Mitigating carbon leakage under the EU ETS: How does State Aid for Indirect Emission Costs affect firm profits?

Non-global climate policies, such as the EU Emissions Trading System (ETS), may suffer from carbon leakage, as firms subject to such policies may experience competitive disadvantages compared to firms operating in more loosely regulated areas. This process may make climate policies ineffective, thus undermining the efforts to fight climate change. Specifically, the EU ETS results in a carbon price that is partly passed through in electricity prices, negatively impacting EU electricity-intensive firms exposed to international competition. To avoid the latter, the EU awards so-called State Aid for Indirect Emission Costs to these firms. We empirically evaluate the extent to which firms obtained windfall profits from this aid in 17 EU countries and the UK between 2014 and 2019. We approximate the amount of aid received by firms based on EU legislation and estimate its effect on firm profits using a fixed effects regression model. Although we find that this policy may have mitigated the carbon leakage risk, we find evidence of over-generosity, with around 22% of beneficiaries possibly gaining windfall profits.