Carbon leakage happens when climate regulations in one country push production to another country with weaker rules, resulting in no net reduction in global emissions. A factory facing a carbon tax in Germany, for example, might relocate to a country without one, taking its pollution along with it. The emissions don’t disappear; they just move somewhere else.
How Carbon Leakage Works
The basic logic is straightforward. When a government puts a price on carbon emissions, whether through a carbon tax or a cap-and-trade system, it raises the cost of doing business for companies that burn fossil fuels or run energy-intensive processes. If competitors in other countries don’t face the same costs, the regulated companies are at a disadvantage. They can either absorb the higher costs, pass them to customers, or move operations somewhere cheaper.
That third option is carbon leakage. The additional emissions generated by shifting production to a less-regulated country are the “leaked” carbon. In the worst case, the new location has dirtier technology or looser environmental standards, meaning the same product now generates even more pollution than before the policy existed.
There’s also an indirect route. When a group of countries reduces its demand for fossil fuels, global fuel prices drop. Cheaper oil and gas make it more attractive for unregulated countries to consume more, partially or fully offsetting the original emissions savings. Economist Hans-Werner Sinn called this the “Green Paradox”: if fossil fuel producers see their future market shrinking, they may accelerate extraction now while prices are still viable, actually speeding up emissions in the short term rather than slowing them down.
Which Industries Are Most at Risk
Carbon leakage is most threatening in industries that are both energy-intensive and trade-exposed. “Energy-intensive” means production requires enormous amounts of heat, electricity, or chemical processing. “Trade-exposed” means the products compete on global markets, so companies can’t simply raise prices without losing customers to foreign rivals.
The sectors most commonly flagged include steel, aluminum, cement, fertilizer, glass, paper, and petroleum refining. These industries share a common profile: their products are relatively standardized commodities, margins are thin, and shipping costs are low enough that importing from overseas is practical. A ton of steel from India competes directly with a ton of steel from Europe, so even a modest cost difference from carbon pricing can shift trade flows.
Not every industry faces the same risk. A software company or a hospital doesn’t compete with foreign producers in the same way. The concern is concentrated in a specific band of heavy manufacturing where energy costs make up a large share of total production costs and where international competition is fierce.
How Large Is the Problem
Estimates vary enormously depending on the model, the policy being studied, and the assumptions built in. An OECD analysis of carbon leakage through trade found a median leakage rate of about 3%, meaning that for every 100 tons of emissions reduced by a climate policy, 3 tons reappeared elsewhere through trade shifts. But the average was 14%, pulled up by certain country-sector combinations where leakage was far more severe. Small open economies and emission-heavy sectors like basic metals showed significantly higher rates.
Academic modeling has produced an even wider range. Studies using large-scale economic simulations have calculated leakage rates anywhere from negative 14% (meaning the policy actually reduced emissions abroad too) to over 100% (meaning the policy backfired entirely, increasing global emissions). That 100%-plus scenario is rare in practice but theoretically possible when global fuel price effects and investment relocation both push in the wrong direction.
One concrete example: researchers at MIT studied California’s cap-and-trade program and estimated its leakage rate at about 9%. California addressed this partly by including imported electricity under its emissions cap and banning “resource shuffling,” where utilities swap clean power into the state on paper while selling dirty power elsewhere. Without those rules, leakage would have been substantially higher.
How Governments Try to Prevent It
The most common defense is giving free emissions permits to industries at high risk of relocating. Under the EU’s Emissions Trading System, the world’s largest carbon market, companies in vulnerable sectors receive free allowances instead of having to buy them at auction. The number of free permits is calculated using benchmarks based on the 10% most efficient facilities in each sector. If your factory matches those top performers, you get enough free allowances to cover your emissions. If your factory is less efficient, you face a cost gap that incentivizes upgrades without pushing you out of the country entirely. Sectors on the EU’s carbon leakage list can receive up to 100% of their allowances for free, while less exposed sectors receive 30%, a share that will phase out by 2030.
Free allowances work as a stopgap, but they have a downside: they weaken the financial signal that’s supposed to drive emissions reductions. If companies get permits for free, the urgency to cut pollution drops. This tension between protecting competitiveness and actually reducing emissions is the central challenge of carbon leakage policy.
Border Carbon Adjustments
The newer and more ambitious approach is taxing imports based on their carbon content. The EU’s Carbon Border Adjustment Mechanism, or CBAM, entered its definitive phase on January 1, 2026, after a transitional reporting period that began in October 2023. It currently covers cement, iron and steel, aluminum, fertilizers, electricity, and hydrogen.
The system works like this: EU importers must buy CBAM certificates corresponding to the emissions embedded in the goods they bring in. The certificate price is tied to the EU carbon market auction price. If the exporting country already charges a carbon price, that amount can be deducted, so importers aren’t double-taxed. Importers bringing in more than 50 tonnes of covered goods need to register as authorized CBAM declarants.
The goal is to level the playing field. A steel producer in the EU paying for carbon permits should face the same competitive conditions as a steel exporter in a country without carbon pricing. If the border adjustment works as designed, there’s no cost advantage to relocating, which removes the incentive for leakage in the first place. As CBAM scales up, the EU plans to phase out free allowances in the covered sectors, replacing one anti-leakage tool with another that preserves the emissions reduction incentive.
Why Policy Design Matters
Not all climate policies create the same leakage risk. The OECD found that market-based instruments like carbon taxes and emissions trading systems tend to increase both the volume and carbon intensity of imports, because they raise domestic costs without changing anything abroad. Technology-support policies, such as subsidies for clean energy or efficiency upgrades, work differently. They reduce the carbon intensity of production without raising costs in a way that disadvantages domestic producers, which means they tend to lower leakage risk.
This distinction matters for policymakers choosing their toolkit. A carbon tax paired with border adjustments addresses leakage head-on. Clean energy subsidies sidestep the problem by making domestic production cheaper rather than making dirty production more expensive. In practice, most countries use a combination, layering carbon pricing with technology incentives and trade protections to manage the different channels through which emissions can leak.
The broader lesson is that climate policy doesn’t operate in a vacuum. A regulation that cuts emissions within one border can shift them to another if the policy doesn’t account for how global markets respond. Carbon leakage is the reason why international coordination on climate policy matters so much, and why unilateral action, while valuable, comes with built-in limits that need to be actively managed.