Pricing greenhouse gas emissions is one of the most important tools to decarbonise economies, and it has been implemented in the EU since 2005 through the EU Emissions Trading System (ETS). As part of this policy, the heavy industry benefits from large exemptions and receives nearly all of its allowances (i.e. pollution permits) for free. This has led to significant windfall profits for companies and is tantamount to subsidising pollution. The free allocation is supposed to prevent so-called “carbon leakage”, a hypothetical concern according to which companies will relocate their production from the EU if they are faced with excessive carbon prices domestically. 

There is no evidence of carbon leakage having taken place due to climate policies such as the EU ETS, and ex-ante theoretical predictions have found a very limited risk in the future, materialising (theoretically) only at very high carbon prices. Therefore, the free allocation should be fully phased out. Moreover, while the power sector, which must purchase its allowances, has decarbonised steadily year after the year, industrial emissions have stagnated since 2012.

As part of the EU Green Deal, the European Commission is considering a Carbon Border Adjustment Mechanism (CBAM) to reduce the risk of carbon leakage, as an alternative to the existing measures under the EU ETS. This implies it would allow a phase-out of free allocation. Given the lack of evidence to support the theoretical risk of carbon leakage, neither the free allocation of pollution permits nor a CBAM are necessary tools for climate action. However, a CBAM is preferable to free allocation as a CBAM ensures that polluters pay for their emissions. If a CBAM is to be introduced, the following prerequisites and design elements are necessary.

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