How to regulate carbon leakage?
This article by Juan Montero and Matthias Finger, FSR, originally appeared in the Policy Brief on Carbon leakage and mitigating measures.
The EU model of regulation stems from the time of the liberalisation of the network industries, i.e. from the 1990s onwards. Deregulation and accompanying re-regulation were aimed at making the different network industries more efficient, more innovative and more competitive. European aviation, but behind telecommunications, is without doubt a success story in this regard.
Since the 90s, the EU's regulatory model has focused on liberalising network industries, leading to increased efficiency and competition, particularly in aviation. However, the 2020s have shifted the emphasis to decarbonisation, driven by the Green Deal and the Fit for 55 Package. These decarbonisation efforts increase costs for the aviation sector, where substantial investments in alternative fuels and engines are needed. They also disproportionately affect European carriers due to 'carbon leakage,' as non-European airlines face less stringent regulations. The current tools, EU ETS and SAF mandates, may harm the European tourism sector and create competitive disadvantages for EU-based airlines. Regulatory and policy alternatives should take these problems into account to take a more effective global approach.
However, in the 2020s decarbonisation became the new overarching priority, at least in Europe owing to the Green Deal and the Fit for 55 Package. In aviation, these were translated into the Emission Trading System (ETS) covering intra-EEA flights and the ReFuelEU Aviation Regulation, which created an albeit limited market for Sustainable Aviation Fuels (SAFs). However, decarbonisation policies are not competition policies as the liberalisation policies were. Instead of reducing costs and making the industry more competitive, decarbonisation policies overall increase costs. This is particularly the case for the aviation sector, where CO2 and other greenhouse gas emissions are particularly difficult to abate and therefore require substantial long-term investment, primarily in fuel and engine alternatives.
This would not be a problem if all industry actors were affected in the same way, meaning markets would not be distorted. But unfortunately, this is not the case in a totally global industry such as aviation. Consequently, European decarbonisation policies affect European carriers much more than non-European carriers, leading to significant market distortions and competitive disadvantages for them.
The term ‘carbon leakage’ has been created in order to capture this phenomenon. Carbon leakage suggests that it would be sufficient to plug the leak in order to fix the problem. While this may work in extraction and production industries such as mining and aluminium, in which a Cross-Border Adjustment Mechanism (CBAM) can indeed remedy carbon leakage (to a certain extent), applying a CBAM in global service industries is a little bit trickier.
So how can carbon leakage be avoided in a hard-to-abate global industry such as aviation? Currently, there are two main instruments available, namely the EU ETS and SAF mandates. Both are market-distorting and competitiveness-reducing. As was mentioned, the ETS currently only covers intra-European flights, and therefore affects low cost-carriers and regional airlines, the flights of which are primarily inside Europe, more than network carriers. This may not directly affect the European aviation industry, but it might affect the European tourism industry, as flights to non-EU countries are comparatively cheaper than intra-EU flights. Should the ETS one day be applied to EU-inbound and perhaps even to EU-outbound flights, the effects will be similar to a CBAM (see below). As for the SAF mandate – SAFs being typically more expensive for a certain time to come – it affects all airlines leaving European airports. These include – and increasingly will affect as the proportion of SAFs mandated steeply increases over time – EU-based network carriers more than non-EU carriers with a hub close to an EU border, such as Istanbul (Türkiye) and Casablanca (Morocco), thus distorting the long-haul aviation market. It will also negatively affect the European transit market for both passengers and freight, as passengers and cargo currently transiting through an EU hub will incur higher costs than passengers and freight transiting through a non-EU hub. In short, EU-based network carriers will become less competitive globally.
The remedies currently under consideration – namely a CBAM and some sort of SAF levy or more generally a climate levy – will not reduce the impacts of European decarbonisation policies (both ETS and SAF) on the European aviation, tourism and cargo industries, as these root causes can only be effectively addressed with truly global decarbonisation. Worse, both a CBAM and a SAF/climate levy will have the same consequences as the extension of the EU ETS to international flights (inbound and outbound) and will simply exacerbate the effects of the already existing SAF levy. In addition, they will add more complexity to the application of decarbonisation policies and increase regulatory compliance costs.
One could of course go for a very lightweight approach, and this seems to be currently the idea. In this case, both a CBAM and a SAF/climate levy would only be applied in very particular cases, thus remedying only the most obvious and most problematic cases of market distortions caused by EU decarbonisation policies. But it is not certain that such remedies will not create further market distortion in the process. Plugging one leakage somewhere will generate new leakages somewhere else, calling for more plugging, and ultimately leading to a regulatory nightmare.
Nevertheless, this may well currently be the only available option, while waiting for a truly global approach to decarbonising aviation. This would mean a much more ambitious CORSIA applied to all air carriers equally worldwide. This means that the EU should more actively lobby for a CORSIA, as there is no real alternative to it.
Read the full Policy Brief on Carbon Leakage and Mitigating Measures for more information.
