Europe’s plan for carbon border adjustment

One-third of European greenhouse gas emissions (GHG) are embedded in the import of goods and services. While the EU Emissions Trading Scheme (ETS) sets a price and limit on carbon emissions for domestic firms, no such measure exists for products made abroad. Without better accountability of imported emissions, there will be no real industrial decarbonisation. That’s why the European Commission is going to put forth a proposal for a Carbon Border Adjustment Mechanism (CBAM) in July 2021, as part of the EU Green Deal.

Industrialised states consume (import) more CO2 than they produce (export).
Vice versa for emerging markets (Cesar and Polge 2020)

What/why/how of a CBAM

The CBAM is an import tax applied to goods and services upon entrance into the European Single Market. Three main elements are important when considering support for a CBAM: carbon leakage, asymmetric competition, and lack of convergence in global carbon pricing.

1 Reduce carbon leakage: apply carbon pricing on all firms accessing the Single Market

Carbon leakage refers to the practice of polluting firms shifting their production processes to countries with laxer environmental standards. High rates of delocalisation are tied to higher carbon prices and the absence of free allocation measures.

2 Symmetrical costs: allow domestic firms to remain competitive with foreign firms

Asymmetric competition between European and foreign firms results from the absence of carbon costs on the latter. EU ETS prices have become especially high following Covid-19, putting European firms at a disadvantage against foreign firms and preventing higher investments in clean technologies.

3 Greening through trade: diffuse pricing mechanisms through global supply chains

Carbon pricing mechanisms range greatly between states – $0.5/tCO2 in Ukraine against $139/tCO2 in Sweden, for example (see figure below). A global carbon tax of $50-100 is needed by 2030 to satisfy 2-degree targets. A CBAM could mainstream carbon pricing mechanisms, eventually leading to a convergence in national jurisdictions. It’s a way of developing a global price on carbon without saying those words.

World Bank/Ifo Institute

Optimal Design

Planned to be operational in 2023, the EU’s CBAM design has yet to be finalised. Policymakers and academics have mostly agreed on a progressive sectoral coverage, ideally starting with the most polluting industries: steel, cement, aluminium, glass, paper, and chemicals. The European Parliament has drawn up its own version, which covers imports of all goods under the current Emissions Trading System (ETS). On this basis, the idea is to apply the daily ETS price to carbon imports. In line with the recommendations of the Banque de France, I rank three design options by order of ambition.

Least ambitiousbenchmark foreign emissions on EU emissions (using data from EU ETS). Extending ETS to importers is easiest politically because it doesn’t require the creation of new policy tools and calls upon less voting in the European Council.

More ambitiousbenchmark on global emissions. This procedure would use standardised emissions ratings for each product and is favoured by the European Parliament. One advantage is reduced transaction costs for importers, who might not have the funds needed to provide data on embedded carbon emissions within their goods.

Most ambitiousdeconstruct the Global Value Chain to include indirect imports. This levels the playing field for production costs. For example, a truck might be taxed in proportion to the amount of steel it contains. This is the most robust framework; inclusion of indirect imports prevents EU firms from outsourcing construction of product parts.

Contentions remain

Already in 2009, economic policy thinkers were discussing a ‘carbon border tax‘ for Europe. Twelve years on, adequately designing a CBAM still comes with significant challenges. On the political side, many agree a flat tariff equal for all countries is both unfair and infeasible. Germany believes third countries will view the mechanism as green protectionism and retaliate. US climate lead John Kerry agrees that it risks derailing trade, development, and climate policy all at once, and as such should only be considered a ‘last resort’. The key is to remember who is most targeted – emerging middle-income states (high GHG emission rates and low carbon pricing commitment) – and who is not. On this basis, two groups of states should receive differential treatment:

Developing countries: A CBAM could have different effects on countries at different levels of development. Developing country negotiators might shrug a principle based on regulatory convergence, for they emphasise ‘common but differentiated responsibility’ in all climate related engagement. In particular, Least Developed Countries (LICs), who import around 116 billion EUR into the EU yearly, would find it difficult to take on extra costs at the border. This problem was central to CBAM discussions at the WTO Committee on Trade & Environment meeting held in March 2021, triggering talk of an exemptions list. One way of doing this could be fixing a minimum import proportion, as per the Generalised Scheme of Preferences (GSP) conditions.

Countries with active market mechanisms: Another problem to consider is the entrance of firms from better-than-benchmark states. Those who already apply carbon pricing at a higher rate than the proposed CBAM, like Norway or Canada. In this regard, it would be important to prevent any double payment (of carbon price at home and CBAM in EU). Reducing the charge for goods produced with fewer emissions than European equivalents would be a good way of incentivising lower-emission industrial processes.

LICs could be exempt from CBAM – Centre for European Reform (Lowe 2021)

Potential economic complexities related to CBAM merit equal attention. These can also be separated into two broad categories: pricing and accounting. CBAM pricing must allow high-performing firms from target emerging markets to stay competitive in the Single Market. Otherwise, there is a risk of Europe becoming a low-carbon island; non-competitive goods will simply find elsewhere to go and net production-related emissions won’t decrease. However, this risk might decrease should a European CBAM be paired with similar mechanisms in the US and Japan, altogether accounting for 40% of the world economy.

Pricing will also influence country-level differences in terms of industrial norms. The OECD’s example of furnaces used for steel production is a powerful one: whereas in China and Ukraine blast furnaces release 2tCO2/t, in Turkey electric furnaces emit 1tCO2/t. As a result, different tax rates on imported emissions for steel production would put Turkey at an advantage over its competitors. As per the objectives detailed above, desire by Chinese and Ukrainian firms to reduce carbon costs might incentivise the replacement of energy-intensive furnaces. But it might create even more substitution strategies and eventually carbon leakage. That’s why getting the price right is absolutely essential to stimulate a norm diffusion process.

In terms of accounting, the main problem is that calculating embedded carbon within a good is not such a simple process. Streamlining carbon costs along the entire value chain – in a way that aligns with EU regulation – will be costly for foreign firms who already lack financial capital.  Again, the accumulation of production costs, the import tax, and the calculation of embedded carbon might just deter firms from the European market. A cement industry representative has suggested that these costs might push firms to adjust their own pricing, with ripple effects throughout the supply chain, including price hikes for secondary buyers and even consumers.

COP26 promotional image – a global carbon price will be on the agenda in Glasgow (1-12 November 2021)

Next Steps

The European Commission is preparing the deployment of its methodology in the lead-up to COP26, an opportune moment to internationalise the carbon pricing debate. The CBAM symbolises the need for a uniform emissions accountability around the world. Decarbonisation of one region makes no sense if it is entirely counterbalanced by booming emissions elsewhere. Accounting for carbon at the border of the world’s second-largest consumer market is an important step in reducing the incompatibility between a European Green Deal and burden-shifting norms, between the ETS and pollution havens. Brussels should focus on getting the United States on board, as President Biden is favourable both to a transatlantic green trade agenda and to an American quota system for imports. This would grant the CBAM some much needed political weight.

Finally, the EU must decide where funds received will go. Former WTO DG Pascal Lamy emphasises the money should not serve as fiscal repayment for Next Generation EU (€750 billion loan) but should rather be steered towards sustainable investment through a climate bank. A European CBAM will set the stage for multilateral carbon pricing and green trade policies in the decade to come; it must be robust, impactful, inclusice, all while steering clear from protectionist undertones.

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