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How are climate change policies affecting firms’ competitiveness?

Policies to tackle climate change can impose costs on firms, especially those with high emissions of greenhouse gases, potentially reducing their competitiveness in global markets. Such measures can also encourage innovation and provide opportunities for growth.

As governments around the world recognise the need to combat climate change, measures that include carbon taxes, subsidies, bans, caps and regulations are increasingly being put in place to limit and/or reduce greenhouse gas emissions.

These policies impose a constraint on firms' emissions and, for some, will increase their production costs. For others, they may provide opportunities for growth.

Whichever sector firms operate in, climate change and the range of policy responses will lead them to evaluate their competitiveness and rethink their business strategies.

Climate change policies

By producing and consuming goods, firms and households emit greenhouse gases either directly or indirectly – for example, by using electricity produced by burning gas. These emissions impose external effects and costs on others through the increased risks from climate change and hence on people’s future wellbeing. This raises both ethical and economic questions as firms and households must strike a balance between the goals of producing and consuming more today, and limiting the dangerous effects of climate change in the future.

As a response, policies can ensure that the expected impacts of emissions are taken into account and therefore that the risk of climate change is reduced. Those introduced so far have focused on reducing levels of carbon dioxide in the atmosphere. They include carbon taxes, subsidies, bans, caps and regulations. For example, a cap would regulate the amount of greenhouse gases that a given steel plant can emit, whereas a carbon tax would ensure that a firm pays a tax per tonne of carbon it emits from its factory each year.

The policy known as cap-and-trade combines a quantity-based limit on emissions from a certain number of sectors of the economy with a price-based approach that places a cost on emissions. One example is the European Union’s (EU) Emissions Trading System(ETS), launched in 2005. It is the largest carbon cap-and-trade scheme in the world, and now covers more than 12,000 polluting installations across the EU.

Under the ETS, the EU and national governments decide on the overall emissions cap – which is tightened every year – hence fixing the number of ‘permits’ available. A large proportion of these are auctioned and the rest are distributed so that each firm starts the year with a certain number. At the end of the year, each plant has to submit one permit per tonne of carbon it has emitted.

A market is in place so that firms can exchange permits for a price: if a firm has received or bought too many permits for the amount it is planning to emit, it can sell them on the market, and vice versa. Depending on the price, each firm will decide whether to reduce its emissions or buy a permit, and as a result, the reduction in emissions for the region is achieved at least cost. Similar carbon-trading schemes exist in growing numbers elsewhere in the world, including the UK and China.

Different climate change mitigation policies have varying costs associated with reducing a tonne of carbon dioxide, as illustrated in Figure 1. Each of these governmental interventions can affect firms’ competitiveness.

Figure 1: The cost of reducing a tonne of carbon dioxide – alternative climate mitigation policies

Source: Gillingham and Stock, 2018; and Colmer et al, 2020

What are the impacts of policies on firms’ competitiveness?

There are fears that introducing unilateral domestic climate change policies – by raising costs of producing in that country – will harm firms with competitors in other countries that are not facing the same policies.

In addition to potential economic costs, this could also lead to the relocation of emissions-intensive activities (and emissions) abroad – what is known as ‘carbon leakage’. Such an outcome would imply that these policies do not achieve their objective of reducing the impacts of climate change, as emissions are merely diverted elsewhere. This is also costly from an economic point of view.

This is a particular worry for sectors that are heavily traded and generate high levels of emissions. In the UK, analysis by the Committee on Climate Change identified iron and steel, refined petroleum products, aluminium, other inorganic chemicals, pulp and paper and rubber tyres as potentially vulnerable sectors.

Analysis finds mixed evidence about the extent of carbon leakage under different scenarios (Carbone and Rivers, 2017). Empirical research shows that environmental regulations can have impacts – albeit small ones compared with general trends in production – on trade, employment, production location and productivity in the short run (Dechezleprêtre and Sato, 2017). But these primarily affect emissions- and energy-intensive sectors.

Other studies suggest that climate policies with moderate carbon price levels have not led to any changes in trade flows, employment levels or foreign direct investment to date. For example, French manufacturing firms reduced their carbon emissions by 8-12% as a result of phase two of the ETS, compared with unregulated firms. But this had no effect on employment or value-added, nor on total imports of intermediate goods, whether measured in carbon content or value (Colmer et al, 2020).

Research also finds no evidence of multinationals displacing their emissions toward non-EU countries as a result of the ETS (Dechezleprêtre et al, 2021).

In the future, carbon prices and policy are likely to create more pressure on regulated producers. Several countries and regions, such as Canada and the EU, are considering the adoption of border taxes on carbon.

Such co-regulation instruments, which have already been introduced in California, can help to level the carbon playing field by taxing the emissions embedded in carbon-intensive imports. But it is currently difficult to count the emissions in imported products and therefore to implement these border taxes (Fowlie, 2021).

In addition, if not designed properly and if carbon intensities are not well assigned, a border tax could lead to protectionism – if low-carbon imports have had to pay compliance costs. Under-counting of imported emissions or ‘reshuffling’ could also result if suppliers – of electricity, for example – redirect their carbon-intensive resources to non-regulated regions, hence limiting the effect of the tax.

Supply chains and investors

Extreme weather events – such as droughts, floods and flash fires – anywhere in the world in which a firm has a part of its supply chain can affect its costs and competitiveness. So too can the related repercussions of these events, including workforce migration or infrastructure damage.

Similarly, climate change policies could affect firms’ supply chains. They therefore need to be anticipated, and their impact and associated volatility considered in firms’ risk management and business strategies.

Climate policies and the speed at which society moves to a net-zero economy can affect certain sectors, as well as the stability of the financial system. This is known as transition risk. For example, meeting the Paris agreement made at COP21 in 2015 implies that two-thirds of the world’s known fossil fuel reserves would not be usable.

Strong policies that could result from Paris-aligned commitments would have significant implications for the value of firms in the oil and gas industry or emissions-intensive sectors. In turn, banks and insurance companies, as well as investors in those sectors, could choose to reduce their exposure to these risks. This would affect the availability of capital for those sectors, and if happening on too short a scale could even put financial stability at risk.


Climate change regulations can also be considered as drivers of economic growth. By promoting cost-cutting efficiency improvements, binding climate policies can have a net positive effect on the competitiveness of firms.

Policies can foster innovation in technologies that help firms to lead internationally and increase their market share. Empirical evidence reveals that carbon pricing drives innovation and adoption of low-carbon technologies, with a response lag of five years or under (Dechezleprêtre et al, 2016).

In addition, evidence shows that firms engaging in ‘clean’ research and development (R&D) activities increase their stock market valuation (Dechezleprêtre et al, 2021. Through more and better investments in innovation, infrastructure and skills, governments’ growth strategies can put climate change at their core (Rydge et al, 2018).


All parts of society will be affected by climate change and the policies put in place to address it. Businesses are key actors on these fronts and both risks and opportunities arise from regulation and the price of carbon that results.

By identifying both the benefits and costs, innovating, adapting their strategies and rethinking their production processes, firms’ competitiveness could even be enhanced by the transition to net zero.

Policies need to be designed carefully to ensure that sectors that are hard to decarbonise create roadmaps for achieving a circular economy and increase resource productivity. Policies also need to promote high levels of innovation and investment in all sectors, to achieve green and inclusive growth, and to reach a net-zero society.

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Author: Mirabelle Muûls, Imperial College London
Photo by ThisisEngineering on Unsplash
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