Carbon leakage can have
many causes. For instance, if the carbon emission policy of a country raises
the cost of local emission, then another country with a more relaxed policy
would have a comparative advantage. Carbon Leakage increases firms cost by
attempting to make firms internalise the negative externalities they cause, the
pollution they produce. This leads increase in costs cause firms to move to
regions with more relaxed carbon emission policies with cheaper costs. Rather
than incentivising firm innovation, the carbon emission costs could lead firms
to move abroad as there are cheaper forms of production because climate and
emission policies are not universal policies. Due to this, it is clearly
arguable that by not acknowledging carbon leakage, carbon emission policies can
lead to innovation failure as firms will simply move to another country with a
more relaxed climate policy and pollute more in other region. A possible
solution for this is that policies that aim to tackle carbon leakage need to be
universal or face the potential of carbon emission policies failing to be
implemented correctly. The
EU ETS has a ‘cap and trade’ system which aims to reduce carbon emissions in
general. This aims to cap the overall level of emissions allowed to be produced
by setting an aggregate emission limit. Within that limit, participants in the
system are able to buy and sell permits as they need it. These permits are the
trading ‘currency’ at the heart of the system. The gradual cap on the total
number of permits creates scarcity for these allowances in the market. This
scarcity in permits means that the permits tend to be higher in price and thus
incentivises firms to produce less carbon emissions in order to reduce their
need for the permits. However, if the demand for a
firm’s goods remains the same, production may move offshore to a cheaper
country with lower emission standards, and global emissions will not be
reduced. Arguments that the risk of
leakage undermines the environmental outcomes, while at the same time leading
to a decline in domestic production with potential job losses, can weaken
support for the introduction of carbon pricing. In addition, measures to
address carbon leakage normally involve the use of fiscal resources (explicit
or implicit) that could be used for other purposes (to compensate households or
other affected groups, or other general uses of revenue). This trade-off often
requires a degree of political judgment providing the incentive for different
interests to persuade decision makers. Pollution permits would fall
in price as a result of carbon leakage meaning firms do not pay the full cost
of pollution and also do not have to internalise the cost of the negative
externality they have caused.

The EU ETS
works on the ‘cap and trade’ principle. A cap is set on
the total amount of certain greenhouse gases that can be emitted by
installations covered by the system. The cap is reduced over time so that total emissions fall. 

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