Carbon Border Adjustment Mechanism and Free Allowances

Abstract: Carbon leakage is an obstacle to the implementation of carbon pricing, such as emission permit markets in a world open to trade. The greenhouse gas emission reduction induced domestically can be offset by a growing share of imported products with a higher carbon footprint. We investigate two policy instruments that aim at mitigating carbon leakage: free allowances and the Carbon Border Adjustment Mechanism (CBAM). We show that both instruments impact differently trade, emissions and welfare. Free allowances give a comparative advantage to the domestic firms whose abatement cost is lower than the revenue from their net position in the permit market. As a consequence, those firms are able to export, which reverses the leakage problem. In contrast, the CBAM makes imported products more expensive, which reduces trade. We identify the determinants of the economic outcomes with one of the two instruments or both under perfect and imperfect competition. We also characterize the optimal share of free allowances and optimal carbon price under the CBAM.