Mitigating Emissions Leakage in Incomplete Carbon Markets

Policies regulating greenhouse gas emissions apply to a small subset of emitting sources. This raises a formidable concern: emissions can “leak” from regulated to unregulated sources. We provide a theoretical basis for deriving industry-specific measures of leakage risk and for calibrating the output-based subsidies that are currently used to mitigate leakage. Using US energy price variation as a proxy for variation that would be induced by a domestic carbon price, we show how theoretically consistent leakage-mitigating subsidies can be calibrated. We simulate the impacts of a domestic carbon price on US manufacturing with and without these subsidies. Absent mitigation, emissions leakage is substantial. Output-based subsidies targeted on the basis of our leakage risk measures significantly reduce this leakage risk. In contrast, the current practice of coarsely targeting subsidies on the basis of emissions intensity and trade exposure delivers a small fraction of leakage mitigation benefits while incurring significant costs.