Carbon Leakage in a Small Open Economy with Capital Mobility

When international prices and foreign environmental policies are unaffected by domestic actions, carbon leakage is generated through the substitution of carbon-intensive domestic products with imports. This paper studies this “small open economy” leakage effect, using a numerical general equilibrium model of the Italian economy. The comparison of alternative simulation scenarios highlights that the amount of leakage depends on how pollution rights are distributed and on the degree of capital mobility in international markets. The more effective a redistribution scheme is in lowering the costs of emissions control, the higher is the carbon leakage, since this is associated with the overall economic performance. In addition, the higher the degree of capital mobility is, the higher are growth rates and uncontrolled emissions, on one hand, and the induced leakage in the presence of emissions reduction, on the other hand.