This summary provides an overview of key points about emissions leakage from the document: 1) Emissions leakage occurs when carbon pricing programs cause domestic production to decrease while exports to the regulated area increase, undermining the environmental goals. California's cap-and-trade program aims to limit this by regulating imports as well. 2) The California Air Resources Board (ARB) conducts detailed analysis of industry sectors to assess leakage risk based on emissions intensity and trade exposure. ARB allocates free allowances to limit compliance costs for high-risk sectors. 3) While incentive-based approaches help, some argue ARB is not strict enough in regulating high-emitting sectors most responsible for greenhouse gas reductions. Border

1. Section I. Introduction to Emissions Leakage
Emissions leakage is a potential problem posed by greenhouse gas emissions cap
and trade programs. In California, greenhouse gas emissions cap and trade programs are a
way of encouraging the growth and long-term sustainability of a market that favors
renewable energy over carbon and other greenhouse gas-fueled plants while sustaining a
viable economy. This can be done by putting a cap on aggregate pollution emissions,
which makes allowed emissions scarce (Hackett 2011). Overall emissions cap then is
divided into shares and allocated in the form of tradable allowances (Hackett 2011).
However, these programs pose the risk of emissions leakage: an economy that will reduce
domestic production in the area regulated, then export goods back into the area (Hackett
2011). This poses the potential problem of creating “pollution havens” in areas where
emissions are not regulated (Hackett 2011). This paper will firstly review and evaluate
how AB32 addresses leakage, then will offer potential market interventions including an
evaluation of legal restraints and overall effectiveness, and finally concludes that
California must reduce consumption demand overall for a thorough solution to emissions
leakage.
Section II. AB32 and Leakage
A. Overview of California Air Resources Board
In 2006, Assembly Bill 32, or the California Global Warming Solutions Act
passed, appointing the Air Resources Board as lead agency to implement a reduction in
GHG emissions back to 1990 levels by 2020 - a fifteen percent decrease (ARB 2014
“Assembly Bill 32”). The Air Resources Board is doing this by developing a cap and
trade program for greenhouse gases “that links with other Western Climate Initiative

2. partner programs to create a regional market system.” (ARB 2014 “Appendix B of Initial
Scoping Plan”). On January 1, 2013 the largest emitters began to pay direct compliance
costs for their emissions, as determined and regulated by the Air Resources Board (ARB
2014 “Appendix B of Initial Scoping Plan”). The Air Resources Board distributes
allowances to firms and these allowances are traded between firms in an auction market
overseen by the Air Resources Board (ARB 2011).
B. ARB Classification of Risk of Leakage
The risk of leakage is identified by the ARB as depending on emissions intensity
and trade exposure (ARB 2012). In 2009, the ARB established the Economic and
Allocation Advisory Committee (EAAC 2010). The EAAC suggests that it is necessary
to specify two mechanisms for allowance distribution- the way that emissions allowances
are to be put into circulation, and how they are distributed amongst parties. The ARB’s
allowance distribution is based on a leakage classification analysis using the 6- digit level
North American Industry Classification System (ARB 2012). The NAICS is a widely
used system to define different sectors and activities so that ARB may thoroughly assess
the risk of leakage per activity/sector (NAICS 2010). Emissions intensity is based on the
amount of greenhouse gas emitted divided by the value added (ARB 2012). Levels of risk
are used to classify the emissions intensity and the trade intensity which, combined, is the
overall risk to leakage (ARB 2012). This is what is used to determine how allowances are
to be distributed amongst parties.
C. ARB’s Limitations of Leakage
To limit leakage, the ARB focuses on reducing the compliance costs that firms
have to pay. First, it is important to consider whether to regulate downstream or upstream

