Greening industry and the carbon leakage dilemma

A small group of commodities such as steel, cement, aluminum, and various chemical products account for around 22% of global CO2 emissions (see Figure 1). Often referred to as basic materials, these goods play a vital role in economic development, and as a result global demand is expected to increase dramatically – up to fourfold this century. That makes them an inescapable part of the net-zero equation, but tackling emissions from basic materials poses unique challenges.

Figure 1: Percentage contribution of basic materials in global CO2 emissions

Source: Based on Bataille, 2019

The emissions they produce are simply hard to abate for a number of reasons. First, their energy demand is high, with limited opportunities for clean electrification. Second, greenhouse gases are released through chemical transformation of raw inputs during production processes (known as “process emissions”). Finally, further emissions are released at the end of the product’s life. Recent research shows that reducing demand for these goods through a circular economy can reduce their production and associated emissions. Therefore, the abatement challenge calls for measures on both the supply and demand sides, from production innovation to more efficient use of materials downstream (see Figure 2).

Carbon pricing would help incentivize these measures on both the supply and demand sides. But differences in the level of carbon pricing across jurisdictions create unequal burdens on the cost of production, which can lead to a loss of market share to firms that face lower constraints on their emissions intensity or investment flowing to regions with laxer standards. This phenomenon, known as carbon leakage, is especially problematic for basic materials, which are highly emissions-intensive, homogenous, and traded globally.

Figure 2: the role of demand and supply side measures in decarbonizing European basic materials

Source: Based on Material Economics, 2019

To address the risk of carbon leakage, emissions trading systems (ETSs) around the world give an amount of allowances to industrial producers for free using specific rules and criteria. This free allocation blunts the effect of higher production costs and therefore reduces leakage risks, but in doing so limits incentives to reduce emissions and can distort low-carbon investment. Especially when free allocation is linked to output, carbon prices are not properly reflected in the costs of carbon-intensive products, meaning there is little to no incentive to use less of them.

On top of this, systems that have a high share of industrial emissions may not have sufficient allowances to award freely as allowance budgets decline with targets required for net zero. Finally, as more jurisdictions begin to price industrial emissions to meet their Paris Agreement obligations, an approach that offers free allocation to firms regardless of the carbon pricing of their competitors will increasingly come into question as overly protective, a misguided use of scares resources, and incompatible with net-zero goals.

Where does this carbon leakage dilemma leave policymakers working to decarbonize industry? The industrial decarbonization and carbon leakage challenge, the remedies applied so far, possible alternatives, and additional policies to support decarbonization are explored in a new report by the International Carbon Action Partnership (ICAP), an intergovernmental organization on ETSs.

A framework for assessing climate mitigation approaches that balances the objectives of leakage protection, incentives for decarbonization, and political durability is developed and then applied to assess current approaches to free allowance allocation as well as alternative leakage measures, including border carbon adjustments (BCA) and consumption charges. Given the legal and administrative complexity of BCAs, we offer analysis on the key design choices and guidelines to help navigate the likely trade-offs between effectiveness and feasibility. Because carbon pricing alone will not likely be enough for deep decarbonization of industry, the report closes with a review of supporting policies aimed at spurring low-carbon technologies, de-risking investments in production innovation, and stimulating markets for low-carbon goods.

The importance and urgency of the challenge before us demands that we consider policies to address the risk of carbon leakage in light of the more ambitious climate targets ahead and a changing carbon- pricing landscape. ICAP is committed to furthering global dialogue on the role carbon pricing can play in a sustainable and just transition to net zero.