Carbon Trading, Emissions Leakage and Waterbeds

Cap-and-trade markets for carbon emissions are often touted as cost-effective, market-based solutions to climate change. Their prominence has slowly risen over the past two decades, with large systems in place in the European Union (the EU ETS) and California, among others. China is planning for a nationwide market that will replace its seven regional pilots.

Despite their attractions, cap-and-trade systems bring with them a set of unintended consequences. Polluters may move production to countries without a price on carbon. And once an emissions cap is set, it becomes difficult for additional climate policies to reduce emissions further. Such interactions between policies often lead to “emissions leakage”—emissions reductions from additional policies are offset by emissions increases in other countries or sectors.

In this project, Risk Center researchers and colleagues at partner universities are investigating how to improve policy design and mitigate emissions leakage from additional climate policies. For more information, contact Arthur van Benthem.

Understanding Overlapping Policies: Internal Carbon Leakage and the Punctured Waterbed

Grischa Perino, Robert Ritz, and Arthur van Benthem

Project Overview

This project presents an integrated framework to understand the emissions impact of unilateral overlapping policies within a carbon-pricing system, such as renewable energy support in the presence of a cap-and-trade market. “Internal carbon leakage” captures emissions displacement within the system (e.g., due to greater electricity imports or exports from/to a neighbouring country). The “waterbed effect” captures the policy’s interaction with the carbon market’s overall emissions cap—the extent to which additional carbon reductions in one country or sector can change the overall cap. Current market rules in the reformed EU ETS, California’s carbon market and the Regional Greenhouse Gas Initiative feature “punctured” waterbeds that allow overlapping policies to affect aggregate emissions through increased cancellations of allowances. We study internal carbon leakage for different types of policy such as a carbon price floor (perhaps with a border tax adjustment), an energy efficiency program, and renewables support. The sign and magnitude of the climate benefit from an overlapping policy varies widely depending on its design, location and timing. Punctured waterbeds raise the stakes: well-designed overlapping policies can be much more climate-effective but others now backfire.

Do States’ Electric Vehicle and Gasoline Policies Leak Away?

Mark Jacobsen and Arthur van Benthem

Project Overview

Transportation has recently surpassed electricity as the largest source of carbon emissions in the United States (29%) and is one of the major sources of carbon emissions worldwide (14%). Driven by concerns about climate change and tailpipe pollution, a large number of U.S. states and E.U. member states adopt stringent policies on automobiles, including fuel-economy standards, gasoline taxes, electric vehicle mandates, and new-vehicle emissions standards.

However, these states do not operate in a vacuum and are also subject to transportation policy at the U.S. federal level or the European Commission level.  This leads to a complex system of (partially) overlapping policies. For example, California and a group of other states currently plan to set a fuel-economy standard that is more stringent than the federal Corporate Average Fuel Economy (CAFE) standard. But, vehicle sales in these states are still counted when determining compliance with the national CAFE standard. Another example is California’s zero-emissions vehicle (ZEV) mandate, under which automakers are required to sell a minimum percentage of (mostly) battery-electric vehicles. While this goes beyond what the federal CAFE standard requires, the policy still interacts with (and typically relaxes) the federal standard.

Such interactions can lead to emissions leakage. The state-level policy reduces vehicle emissions in the adopting states, but can cause substantial emissions increases in the rest of the country. This leakage is a result of the nesting in the regulation: the state-level efforts effectively loosen the national standard, giving automakers scope to profitably increase sales of high-emissions automobiles in non-adopting states.  Similar issues appear in cap-and-trade markets such as the E.U.’s Emissions Trading Scheme (ETS), where—until recently—most national carbon policies would fully leak away to other ETS countries.

These issues present individual states and countries with a crucially important yet subtle question: how to design policies that mitigate the concern of emissions leakage in the presence of a pre-existing federal policy? This is our main research question, which is highly policy-relevant, yet poorly understood. In ongoing work, we present a theoretical model that can be applied to a range of state-level policies that aim to reduce carbon emissions from transport: for example, California’s electric vehicle mandate, emissions-based registration fees, scrappage subsidies, and various possible designs for state-level fuel-economy standards.


Perino, G., R.A. Ritz, and A.A. van Benthem (2019). Understanding Overlapping Policies: Internal Carbon Leakage and the Punctured Waterbed. National Bureau of Economic Research.