Editing IPCC:AR6/WGIII/Chapter-12 (section)

==== 12.6.3.1 Cross-sectoral Aspects of Carbon Leakage ====

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Carbon leakage occurs when mitigation measures implemented in one country or sector lead to a rise in emissions in other countries or sectors. Three types of spillovers are possible: (i) domestic cross-sectoral spillovers when mitigation policy in one sector leads to the re-allocation of labour and capital towards the other sectors of the same country; (ii) international spillovers within a single sector when mitigation policy leads to substitution of domestic production of carbon-intensive goods with their imports from abroad; and (iii) international cross-sectoral spillovers when mitigation policy in one sector in one country leads to the rise in emissions in other sectors in other countries. While the first two are described in [[IPCC:Wg3:Chapter:Chapter-13#13.6|Section 13.6]] , this section focuses on the third. Though some papers address this type of leakage, there is still a significant lack of knowledge on this topic.

One possible channel of cross-sectoral international carbon leakage is through global value chains. Mitigation policy in one country not only leads to shifts in competitiveness across industries producing final goods but also across those producing raw materials and intermediary goods all over the world.

This type of leakage is especially important because the countries that provide basic materials are usually emerging or developing economies, many of which have no or limited regulation of GHG emissions. For this reason, foreign direct investment in developing economies usually leads to an increase in emissions ( [[#Kivyiro--2014|Kivyiro and Arminen 2014]] ; [[#Shahbaz--2015|Shahbaz et al. 2015]] ; [[#Bakhsh--2017|Bakhsh et al. 2017]] ): in the case of basic materials the effect of expansion of economic activity on emissions exceeds the effect of technological spillovers, while for developed countries the effect is opposite ( [[#Shahbaz--2015|Shahbaz et al. 2015]] ; [[#Pazienza--2019|Pazienza 2019]] ). [[#Meng--2018|Meng et al. (2018)]] calculated that environmental cost for generating one unit of GDP through international trade was 1.4 times higher than that through domestic production in 1995. By 2009, this difference increased to 1.8 times. Carbon leakage due to the differences in environmental regulation was the main driver of this increase.

In order to address emissions leakage through global value chains, [[#Liu--2017|Liu and Fan (2017)]] propose the value-added-based emissions accounting principle, which makes it possible to account for GHG emissions within the context of the economic benefit principle. [[#Davis--2011|Davis et al. (2011)]] notice that the analysis of value chains gives an opportunity to find the point where regulation would be the most efficient and the least vulnerable to leakage. For instance, transaction costs of global climate policy and the risks of leakage may be reduced if emissions are regulated at the extraction stage as there are far fewer agents involved in this process than in burning of fossil fuels or consumption of energy-intensive goods. [[#Li--2020|Li et al. (2020)]] calls for coordinated efforts to reduce emissions embodied in trade flows in pairs of the economies with the highest leakage, such as China and the United States, China and Germany, China and Japan, Russia and Germany.

Unfortunately, these proposals either face difficulties in collection and verification of data on emissions along value chains or require a high level of international cooperation, which is hardly achievable at the moment. [[#Neuhoff--2016|Neuhoff et al. (2016)]] and [[#Pollitt--2020|Pollitt et al. (2020)]] focus on the regulation of emissions embodied in global value chains through national policy instruments. They propose implementation of a charge on consumption of imported basic materials into the European emissions trading system. Such a charge, equivalent to around EUR80 tCO 2 –1 , could reduce the EU’s total CO 2 emissions by up to 10% by 2050 ( [[#Pollitt--2020|Pollitt et al. 2020]] ) without significant effects on competitiveness. This proposal is very close to the carbon border adjustment introduced in the EU and described in more detail in Sections 13.2 and 13.6.

Cross-sectoral effects of carbon leakage also occur through the multiplier effect, when the mitigation policy in any sector in country A leads to the increase of relative competitiveness and therefore production of the same sector in country B, which automatically leads to the expansion of economic activity in other sectors of country B. This expansion may in turn lead to the rise of production and emissions in country A as a result of feedback effects. These spillovers should be taken into consideration while designing climate policy, along with potential synergies that may appear due to joint efforts. However, the scale of these effects with regards to leakage should not be overestimated. Even for intrasectoral leakage, many ''ex ante'' modelling studies generally suggest limited carbon leakage rates (Chapter 13). Intersectoral leakage should be even less significant. Interregional spillover and feedback effects are well studied in China ( [[#Zhang--2017|Zhang 2017]] ; [[#Ning--2019|Ning et al. 2019]] ). Even within a single country, interregional spillover effects are much lower than intraregional effects, and feedback effects are even less intense. Cross-sectoral spillovers across national borders as a result of mitigation policy should be even smaller, although these are less well studied. In future, if the differences in carbon price between regions increase, leakage through cross-sectoral multipliers may play a more important role.

Another important cross-sectoral aspect of carbon leakage concerns the transport sector. If mitigation policy leads to the substitution of domestic carbon-intensive production with imports, one of the side effects of this substitution is the rise of emissions from transportation of imported goods. International transport is responsible for about a third of worldwide trade-related emissions, and over 75% of emissions for major manufacturing categories ( [[#Cristea--2013|Cristea et al. 2013]] ). Carbon leakage would potentially increase the emissions from transportation significantly as the trade of major consuming economies of the EU and US would shift towards distant trading partners in East and South Asia. [[#Meng--2018|Meng et al. (2018)]] consider more distant transportation as one of the major contributors to the rise in emissions embodied in international trade from 1995 to 2009.

Emissions leakage due to international trade, investment and value chains is a significant obstacle to more ambitious climate policies in many regions. However, it does not mean that disruption of trade would reduce global emissions. Zhang et al. (2020) show that deglobalisation and the drop in international trade may result in emissions reductions in the short term, but in the longer term it will make each country build more complete industrial systems to satisfy their final demand, although they have comparative disadvantages in some production stages. As a result, emissions would increase. According to Zhang et al. (2020), for China, the decrease of the degree of global value chain participation (which ranges from 0 to 1) by 0.1 would lead to an increase in gross carbon intensity of China’s exports of 11.7%. On distributional implications, [[#Parrado--2014|Parrado and De Cian (2014)]] report that trade-driven spillover effects transmitted through imports of materials and equipment result in significant inter-sectoral distributional effects, with some sectors witnessing substantial expansion in activity and emissions and others witnessing a decline in activities and emissions.

It should also be mentioned that international trade leads to important knowledge and technology spillovers (Sections 16.3 and 16.5) and is critically important for achieving other Sustainable Development Goals ( [[#12.6.1|Section 12.6.1]] ). Any policies imposing additional barriers to international trade should therefore be implemented with great caution and require comprehensive evaluation of various economic, social and environmental effects.

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