirical evidence for carbon leakage, also because industries are often shielded politically against international competition. In the EU emission trading system, for example, free allocation of permits has avoided leakage at a relevant scale15–17. Arguably, this might change if climate targets become more stringent2,18,19. Ex-ante literature hence highlights the role for the EU CBAM, which is estimated to reduce leakage by about one third13. If a border carbon adjustment mechanism covered all relevant sectors, leakage could be reduced even further12.

Leakage will remain a key topic on the international agenda as climate policy becomes more ambitious and at the same time continues to vary significantly regarding the speed and ambition across countries and regions. As a multilateral, UNFCCC-like solution is highly unlikely, minilateral carbon clubs, as for example agreed by the G7, might form the nucleus of a broader future agreement. Such clubs are agreements amongst countries on common emission reduction obligations and penalties if goals are not met3,20. A system of beneficial carrots for members (including financial support, access to specific technologies etc.) and sticks for non-participants (including sanctions or CBAMs) would be necessary to achieve common emissions reductions or to implement a broadening carbon price. Rather than focusing on the entire economy, initial agreements might first focus on certain sectors (e.g. steel), e.g. by ensuring to buy green products at a certain fixed price.

It is important to keep these carbon club agreements inclusive if a global participation is eventually envisaged. In this regard, various issues relevant for mitigation may have to be linked. For instance, Just Energy Transition Packages (JETPs) to phase out coal power plants, currently discussed in selected countries, can be linked to reforming energy markets – a precondition to eventually introduce effective carbon pricing. Or commitments to a future carbon price might already today give access to export credits to build electricity grids or de-risk investments in renewable energies. A reform of financing by multilateral development banks, as suggested in the Bridgetown Initiative21 could support these efforts. Well-designed issue linking carbon clubs can eventually grow to become mitigation clubs, designed to effectively help members to bring down emissions while having access to common benefits. When safeguarding those clubs to non-members, e.g. through BCAs, clubs should constantly engage in diplomatic efforts for a collaborative solution with affected countries.


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