Carbon these allowances in the market. This

Carbon
leakage can occur for a number of reasons. For instance, if the carbon emission
policy of a country raises the cost of local emission, then another country
with a more relaxed policy would have a comparative advantage. Carbon Leakage
increases firms cost by attempting to make firms internalise the negative
externalities they cause, the pollution they produce. This leads increase in
costs cause firms to move to regions with more relaxed carbon emission policies
with cheaper costs. Rather than incentivising firm innovation, the carbon
emission costs could lead firms to move abroad as there are cheaper forms of
production because climate and emission policies are not universal policies.
Due to this, it is clearly arguable that by not acknowledging carbon leakage,
carbon emission policies can lead to innovation failure as firms will simply
move to another country with a more relaxed climate policy and pollute more in
other region. A possible solution for this is that policies that aim to tackle
carbon leakage need to be universal or face the potential of carbon emission
policies failing to be implemented correctly.  The
EU ETS has a ‘cap and trade’ system which aims to reduce carbon emissions in
general. This aims to cap the overall level of emissions allowed to be produced
by setting an aggregate emission limit. Within that limit, participants in the
system are able to buy and sell permits as they need it. These permits are the
trading ‘currency’ at the heart of the system. The gradual cap on the total
number of permits creates scarcity for these allowances in the market. This
scarcity in permits means that the permits tend to be higher in price and thus provides an incentive for firms to produce less carbon emissions in order to reduce their
need for the permits. However, if the demand for a
firm’s goods remains the same, production may move offshore to a cheaper
country with lower emission standards, and global emissions will not be
reduced. Arguments that the risk of
leakage undermines the environmental outcomes, while at the same time leading
to a decline in domestic production with potential job losses, can weaken
support for the introduction of carbon pricing. In addition, measures to
address carbon leakage normally involve the use of fiscal resources (explicit
or implicit) that could be used for other purposes (to compensate households or
other affected groups, or other general uses of revenue). This trade-off often
requires a degree of political judgment providing the incentive for different
interests to persuade decision makers. Pollution permits would fall
in price as a result of carbon leakage meaning firms do not pay the full cost
of pollution and also do not have to internalise the cost of the negative
externality they have caused.