To date, European climate policy has not yet led to widespread relocations of energy-intensive production abroad by domestic firms, the Bundesbank explains in its latest Monthly Report. In this, the Bundesbank’s economists examine the impact of the EU Emissions Trading System (EU ETS) on the foreign direct investment decisions taken by German manufacturing sector enterprises.

Even before stricter rules under the EU ETS entered into force, emissions-intensive enterprises had a preference to produce in non-European locations with lower energy prices, they explain. In addition, the Bundesbank’s experts find that the stocks of foreign direct investment held by enterprises with high and low greenhouse gas emissions developed similarly as the European climate policy reforms unfolded. In other words, a firm’s energy intensity had no noticeable impact on the volume of its investment in non-EEA countries.

European emissions legislation is effective

What the Monthly Report article also reveals is that firms that operated predominantly within the European Economic Area (EEA) with their affiliates were already emitting less greenhouse gas from 2016 onwards compared with previous years. By contrast, the greenhouse gas emissions of firms with high stocks of outward foreign direct investment in countries outside the EEA rose steadily until mid-2018, only then experiencing a marked decline. According to the article, Empirical studies suggest that European emissions trading may have caused firms within the EEA to reduce their greenhouse gas emissions. However, the authors stress the need to bear in mind that developments in greenhouse gas emissions were driven substantially by only a few large companies.

Future relocations of production sites and emissions cannot be ruled out

The article points out that the possibility of German firms relocating emissions-intensive production processes to countries with less stringent climate policies cannot be ruled out. This would be the case if carbon pricing were to remain higher in Europe than in the rest of the world on a lasting basis. In the medium term, this scenario would lead to German firms importing more emissions-intensive intermediate goods instead of producing them domestically at large expense. As a result, greenhouse gas emissions would be relocated to places where they are not priced at all, or only to a limited extent, through climate policy measures. Another consequence of this scenario would be a decline in the international competitiveness of domestic firms. This would also affect carbon-intensive manufacturing sectors in particular.

The EU’s carbon border adjustment mechanism (CBAM) could reduce the incentive to import intermediate goods from outside the EU. This is illustrated by macroeconomic modelling. The CBAM is an EU tool that applies compensatory taxes to imports from non-EEA countries that do not have a system of carbon pricing. However, the CBAM consequently also affects production costs, as it makes intermediate goods from abroad more expensive.

The CBAM does not fully compensate for the international competitive disadvantage to domestic firms, as it essentially only prices greenhouse gas emissions embedded in goods and services brought to market in the EEA; the non-EEA market is left largely unaffected.

Policy measures to encourage innovation are essential

According to the article, Framework conditions that encourage innovation in low-emissions technologies are crucial to effective climate policy. The experts emphasise that these should include, for example, swift approval procedures and a clear economic policy strategy. They find that the incentives for relocating production processes are likely to diminish to the extent that innovative technology helps to reduce emissions cost-effectively.