Changes to the EU Emissions Trading System
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The European Union is a global leader in climate policy. However, its ambitious emissions reduction targets also create significant challenges for industrial competitiveness. As carbon prices continue to rise across Europe, companies are facing increasing compliance costs, while many competitors in other regions of the world continue to operate under far less stringent carbon pricing regimes. This creates a risk that production, investment, and jobs may move outside the European Union without reducing overall global emissions. This phenomenon is known as carbon leakage.
To address this challenge, the EU is introducing the Carbon Border Adjustment Mechanism (CBAM), which will gradually replace the existing system of free emission allowance allocation. Recent research suggests that the interaction between CBAM and the phase-out of free allowances will be one of the key factors shaping the future of European industry.
Carbon leakage is becoming a real risk
Carbon leakage occurs when stricter climate policies in one region lead companies to relocate production to jurisdictions with less stringent environmental requirements. In such cases, emissions decline within Europe but increase elsewhere. As a result, industrial capacity, jobs, and investments may be lost, while the overall climate benefit remains limited.
For many years, some experts considered this risk relatively small. However, recent empirical studies increasingly identify a direct link between rising carbon costs and the relocation of production outside Europe. This is particularly relevant for energy-intensive sectors competing on global markets, where companies are often unable to fully pass higher costs on to consumers.
CBAM changes the rules of the game
To address unfair competition, the European Union is implementing CBAM with the objective of ensuring that imported goods face a carbon cost comparable to that borne by products manufactured within the EU. Initially, the mechanism covers sectors such as steel, cement, aluminum, fertilizers, and hydrogen.
CBAM significantly improves competitive conditions for European producers in the domestic market. However, it does not solve every challenge. While it protects against cheaper imports, it cannot fully compensate for lost competitiveness in export markets. Nor does it address situations where higher costs are transferred further down the value chain. The study therefore concludes that CBAM cannot fully replace other instruments aimed at reducing carbon leakage.
The importance of free allowances during the transition
International comparisons show that many jurisdictions continue to rely on free allocation mechanisms or similar instruments that result in very low effective carbon costs for industrial companies. This means that European firms already operate under considerably more challenging conditions than many of their global competitors.
Recent policy discussions often assume that CBAM can gradually replace free emission allowances. However, the study demonstrates that these instruments perform different functions. CBAM influences competition at the border, while free allocation reduces actual compliance costs and preserves companies’ capacity to invest in modernization and decarbonization.
The study reaches a clear conclusion: maintaining a reasonable level of free allocation during the transition period can help prevent rapid deindustrialization while providing companies with sufficient time to undertake the investments required for emissions reductions.
Impacts on supply chains and competitiveness
Modeling results from the steel and fertilizer sectors reveal an important trend. CBAM supports domestic production and reduces imports in sectors directly covered by the mechanism. At the same time, higher input costs reduce competitiveness in downstream industries, including automotive manufacturing and agriculture.
As a result, carbon leakage risks do not disappear entirely but instead shift further along the value chain. If free allocation is rapidly phased out, inflationary pressures increase, production volumes decline in downstream sectors, and imports of finished products become more attractive. By contrast, maintaining free allocation mitigates these negative effects and enables a more gradual transition.
Future challenges for European industry
CBAM is an important component of the EU’s climate policy because it reduces competitive pressure from imports and encourages lower-emission production both inside and outside Europe.
At the same time, the EU Emissions Trading System operates at some of the highest carbon price levels in the world. While European companies face increasing carbon-related costs, carbon prices in many other jurisdictions remain significantly lower, creating additional challenges for the international competitiveness of European industry.
The study concludes that CBAM alone is not sufficient to fully eliminate the risk of carbon leakage. Questions surrounding export competitiveness and supply-chain resilience remain particularly important. Consequently, a successful transition to a climate-neutral economy will require a careful balance between ambitious climate objectives and the preservation of industrial competitiveness.
A balanced combination of CBAM and free emission allowances may prove to be one of the key prerequisites for enabling Europe to achieve its climate neutrality goals while maintaining a strong and competitive industrial base.
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