The Challenge of Carbon Leakage and Proposed Solutions for Allocation in the EU ETS

Carbon leakage refers to the risk faced by companies relocating their production outside Europe due to increased costs associated with climate policies. This results in emissions occurring outside the EU emissions cap, potentially leading to higher global greenhouse gas emissions and lower efficiency levels.

To address this issue, the European Commission (EC) is mandated to identify sectors or sub-sectors deemed to be significantly at risk of carbon leakage. During Phase III (2013-2020), sectors on the carbon leakage list were granted 100% of their benchmark allocation for free, while sectors not at risk received a diminishing share of their benchmark emissions for free.

A sector or sub-sector is considered at significant risk of carbon leakage if two conditions are met: First, the additional costs associated with implementing the directive would increase production costs by at least 5% of the Gross Value Added. Second, the trade intensity (imports and exports) of the sector with non-EU countries exceeds 10%.

Furthermore, a sector or sub-sector is also deemed at risk of carbon leakage if either the amount of the additional costs to at least 30% or the trade intensity with non-EU countries exceeds 30%.

In Phase IV, the EC intends to reduce the number of sectors on the carbon leakage list from 180 to around 50. Installations on this list will continue to receive 100% of their benchmarked allowances for free, while the remaining sectors, categorized as lower risk, will only receive 30% of their benchmark for free.

The current EC proposal includes the implementation of the Cross-Sectoral Correction Factor (CSCF) to preserve the absolute cap of EU ETS emissions. However, there is controversy surrounding the CSCF as it reduces the free allocation for all installations by the same percentage, irrespective of whether they are on the carbon leakage list or not.

In response to these challenges, environmental bodies in the UK and France have advocated for a four-tiered leakage list approach. This approach aims to categorize the risk faced by installations into four groups instead of the current binary classification. The objective is to ensure a more equitable distribution of free allocation to those installations that are most exposed and in need of support. Adopting a tiered leakage system would also eliminate the necessity for implementing the CSCF.