Carbon Leakage in the Regional Greenhouse Gas Initiative: Lessons Learnt for the European Union Emissions Trading Scheme

Abstract

Emissions trading systems (ETSs) are emerging around the globe in response to climate change concerns. A severe side effect that may flow from an ETS is carbon leakage, which is generally understood as the shift of production to less regulated jurisdictions as a result of carbon pricing policy, and affects the environmental effectiveness of any ETS. In the US Regional Greenhouse Gas Initiative (RGGI) concerns about carbon leakage are related to electricity production. In the EU Emissions Trading Scheme (EU ETS), by contrast, concerns focus on industrial production as opposed to electricity production. This paper formulates policy lessons from the carbon leakage discussion in RGGI about the factors that will make carbon leakage in the electricity generation sector (electricity leakage) a problem in the EU ETS.First, electricity leakage depends on the physical opportunity for importing power into the ETS region, which is determined by the existence of cross-border transmission lines, available transmission capacity and demand for imported electricity in the ETS region. Second; leakage occurs when there is a net financial incentive to import electricity. This arises when the costs related to cross-border transmission, including line loss costs, congestion charges and long-term contracts on the electricity market, are outweighed by the existence of considerable production cost differentials between regulated and unregulated out-of-region electricity generation. The paper analyzes how ambitious emission reduction targets and current developments in the framework of the Energy Community Treaty will bring about electricity leakage in the EU ETS. This inevitability requires timely regulatory clarification from the legislator for the purpose of preventing inefficiency from investments that turn out to be redundant ex post (stranded costs).