3. - essentially whether to regulate consumer use or producer use, respectively (Hackett
2011). Upstream regulation results in lower monitoring/enforcing costs, and passes the
cost along to the consumer through an increase in price. (Hackett 2011).
A safety valve is defined as increasing the supply of allowances when a sharp
increase in demand creates a price spike (Hackett 2011). Without a smooth transition
period in which to ease California firms into, there is a high potential of a price spike
creating emissions leakage (ARB 2012). The ARB lowers this risk through free
allocation of allowances (ARB 2012). ARB allocates allowances for the cap and trade
program at no cost to minimize compliance costs for firms, which incentivizes firms to
participate in either lowering emissions, or continuing domestic production rather than
importing. This lowers the risk of emissions leakage (ARB 2012).
D. Evaluation of ARB’s Leakage Assessment and Action
The safety valve used by the ARB that allocates allowances based on risk of
leakage can pose potential problems concerning the effectiveness of the pollution cap.
Deterrence, the primary goal of regulation, “involves establishing a system of monitoring,
enforcement, and sanctioning that prevents some individuals from taking socially harmful
actions.” (Hackett 2011). Socially harmful actions in this case are firms emitting
greenhouse gases and the primary deterrence tool is the pollution cap. With the safety
valve, deterrence is failing to some extent. A larger allocation of allowances to firms
more at risk of pollution and exporting production costs can be seen as a weak
enforcement of the pollution cap. The firms at most risk of leakage and with the most
greenhouse gas emissions are those who need to be most strictly regulated, for these will
make the most difference in the reduction of greenhouse gases in the long run.

4. The previous limits on leakage are all incentive based regulation tools. AB32 has
also implemented the use of a direct tax on imports. The following section will evaluate
these taxes.
Section III. Mitigating Leakage
A. Border Tax Adjustments
Border tax adjustments are a way to mitigate leakage through taxing imports and
encouraging domestic production to continue. The effect on imports and exports of a
border tax adjustment, “are currently viewed as a way to address competitiveness and
carbon leakage concerns associated with a cap-and-trade or any other emission reduction
system which imposes additional costs on domestic producers” (Holzer 2010).
As mentioned earlier, RGGI has not chosen to regulate emissions leakage (Parlar,
Babakitis, and Welton 2012). However, California “has chosen to regulate leakage by
placing compliance obligations on electricity imported into the state as well as generated
in the state” (Parlar et al. 2012). One-quarter of California’s energy is imported, and in
California, emissions leakage poses a larger threat than it poses with RGGI– a regional
initiative (Parlar et al. 2012). Parlar et al. approach leakage by urging a decrease in the
demand of energy so to decrease the compliance costs of emissions reduction to the
generators of electricity. In 1927 Ramsay developed the ‘inverse elasticity rule’ stating
that goods with inelastic demand (less price-sensitive) should have higher taxes applied
to them (Hackett 2011). Parlar et al. and Ramsay’s approaches to demand respectively
necessitate that in California, energy ought to have a higher tax applied to it or that
demand for energy must decrease. It follows then, that a tax at the border on production

5. being exported and goods being imported could prove to be a successful intervention to
address emissions leakage.
B. The Effect of the Commerce Clause on Border Tax Adjustments
There are challenges that are associated with regulating leakage through border
tax adjustments: “in our federal governmental structure, states are limited by the
Constitution in the extent to which they can regulate activities occurring beyond their
own borders…”(Parlar et al.) The Commerce Clause gives the Federal government the
power to regulate commerce within states and outside. The dormant Commerce Clause
“limits states’ ability to impose burdens on interstate commerce” (Parlar et al. 2012).
Some of the ways that imports regulations might violate the Commerce Clause could
include the following. Discrimination- the “differential treatment of in-state and out-of-
state economic interests that benefits the former and burdens the latter” (Parlar et al.
2012). Extraterritorial regulation- applying to commerce happening outside of the
enacting state’s border’s entirely (Parlar et al. 2012). And finally, Pike balancing- the
more lenient standard of when a statute burdens interstate commerce without being either
of the latter (Parlar et al. 2012).
However, Parlar et al. conclude that imports regulations, like a border tax
adjustment, would be ruled constitutional by a reviewing court. There is an exception to
the aforementioned potential problems concerning the legality of imports regulations- the
market participant exception (Parlar et al. 2012). When a state acts like a market
participant, “nothing…prohibits a state … from participating in the market and exercising
the right to favor its own citizens over others”(Parlar et al. 2012). Parlar et al. find that a
tax on imports would not be a discriminatory or extraterritorial regulation as it would not

