Emissions trading system: bridging the gap between environmental targets and fair competition

The effectiveness of the European Emissions Trading System in supporting a level playing field while reducing total emissions is tested. While data show a robust impact on the environment as a steady decrease in carbon emissions is observed, it is reported that its ability to internalize emission costs may improve to better address the import of extra European generated emissions that negatively impact the economy when not properly accounted for. Analyzing data in six European countries between 2016 and 2020, the results suggest competitive advantages for industries with higher extra-European imports of inputs that result in biased production costs that, in turn, alter competitive positioning. The novelty lies in focusing on the threats to fair competition within Europe along with the well-known carbon leakage risk widely investigated by previous literature. Complementary policy tools capable of internalizing emission costs, regardless of their origin, are necessary to improve the healthy functioning of the system. In this regard, carbon taxation may outperform carbon border adjustment, as it is based on consumption patterns. Our results can aid policymakers in designing impact analyses aimed at limiting potential distortions to Europe's level playing field.