Unilateral domestic carbon pricing raises concerns about carbon leakage, prompting calls for protecting exposed industries through either free allocations of emission permits or a carbon border adjustment mechanism. This paper develops a quantitative general equilibrium trade model to evaluate the effects of these unilateral carbon pricing instruments. The model accounts for input-output linkages and firm heterogeneity, capturing the inverse relationship between productivity and emission intensity and generating selection effects and sector-level economies of scale.

It enables a detailed decomposition of emission intensity changes into within- and across-firm adjustments, and a quantification of the role of input-output linkages, economies of scale and selection effects for the impact of unilateral carbon pricing on real income and emissions. Applied to EU climate policy, the model predicts that stricter carbon pricing reduces emissions primarily through within-firm adjustments, and input-output linkages as well as economies of scale amplify carbon leakage and real income losses. Comparing the two protection measures, free allocations result in lower real income losses, while a carbon border adjustment mechanism more effectively mitigates carbon leakage.

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