Report: Carbon Leakage and Competitiveness: International trade effects of carbon pricing

The findings indicate that the current structure of the EU ETS has not negatively affected Swedish firms’ trade in relevant goods.

Mai Ahrne Bojang Trade Policy Adviser

The EU’s carbon pricing system (EU ETS) aims to decarbonise industrial production, but does it affect firms’ competitiveness? This report finds no negative impact on Swedish firms’ international trade performance. The results suggest that climate goals and competitiveness can go hand in hand, although continued monitoring is important as the EU ETS is currently being revised. Mai Ahrne Bojang, one of the authors of the report, explains.

What is carbon pricing, and what is its impact on firms’ competitiveness?

Competitiveness of the European economy is front-and-centre in recent policy debates. At the same time, policies aimed to address climate change continue to move forward. This report finds itself at the intersection of these debates. 

Carbon dioxide emissions are among the main drivers of climate change but their damage is generally not priced into the decisions made by firms. Carbon pricing is a partial solution, as it puts a price on the emission of each tonne of carbon dioxide, following the so-called “polluter pays” principle. While this is meant to encourage firms to invest in cleaner production methods, it also leads to higher production costs, which can affect their competitiveness on domestic and foreign markets.

How has the EU approached this?

Since 2005, the EU has relied on the Emissions Trading System (EU ETS) to incentivise industries to decarbonise their production. While in the early years the carbon price was low, recent changes to the system have seen rapidly increasing prices. To limit the competitiveness impacts of these higher carbon prices, the system includes free allowances. These permits to emit carbon dioxide are given to firms as way to avoid large increases in production costs.

What is carbon leakage and how can it affect international trade flows?

Firms covered by the EU ETS could be at a disadvantage compared with foreign firms that do not face a carbon pricing system. This could lead to higher production (and therefore emissions) in regions not covered by the EU ETS, so-called carbon leakage. There are two channels of leakage that are predominantly relevant for international trade discussions: production leakage and export leakage. Imports could rise if production abroad at a lower cost replaces EU production (production leakage). Exports could drop if EU firms become less competitive on global markets (export leakage).

How do you approach the question?

We examine the impact of higher carbon prices under the EU ETS on international trade, identifying carbon leakage using Swedish firm-level data. We first compare trade flows for EU ETS firms with those of similar firms outside the EU ETS. We then take a broader look at the Swedish economy as a whole, including downstream firms that trade relevant products. As most of the existing literature looks at sector-level data, our focus on firm-level behaviour contributes to our understanding of changes in trade flows for firms directly or indirectly affected by the EU ETS.

What do you find?

The report finds no consistent evidence that the higher EU ETS price has affected firms’ trade performance. Swedish EU ETS firms perform no differently compared with similar firms outside the system. Nor does the broader analysis of the trade flows of all Swedish firms reveal evidence that the ETS price has affected import or export flows. Overall, the findings indicate that the current structure of the EU ETS has not negatively affected Swedish firms’ trade in relevant goods. We argue that this may be due to the free allowances protecting firms from higher costs, or because of Swedish firms adapting their production and reducing emissions as a response to the price signal sent through the EU ETS.

What is the main message you hope that readers take away from the analysis?

The competitive position of Swedish firms and the decarbonisation agenda need not be at odds. In the near future the EU ETS will move away from free allowances to be even more in line with the “polluter pays” principle. It is therefore important to continue monitoring potential carbon leakage and the system’s effect on firms’ competitiveness through the lens of international trade. Additionally, stability and foreseeability in carbon pricing systems are essential to incentivise firms’ decarbonisation strategies.