Plugging carbon leakage

Consider a multinational corporation – let’s call it Bloc S.A. – that manufactures cement. Headquartered in France, it is subject to the rules and regulations of the EU, where strict climate-protecting policies have significantly increased the cost of emitting carbon.

Now consider that Bloc has cement-producing subsidiaries in sub-Saharan Africa, in countries where emitting carbon is cheaper because environmental regulations are less stringent (and economic development opportunities are encouraged).

So, Bloc might cut its costs by shifting some carbon-emitting production from France to its African subsidiaries. This shift is not illegal, yet it is a prime example of carbon leakage; whereby companies move emissions from one place to another instead of taking steps to reduce or stop them, and evade emissions costs in so doing.

Emissions spillover

This is the topic of a new working paper, “Carbon Leakage to Developing Countries”, which asks: “How do climate policies in developed countries spill over to the developing world?”

To answer this, London Business School’s Marcel Olbert and Julian Marenz, working with co-author Diego R. Känzig of Northwestern University, created a novel dataset that combines thousands of multinational firms’ subsidiary locations in Africa with relevant carbon-emissions data for those locations over time. The data clearly shows carbon leakage from the EU into Africa as new climate policies come into effect. The dataset – and the insights gleaned from it – are particularly timely, given that the EU’s Carbon Border Adjustment Mechanism (CBAM) will take effect in 2026.

Climate change is a global problem that must be tackled on a global level – but localised solutions provide productive starting places, especially when the world’s top polluters are prioritised as targets. Marcel explains: “We know Europe’s carbon-curbing policies are working, but we also see that their effects are limited. Given that, we ask: ‘Why aren’t EU policy effects more significant? Are the carbon taxes not high enough to act as sufficient deterrents, or is carbon leakage playing a role?’”

The paper presents strong evidence for carbon leakage and provides decision-makers with data that can help finetune policy, taking economic development considerations into account.

Combatting the climate crisis

Carbon taxes and emissions-trading schemes are two tools that Europe is wielding to discourage harmful emissions within their reach. One of the key pillars of European climate policy is the EU Emissions Trading System (EU ETS), which was the world’s first major carbon market when launched in 2005. The market is based on the “cap and trade” principle, with a set number of allowances. In a nutshell, it requires polluters to pay for their greenhouse gas emissions; incentivising reductions while generating revenues to finance the EU’s green transition.

The EU ETS covers more than 11,000 heavy polluters, accounting for around 40% of total EU greenhouse gas emissions. Studies have indicated that the scheme is working to cut carbon emissions, yet its impact is not as significant as some hoped.

Combatting carbon leakage has been a goal of EU policy for several years. The EU’s industrial installations considered to be the most susceptible to carbon leakage have, over these years, received special support in the form of more free allowances. But those free allowances are being phased out gradually, just as the CBAM comes into force. The CBAM was designed to ensure that the carbon price of imports from non-EU countries is equivalent to the carbon price of EU production in order to help plug arbitrage holes. When the CBAM takes effect, starting in 2026, policy makers will be watching the data closely to see how well the mechanism is working to stop carbon leaks.

The leaks are showing

With the costs of doing business varying considerably from one place to the next, global corporations have always looked to locational arbitrage for competitive advantage. But when it comes to pollution, locational arbitrage is a problem for the planet, bringing to mind the classic arcade game Whac-A-Mole, where whacking the mole in one place simply leads to it popping up somewhere else.

To clearly identify causal carbon leakage effects, the researchers measure multinationals’ exposure to carbon prices three years prior to when the EU ETS pricing pressures really kicked in; from 2007 to 2009. They then analyse exposure to the EU ETS carbon price hikes and how those costs interact with emissions data (and other relevant variables) from 2010 to 2019. The dataset includes more than 1,500 large multinational firms.

Then, focusing on Africa, where many European firms have subsidiaries and lower operational costs on various fronts, the authors zoom in on the exact location of nearly 16,000 subsidiaries that fit the requirements of the study and collect granular emissions data from those locations to observe changes over time, controlling for certain variables.

African subsidiaries of European multinationals and CO2 emissions data

This empirical approach allows observations of climate policies on many levels and in many specific cases. For example, in 2014, France introduced a national carbon tax while Germany did not. So, while both were participating in the EU ETS, some of France’s carbon tax effects could be observed by studying the emissions of African subsidiaries owned by French multinationals and comparing them with those owned by German multinationals. In this instance, the researchers found that local carbon emissions by African subsidiaries of French multinationals increased by approximately 2.4% more than emissions around German-owned subsidiaries after 2014, with effect sizes increasing gradually over time.

Note: This map contains information on carbon taxes and EU ETS prices for selected countries, where effective prices range from €3.47 in Luxembourg to €54.54 in Sweden: https://datawrapper.dwcdn.net/k6hpo/1/

Zooming out, the paper finds that increasing the exposure to European climate policy and higher carbon prices led to statistically significant increases in emissions at African subsidiaries. It also finds that the carbon-leakage effects are more pronounced in African countries with less stringent environmental policies. Marcel says the results indicate that “multinational firms avoid higher policy-induced carbon prices to a significant extent by exporting emissions to the least regulated jurisdictions in the developing world.”

Avoiding negative economic consequences for developing countries

The researchers document carbon leakage to the developing world that arises due to stringent policies in the developed world. But, as Marcel is careful to note, if you manage to reduce emissions in Germany by 2%, this is a very big deal; whereas increasing emissions in Kenya by 10% is not that dire in terms of absolute volumes. 

At the aggregate level, the results of the research document a significant increase in economic activity and emissions in Africa. But, rather than pursue policies that simply target this, the authors conclude that policies to mitigate leakage should balance environmental concerns against development and equity considerations.

This research was supported by the Wheeler Institute for Business and Development at London Business School.