6.3  Carbon leakage

1053.  UK efforts to reach ambitious net zero carbon targets could be undermined by carbon leakage. Carbon leakage is the displacement of production and associated emissions from one jurisdiction to another, due to different levels of climate action across jurisdictions including through carbon pricing and climate regulation. As a result, global emissions in affected sectors could stay the same or rise further. The Net Zero Review conducted by HM Treasury in 2021 suggested that some UK manufacturing sectors have substantially lower emissions intensities compared to some trading partner.749 This means overall increase in emissions in addition to the displacement of UK industry.

1054.  Carbon leakage poses a risk to UK growth through forgone investment in UK industry, offshoring of production and jobs, and greater impacts from climate change associated with higher global emissions. Current carbon leakage policy for UK sectors at greatest risk of carbon leakage is based on Free Allowances under the UK Emissions Trading Scheme (ETS). This provides an asset that can be monetised to support efficiency and decarbonisation, or mitigation against carbon costs. The free allocation approach is being reviewed to seek improvements and, while that is going on, free allocation is guaranteed at current levels until 2026 (worth £2.4bn in 2021).xxxix Additionally, the Government recently extended the Energy Intensive Industries Compensation Scheme until March 2025, compensating firms at risk of carbon leakage for the indirect emission costs in electricity prices due to the UK ETS.

1055.  Carbon leakage should be considered within the UK ETS. Any development of the UK ETS carbon pricing regime (see below) to reduce the cap, phase out free allowances, or include additional sector should consider the risk of carbon leakage and ensure that sufficient mitigation measures are in place.

1056.  Sectors at greatest risk of carbon leakage are highly-traded and energy intensive. They include steel, chemicals, refineries, glass (including ceramics), aluminium, cement, paper and pulp, agriculture, and textiles. The highest-risk energy intensive industries, not including agriculture, represent approximately £39 billion (or 1.9%) of the UK's GVA, approximately 360,000 direct employees and approximately 10% of total UK greenhouse gas emissions (2019), with hubs in the North East, Yorkshire and the Humber, West Midlands, and Wales.750 Similar concerns have been voiced by industry stakeholders for the Review:

"High UK carbon prices and reduced allocation of free ETS allowances, will increase the risk of carbon leakage and reduce availability of capital to invest in decarbonisation. Decarbonisation should not lead to deindustrialisation."- Manufacturers' Climate Change Group (MCCG) and Energy Intensive Users' Group (EIUG)751

1057.  Through the roundtables, the Review has heard concerns about carbon leakage from numerous energy intensive industry stakeholders, calling for the Government to speed up action and decision-making. In particular, a Carbon Border Adjustment Mechanism (CBAM) similar in design to the EU's (see below) is a popular policy proposal to mitigate carbon

1058.  Any international solution to carbon leakage requires progress on establishing methodology to establish the fair comparison of measuring emissions and mitigations. This requires the development of a common international approach to measuring the carbon footprint of key products and assessing the comparability of different approaches to emissions mitigation. The Government is parts of efforts to build consensus across the G7, G20 and OECD, and should extend this work in order to improve the integrity of domestic carbon leakage mitigation measures.

1059.  Internationally, other actors are taking action to mitigate carbon leakage. The most advanced policy is the EU's proposed CBAM, the design of which was going through the final stages of negotiations at the time of writing. The EU will implement reporting requirements from 2023, moving on to a full rollout in parallel to the phase-out of EU ETS Free Allowancesxl. The full CBAM will involve charging imports a charge corresponding to the EU ETS price the good would have incurred, had it been produced in the EU. The EU model includes a deduction based on the carbon price paid in a third country, such as the UK, but those exporters would still need comply with the reporting requirements. This highlights the difficulty that multiple different unilateral measures could pose for free trade even between countries with similar levels of climate ambitions and carbon pricing. In an attempt to provide a forum for like-minded countries to work together on mitigating carbon leakage, the G7, led by Germany, is looking to set up a Climate Club.752 Nonetheless, WTO non-discrimination rules could make it difficult for to coordinate trade policy on CBAMs, particularly considering that the USA and Japan do not currently have a carbon price.753 In addition to the EU's plans for a CBAM, the Canadian government published a consultation for a Border Carbon Adjustment at the start of 2022.

1060.  At a time when stakeholders need certainty in the face of high energy prices, the Government should move forward with its plans to consult as quickly as possible and provide industry with a clear timeframe for decision-making and implementation. Given the difficulty agreeing on mitigations internationally, a meaningful international solution to carbon leakage should be considered a long-term solution and as such the Environment Audit Committee noted in 2022 that "work should start now on a comprehensive UK carbon border approach to address the risks of carbon leakage... [which will] spur international action on multilateral approaches to carbon pricing".754 In May 2022, the Government announced an intention to consult on a range of carbon leakage mitigation measures by the year of the 2022, but this has still not gone ahead. Government should move forward with these plans as quickly as possible, identifying the most appropriate form of carbon leakage mitigation for the UK. This could include a CBAM or mandatory product standards, but care needs to be taken with regards to the risk of circumvention and WTO compliance.755

1061.  As evidenced above, other major international actors have more progressed policies than the UK - for comparison the European Commission consulted on the EU CBAM in 2020. When other jurisdictions restrict access to their markets, the risk of carbon leakage and dumping of high emission goods in the UK would presumably increase further, and as such weakening the position of UK producers. This highlights the need for the Government to take action swifty to reassure stakeholders.

1062.  The Government should progress its consultation on carbon leakage measures, including a CBAM and mandatory product standards. The UK is falling behind on carbon leakage mitigation measures compared to other major actors, such as the EU and Canada. Additionally, industry is increasingly concerned about the lack of certainty of carbon leakage mitigations in the light of current the review of the UK ETS and Free Allowances (see below). While progressing on the carbon leakage consultation, the Government should continue to pursue international coalitions on carbon leakage to minimise trade disruption amongst climate ambitious countries caused by multiple different unilateral carbon leakage measures.

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xxxix  Using average UK ETS price for 2021 leakage. A CBAM would apply the UK ETS price to imported goods, ensuring that UK producers and consumers play on a level playing field. Encouraging UK industry to decarbonise without applying similar standards and costs to imported materials and goods will make the UK uncompetitive, stakeholders argued.

xl  At the time of writing the exact timing of this was still subject to inter-institutional negotiations at the EU level.