Carbon leakage: a mechanism design approach

By Lassi Ahlvik, Matti Liski

Abstract

Polluting firms often press policy makers to offer compensations or roll back regulations by threatening to relocate. Yet, only firms know if they can actually carry out the threat. Using a mechanism design approach, we show how exclusions and the intensity of regulation can be used to save on public funds and allocate regulatory assignments efficiently. Some leakage is always optimal, and the intensity of regulation increases when leakage is introduced; the regulation can even become stronger than in the first best. We provide an illustrative quantification of the optimal carbon leakage policy for the EU emissions trading program.