6. differ largely from the instate tax, making import regulations a constitutional act.
California has not faced any legal challenges so far concerning border tax adjustments,
however, further down the road legal challenges may present themselves when the
planning phase begins to implement certain import regulations (Parlar et al. 2012).
Section IV. Discussion and Conclusion
A. Limitations on Border Tax Adjustments
Some limitations on border tax adjustments include the implementation of the tax
itself. A Pigouvian tax is one that internalizes a negative externality by setting its rate
equal to marginal external cost (Hackett 2011). The Pigouvian tax can be used as the base
for how the border tax ought to work. “The number of allowances surrendered by
importers on a dollars/ton of embedded carbon basis should be equal to the number of
allowances surrendered by domestic producers for the same amount of carbon footprint
when the like products are produced in the importing country” (Holzer 2010). Holzer
addresses the difficulties associated with calculating this carbon footprint altogether, and
concludes that this can skew border tax results.
B. Alternatives to Border Tax Adjustments.
As discussed earlier, the ARB is responsible for allocating allowances for the cap
and trade system. Allowances can either be grandfathered in (free allowance) based on
historical emissions, or the regulating entity can auction off allowances of the cap. Free
allowance allocation can be considered an alternative to border tax adjustments) because
it acts to subsidize some of the high compliance costs associated with the emissions cap.
In California, both allowance allocation systems are utilized through phasing. Allocation
is based on an “industry assistance factor”, which is determined by the firms’ leakage risk

7. and the compliance period. (ARB 2012). After the first compliance period, low and
medium-risk sectors will receive less assistance than high-risk sectors, making the
compliance cost higher (ARB 2012). Between compliance periods, the percentage of
grandfathered allowances will decrease and the percentage of auctioned allowances will
increase. Free allowance allocation can be seen as incentive regulation rather than market
based regulation (Hackett 2011). However, as with carbon border taxes, it might seem
possible that with free allocation of allowances, environmental objectives might still be
undermined (Holzer 2010).
Another alternative to a border tax adjustment is to focus on the stringency of the
cap. With a less stringent cap firms would face lower compliance costs, which would
result in an increase in domestic production, hence solving the problem of leakage
(Hackett 2011; Parlar et al. 2012). In fact, the RGGI is not regulating emissions leakage
as it has been determined that there is no leakage problem through the RGGI (Parlar et
al.) This could be because the emissions cap is so high that few firms had to reduce
production and emissions at all, so no production was exported elsewhere with a higher
cap (Parlar et al.)
C. Conclusion
The complexity of emissions leakage has led to many legal, economic and ethical
questions concerning the tools that are being studied to eliminate leakage. While federal
entities such as RGGI choose not to regulate leakage, the state of California and the ARB
are planning to impose border tax adjustments while continuing to adopt their allowance
allocation depending on risk-classification of leakage (ARB 2012; Parlar et al. 2012).
There are many legal hurdles to consider when imposing a border tax on energy/ coal,

8. which ought to be carefully analyzed when policy makers are choosing a tool to
implement (Holzer 2010). The Air Resources Board seems to be fairly successful so far
at implementing the cap and trade program as well as addressing the concerns of
emissions leakage. However, ARB allowance allocation ought to be analyzed in regards
to long-term consequences and overall effects it might have on the cap and trade system
regionally as well as globally.
In “Growth in Emissions Transfers Via International Trade from 1990 to 2008”,
Peters, Minx, Weber and Edenhofer compare the stabilization of emissions in developed
countries with the doubling of emissions in developing countries from 1990 to 2008.
While states like California are regulating emissions domestically, the demand for
production of goods (consumption demand) has decreased significantly less (Peters et al.
2011). “International trade and investment flows provide a link between production and
consumption in different countries. Ignoring these connections might result in a
misleading analysis of the underlying driving forces of global, regional, and national
emission trends and mitigation policies.” (Peters et al. 2011). In developed countries,
consumption-based emissions have increased more rapidly than other types of emission
(Peters et al. 2011). California and developed countries must decrease demand as a whole
before the problem of leakage can be solved successfully. By taxing imported energy at a
high enough rate, demand will fall. This will gives developing countries less incentive to
export large quantities of energy to developed countries, and will give developed
countries incentive to be more self-sustaining with their energy.