The Leakage effect explained

Conventional business leaders use The Leakage Effect Argument to shut down discussions about genuine sustainability transformations.

They say: "If we don't do it this way, someone else will, and they will do it worse"

However, that's not true. But before, we outline why. Here is a short explanation of what The Leakage Effect is.

Let's say, in a highly simplified example, that your company reduces its emissions by 100 kg CO2 in Denmark because of a new and higher CO2 tax, but your (evil) international competitor increases its emissions by 100 kg CO2 because of that. Winning some of your market share.

In that case, 100% of your reductions have "leaked," and ultimately, there is no reduction at all.

If your competitor had increased its emissions by 20 kg CO2 instead, then 20% would have leaked, and we would see a net reduction of 80%.

One concrete example of The Leakage Effect not being 100%

In Denmark, we have a cement producer, Aalborg Portland, in Denmark (where we are based).

That company was one of the main reasons Denmark got a weaker CO2 tax compared to what experts recommended. Aalborg Portland itself got a big discount.

Why?

Because the company said: If we don't produce this type of cement this way, someone else will do it, and they will do it worse. And it worked despite being false.

That's the power of the leakage effect argument.

Here’s the true story:

(A) Aalborg Portland has higher emissions than other cement producers in Europe (see the literature list for more on this).

(B) The Economic Council of Denmark found the leakage effect in Denmark (across all sectors) to be only 21% with a high CO2 tax (1200 kr/ton of CO2)

(C) In other words, the best guess is that a high CO2 tax would deliver an absolute and global 79% reduction in emissions.

Here’s a screenshot from The Leakage Effect Report, showing that we are not making this stuff up. They did really find it to be 21 pct.

The Leakage Effect in Danish Agriculture

In 2024, an Expert Group For A New Green Tax Reform, made up of Denmark's leading economists, delivered a report to the government with three models for a carbon tax, including an in-depth analysis of the
leakage effect.

They found the leakage effect to be between 8 % - 44 % in the different models.

Model 1: 750 kr/ton CO2: 20.5 % - 44 %
Model 2: 375 kr/ton CO2: 13 % - 29.6 %
Model 3: 125 kr/ton CO2: 8 % - 20.4 %

For all of the leakage effect calculations, it's a condition that there has to be a country which can increase its emissions.

In other words, countries with EU-commitments cannot let their emissions increase based on what
happens in Danish Agriculture, unless they have the "budget" for it - which non European country has. Everyone is in carbon overshoot. But other countries, without Paris Agreement commitments, could, in theory, take over some of the Danish production in response to a high carbon tax.

In other words, even in the most radical scenario with the highest carbon tax, which delivers the most reductions in Denmark (3,2M ton CO2 in 2023), there is a risk of 20.5 % - 44 % leaking elsewhere.

In none of the scenarios are we remotely close to a leakage effect of 100%.

Questions to ask yourself, when considering your company's potential leakage effect

1. Demand: What's the total demand for the product category?

2. Trade routes: How much of this product is traded internationally? (how easy it is for others to sell globally, e.g., take over "your market share" from another country)

3. Sufficiency: How necessary is the product? (if it goes away, will people then demand or forget?)

4. Substitutional: To what degree is it substitutional? (can other less polluting products serve the same need
if it goes away?)

5. Cost and risk: How expensive is it "to leak"? (fx building a new production site or scaling production in an established one.)

6. Time: How time-consuming is it to leak? (fx building a new production site or scaling production in an established one)

7. Legislation: What is your nation's legislation compared to others?

5 takeaways for business leaders

1. The leakage effect is most likely not 100% for your sector, or for your company specifically. There are more cases of this in the further readings. If you reduce your emissions, it will make a difference.
   
   
2. You can analyze the leakage effect based on sectors, countries, and legislation. It's complex, but not a black box.
   
   
3. You can consider imposing an internal CO2 tax to align your incentives with the climate crisis and help you make better decisions - especially if the leakage effect is low. You don't have to wait for legislation in that case.
   
   
4. The leakage effect is not static. What others do will influence it, but it also means that you can influence it.
   
   
5. If you are one of the good guys, you should start lobbying for a high CO2 tax in your country. It will give you a competitive advantage, it will help your country meet its carbon reduction targets, and it will matter in the grand scheme of things (because the leakage effect is most likely not 100%). 

As a final note, we have to remind you that CO2 isn't the only critical problem, we must address.

Sources & Further Readings

Beck, U. R., et al.: Carbon leakage in a small economy: The importance of international climate policies

EU Carbon Leakage

Altinget (In Danish): Aalborg Portlands produktion er slet ikke så grøn, som de påstår
(Aalborg Portland’s production is not as green, as they claim).

Ugebrev (In Danish): Aalborg Portland bagefter peers i CO2-reduktioner

(Aalborg Portland behind peers in CO2-reductions)

The Expert Group For A Green Tax Reform: Grøn skattereform - endelig afrapportering
(The Green Tax Reform - The Final Report)

The Economic Council of Denmark: Diskussionsoplæg: Dansk klimapolitik frem mod 2030.

(Discussion Paper: Danish Climate Policy Towards 2030)

Think Tank Kraka: Landbrugets lækageffekt hænger kritisk af udlandets klimapolitik

(The leakage effect of agriculture is critically dependent on foreign climate policy)