Carbon Leakage

Carbon leakage refers to the risk that climate regulation in one jurisdiction causes carbon-intensive production to shift to less-regulated markets, increasing emissions elsewhere rather than reducing them globally. It occurs when companies move carbon-intensive production abroad to countries where less stringent climate policies are in place, or when domestic products get replaced by more carbon-intensive imports. It is not the same as a company's Scope 3 emissions or supply chain carbon footprint: carbon leakage describes a systemic failure of climate policy, where regulation succeeds locally but displaces the problem rather than solving it.

There are two main drivers:-

1. Cost competitiveness: industries relocate to avoid compliance costs created by carbon pricing or emissions caps.
2. Market substitution: buyers switch to cheaper, higher-emission imports from less-regulated markets, replacing domestic production without any net reduction in global emissions.

Under the EU ETS, installations considered to be at risk of carbon leakage receive some free emission allowances to reduce the competitive disadvantage created by carbon pricing. This protection is being progressively phased out as CBAM is introduced. CBAM applies to imports of goods at most significant risk of carbon leakage: cement, iron and steel, aluminium, fertilisers, electricity, and hydrogen. By requiring importers to pay a carbon price equivalent to what EU producers pay, CBAM removes the cost advantage that less-regulated producers would otherwise hold in the EU market.

Carbon leakage also has implications for Scope 3 reporting. When a company relocates production to a less-regulated jurisdiction, the emissions remain embedded in the goods it purchases or sells. Under the GHG Protocol, those emissions still fall within a company's Scope 3 boundary, meaning leakage may reduce direct emissions while leaving the full value chain footprint largely unchanged.

While CBAM is the most prominent policy response to date, other jurisdictions are developing equivalent border carbon mechanisms. Carbon leakage is not solely a European concern: any jurisdiction that prices carbon unilaterally faces the same structural risk.

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