TECHNICAL NOTE 11 | OCTOBER 2015 Carbon Leakage Theory, Evidence and Policy Design This technical note was prepared for the PMR Secretariat by John Ward, Paul Sammon, and Guy Dundas of Vivid Economics; and Grzegorz Peszko (World Bank Group) and Pauline Kennedy (PMR Secretariat), with support from Sebastian Wienges and Nicolai Prytz (World Bank Group). We would like to acknowledge experts and policy practitioners from those countries featured in this report who participated in interviews and a questionnaire. We would also like to acknowledge their insights and comments as part of the external review process. Please direct any comments and questions about this study to the PMR Secretariat ([email protected]). Technical Note 11 | October 2015 Carbon Leakage Theory, Evidence and Policy Design © 2015 International Bank for Reconstruction and Development/The World Bank 1818 H Street NW, Washington, DC 20433 Telephone: 202-473-1000; Internet: www.worldbank.org This work is a product of external consultants with supervision and contributions of the staff of The World Bank. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Rights and Permissions The material in this work is subject to copyright. Because The World Bank encourages dissemination of its knowledge, this work may be reproduced, in whole or in part, for noncommercial purposes as long as full attribution to this work is given. Attribution—Please cite the work as follows: Partnership for Market Readiness. 2015. “Carbon Leakage: Theory, Evidence, and Policy.” PMR Technical Note 11. World Bank, Washington, DC. License: Creative Commons Attribution CC BY 3.0 IGO Translations—If you create a translation of this work, please add the following disclaimer along with the attribution: This translation was not created by The World Bank and should not be considered an official World Bank translation. The World Bank shall not be liable for any content or error in this translation. Adaptations—If you create an adaptation of this work, please add the following disclaimer along with the attribution: This is an adaptation of an original work by The World Bank. Views and opinions expressed in the adaptation are the sole responsibility of the author or authors of the adaptation and are not endorsed by The World Bank. Third-party content—The World Bank does not necessarily own each component of the content contained within the work. The World Bank therefore does not warrant that the use of any third-party-owned individual component or part contained in the work will not infringe on the rights of those third parties. The risk of claims resulting from such infringement rests solely with you. If you wish to re-use a component of the work, it is your responsibility to determine whether permission is needed for that re-use and to obtain permission from the copyright owner. Examples of components can include, but are not limited to, tables, figures, or images. Any queries on rights and licenses, including subsidiary rights, should be addressed to the Publishing and Knowledge Division, The World Bank Group, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522-2625; e-mail: [email protected]. PMR Technical Note 11 (October 2015) Contents Executive Summary ......................................................................................................................................1 What Is Carbon Leakage? .........................................................................................................................1 Assessing Carbon Leakage ........................................................................................................................2 Managing the Risk of Carbon Leakage .....................................................................................................3 Importance of Engaging with Stakeholders ..............................................................................................6 1. Introduction ..............................................................................................................................................8 1.1. Background and Terms of Reference .................................................................................................8 1.2. The Issue of Carbon Leakage .............................................................................................................8 1.3. Report Structure ................................................................................................................................9 2. Carbon Pricing and Carbon Leakage .......................................................................................................10 2.1. The Objective of Carbon Pricing Policy ............................................................................................10 2.2. The Challenge of Incomplete Carbon Pricing ..................................................................................11 2.3. Competitiveness and Leakage .........................................................................................................12 3. Theory and Evidence of Carbon Leakage ................................................................................................14 3.1. Defining Leakage and Identifying Its Key Channels .........................................................................14 3.2. Modeling Leakage and Other Effects of Carbon Pricing Policies .....................................................17 4. Policy Responses to Carbon Leakage: Which Sectors to Target? ............................................................28 4.1. Breadth of Assistance ......................................................................................................................29 4.2. Criteria to Determine Sectors at Risk...............................................................................................31 5. Policy Responses to Carbon Leakage: How to Support Sectors at Risk ...................................................37 5.1. Integrated versus Complementary Measures .................................................................................37 5.2. Different ormsF of Integrated Measures .........................................................................................37 5.3. Pros and Cons of Different Options .................................................................................................42 5.4. Complementary Policies ..................................................................................................................59 6. Engaging Stakeholders on Carbon Leakage ............................................................................................63 6.1. The Policy Debate and Role of Engagement ....................................................................................63 6.2. Modes of Engagement ....................................................................................................................64 6.3. Framing the Debate .........................................................................................................................67 6.4. Lessons Learned on Stakeholder Engagement ................................................................................69 iii PMR Technical Note 11 (October 2015) Appendix 1: Leakage Prevention Mechanisms in a Range of Carbon Pricing Schemes ..............................71 Appendix 2: Leakage and National Competitiveness .................................................................................77 References ..................................................................................................................................................80 Boxes 1. Modeled Welfare Impacts of Carbon Pricing Policies ..........................................................................19 2. Variations in Key Assumptions Cause Leakage Rate Estimates to Vary between Studies Using Similar Approaches .....................................................................................................................23 3. A Broader Literature on the Impact of Environmental Regulation on Firm Investment and Productions Decisions Tends to Find Little Impact ...............................................................................26 4. Some Countries Provide Different Types of Free Allowance Allocation for Different Sectors ..............39 5. Exemptions to Address Leakage Have Been Applied (or Are Planned to Be Applied) in a Number of Carbon Taxes ......................................................................................................................40 6. Carbon and Energy Taxes Can Be Introduced in Conjunction with Reductions in Other Taxes or Other Forms of Rebate ...........................................................................................................41 7. Aspects of the Californian Carbon Price Scheme Resemble a BCA ......................................................42 8. Pros and Cons of Grandfathering .........................................................................................................45