The increase in carbon dioxide emissions by some countries in reaction to an emission reduction by countries with climate policy (carbon leakage) is seen as a serious threat to unilateral climate policy. Using a two-country model where only one of the countries enforces an exogenous cap on emissions, this paper analyzes the effect of technical change that can be directed towards the clean or dirty input, on carbon leakage. We show that, as long as technical change cannot be directed, there will always be carbon leakage through the standard terms-of-trade effect. However, once we allow for directed technical change, a counterbalancing induced technology effect arises and carbon leakage will generally be lower. Moreover, we show that when the relative demand for energy is sufficiently elastic, carbon leakage may be negative: the technology effect induces the unconstrained region to voluntarily reduce its own emissions
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