When a large country raises its emission taxes, this has two effects. The first one is that domestic emissions are reduced and the second one is that world market prices of goods and factors are changed. The change in prices has an impact on the patterns of specialisation and on the allocation of the factors of production. This may result in an increase in emissions in the rest of the world, the so-called leakage effect. In the case of trans-frontier pollution, leakage reduces the efficiency of domestic environmental policy and, therefore, becomes an issue of significant concern.

Leakage effects can be attributed to three mechanisms. The first one is a change in the pattern of specialisation. Changes in relative prices induce foreign producers to increase their output of environmentally intensive goods. The second mechanism is a relocation of mobile factors of production. Everything else being equal, they move to less regulated countries, causing an increase in emissions there. Finally there is an effect through markets for primary goods, in particular energy. Tighter environmental standards in one country lead to energy price reductions that in turn imply an increase in energy demand abroad. The paper deals with these three mechanisms using a variety of models.

The first model is the competive-markets framework. We consider a model with internationally mobile capital and trade in energy. A realistic numerical example will be used to quantify the leakage effects that are due to capital mobility and to changes in energy prices. I then address the issues of non-cooperative environmental policies and environmentally motivated trade interventions.

Afterwards, a number of non-competitive models are considered. A variant of Krugman's intra-industry trade model produces the interesting result that there may be an inverse leakage effect. If one country tightens its environmental policies, emissions in the rest of the world are reduced as well. The underlying reason is that environmental policy now has a market-structure effect which reduces emissions and environmental damage. Finally the paper looks at non-competitive models with given market structure and it is seen that the leakage effects have the normal sign. But they tend to be much larger than those known from the competitive general-equilibrium models. This explains why computable general-equlibrium models have found leakage effects of usually less than 10 per cent, whereas studies using calibrated oligopoly models have found much higher leakage rates. The paper provides some insights on the origins of these discrepancies.