Carbon leakage is an important concern because it can reduce the environmental effectiveness of the Kyoto Protocol. The Clean Development Mechanism, one of the flexibility mechanisms allowed under the protocol, has the potential to reduce carbon leakage significantly because it reduces the relative competitive disadvantage to Annex B countries of restricting greenhouse gas emissions. The economic intuition behind this mechanism is explored in a theoretical analysis. It is then analyzed numerically using a CGE model. The results indicate that, assuming appropriate accounting for leakage and under realistic assumptions on CDM activity, the CDM has the potential to reduce the magnitude of carbon leakage by around three fifths.