Mind the Market: A Novel Measure of Carbon Leakage Risk

Defining a fair and transparent measure of carbon leakage risk is essential to ensure the effectiveness of the EU's climate policies. This paper proposes a novel methodology to assess this risk, which takes market structure into account -- a key factor often overlooked in both academic research and policymaking. The methodology involves applying the micro-founded hypothetical monopolist test (or SSNIP test) at the country-product level. It allows for the definition of the relevant market for four products in the steel and cement industries. The inputs required for the hypothetical monopolist test are derived by estimating a product-level gravity equation. The findings from this study illustrate that market structure differs substantially at the product level, even within a single industry. Clinker appears as the product most at risk of carbon leakage. This suggests that carbon leakage risks should be computed by policymakers at a highly granular level and taking market structure into account.