The economics of carbon leakage mitigation policies

In a trade model with endogenous emissions abatement, we investigate the impact of three policy instruments aimed at mitigating carbon leakage: free emission allowances, a Carbon Border Adjustment Mechanism (CBAM), and a CBAM with export rebates. We show that providing free allowances does not alter the incentives to abate carbon emissions, but, instead fosters the entry of more carbon intensive producers. This "levels the playing field" both domestically and internationally, and may even reverse carbon leakage. In contrast, a CBAM only levels the playing field domestically, and may lead to an autarky equilibrium. To reverse carbon leakage, a CBAM must be complemented with export rebates. We further show that a CBAM and export rebates improve welfare for any carbon price, and we identify the optimal share of free allowances with or without a CBAM. Finally, we perform a calibration exercise on cement and steel sectors to simulate the effects of the CBAM recently adopted by the European Union. Our model predicts a scenario with reverse carbon leakage and significant welfare gains for both sectors.