The EU’s “stick approach” to climate action: CBAM

The European Union (EU) is set to strengthen its climate mitigation framework with the adoption of the first carbon border tax in the world targeting the carbon content of imported products. This innovative policy measure, called the Carbon Border Adjustment Mechanism (CBAM), is due to launch in October 2023 and set to become a key pillar of European climate policy.

The EU is already a global leader in climate regulation having introduced its carbon pricing policy in 2005, the EU Emissions Trading Scheme (EU ETS), to encourage decarbonisation. We anticipate that the introduction of the new policy measure could spur more stringent climate regulation in other countries.

The new scheme will force companies that import into the EU to purchase so-called “CBAM certificates” to pay the difference between the carbon price paid in the country of production and the price of carbon allowances in the EU ETS. It has the potential to incentivise the EU’s trading partners to scale up their own carbon pricing, or risk losing the demand from the world’s largest trading bloc.

A cornerstone of European climate mitigation policy

This acceleration in policy action is seen as essential for progress to be made to slow global warming and reduce greenhouse gas (GHG) emissions. Putting a price on emissions is key to incentivise countries to shift towards net zero by 2050 and in turn reduce the long-term physical risks ofunchecked climate change, such as severe floods and droughts.

The “stick approach” of the EU to climate mitigation is in stark contrast to that recently adopted by the US, another large emitter. For political reasons, America has no carbon policy at the federal level. As we have argued in a recent paper (see The green subsidy race and how it’s changing the global economy), the US has instead preferred the “carrot approach” by providing green subsidies to boost green energy production.

The EU ETS is the world’s first major carbon market and is one of the largest. This ‘cap-and-trade’ system limits the amount of emissions that can be released from industrial installations in a certain number of sectors. In particular, it covers CO2 emissions from electricity and heat generation and energy-intensive industry sectors, such as oil refineries, steelworks, and producers of iron, aluminium, cement, paper, and glass.

The scheme also covers aviation within the European Economic Area and will include shipping from 2024. Emissions caps will be gradually tightened every year in order to achieve the desired GHG reductions and polluters can buy carbon allowances on the EU ETS trading market. They face a fine for CO2emissions uncovered by allowances.

The use of a market based approach allows for the wider economy to efficiently allocate the resource of the carbon credits to where it adds the greatest value.

This policy has proven to be an effective tool in reducing carbon emissions. The European Commission (EC) estimates that the EU ETS delivered almost 43% of the GHG emissions reduction achieved by power generation and energy-intensive industries over the past 16 years.

The risk of carbon leakage and the need to address it

Given there is a large disparity in carbon pricing across countries, the risk of carbon leakage is high. This is the danger that EU companies relocate carbon-intensive production to other jurisdictions to take advantage of less severe climate regulation. This would undermine the EU’s climate mitigation efforts as the reduction in domestic emissions would be offset by greater polluting activity abroad.

Using data from the World Bank, we have calculated an emissions-weighted average price for different countries based on their carbon prices and emissions covered. As we have highlighted in our regime shift series (see Regime shift: the accelerating response to climate change) our analysis on the effective carbon price finds that countries like Norway, Sweden, Switzerland and the EU as a bloc are leading in terms of climate action, reflecting the strong ambition in the continent to tackle global warming (chart 1).

Emerging countries like China, South Africa and Mexico have a much lower carbon price, and other large emitters such as Australia and India have no price on emissions at all. This suggests that European companies could see some benefits in increasing the capacity of production of carbon-intensive goods abroad and reducing it at home.

Although weak, there is some historical evidence that unilateral climate policy has contributed to carbon leakage. We can see this by comparing “territorial emissions”(CO2 emissions generated by producing goods and services within the borders of a country or economic bloc) with carbon footprint data.

The carbon footprint captures the emissions embodied in all goods and services consumed within a country or bloc, and the difference between these two measures gives an indication of net imports of CO2. When the EU ETS was implemented in 2005 there was a small increase in net CO2 imports (chart 2), suggesting some emissions had merely shifted abroad, in a process of carbon leakage.

It is important to highlight that evidence to date of carbon leakage has been insubstantial as the EU carbon price has been low over the past two decades. The price of allowances has remained low since the launch of EU ETS, below €30 per tonne until as recently as February 2021. They had traded at a very low level of €3 in 2012. But carbon prices in the EU have risen sharply over the past couple of years on stronger demand for allowances from industrial firms, and this could trigger higher carbon leakage.

The price of permits traded at a record high of €101.25 in February this year.

So far, the EU has handed out free allowances in an effort to prevent the risk of carbon leakage. The majority of allowances were distributed for free in the scheme’s first two trading periods covering 2005-2007 and 2008-2012. This contributed to the low carbon prices seen. Another shortcoming of free allowances is that they do not generate revenues for public finances.

For these two reasons, free allowances are not an efficient tool and have been largely criticised as they have also reduced the incentive to invest in domestic greener production.

As a result the EU now wants to reform and improve its climate mitigation framework by implementing the CBAM. Putting a price on the carbon content of imported goods will effectively reduce the risk of carbon leakage, while promoting decarbonisation domestically and abroad. As carbon prices rise in Europe, the CBAM will also protect the competitiveness of EU industrial firms, which has already been threatened by the lack of action elsewhere.

More recently, higher wholesale energy prices due to the war in Ukraine, and the green subsidies in the US have added to the pressures facing EU industry.

Recent modelling from the EC shows that the CBAM could not only reduce emissions by nearly 14% compared to a 2030 baseline, but also have little impact on output while cutting leakage by nearly 30% in CBAM sectors. This is in sharp contrast with the free allocation policy that is currently in place, where leakage is estimated to increase in CBAM covered sectors by almost 10% by 2030.

The adoption of the CBAM will also be beneficial for EU finances. Carbon emissions embedded in EU imports represent over 20% of EU emissions. Therefore, putting a price on them will generate extra revenues for the bloc. The EC estimates CBAM revenues to be around €1 billion per year from 2026-2030, of which 75% will go to the EU budget and the remaining 25% will be transferred to national budgets.

How the CBAM will actually work and its implications

The CBAM will work in parallel with the EU ETS by applying a carbon price to imported goods that is equivalent to the carbon price applied to goods manufactured in the EU, though the use of the aforementioned CBAM certificates.

The mechanism will initially apply only to carbon intensive industries, including the iron and steel, fertiliser, aluminium, electricity production and cement sectors. If it is considered a success, the EU is planning to expand CBAM to other goods, such as cars and organic chemicals. The scheme will begin to operate from 1 October 2023 but with a transition period where the obligations of the importer are limited to reporting only.

As it will be phased in at the same speed that free EU ETS allowances are phased out, CBAM’s implementation will require parallel reforms to the cap-and-trade system.

So, importers will need to buy CBAM certificates based on the emissions content of the imported goods from 2026. However, it will only be fully implemented in 2034 when the distribution of free allowances in the EU ETS will end (chart 3). This will have secondary benefits on climate mitigation as the phase-out of free allocations is likely to provide more incentives to the European industry to decarbonise.

The CBAM will have important implications for international trade with the potential to encourage European trading partners to decarbonise their production processes. Other countries could raise their level of climate ambition so that they can access the EU market without additional costs being added to their exports. The mechanism is likely to force policymakers to talk about establishing a carbon price in countries where currently there is no pricing mechanism for domestic emissions. More recently, Singapore and Taiwan have signalled the CBAM proposal would be a key driver to adopt or enhance their carbon pricing schemes.

Our analysis shows that the impact of the EU CBAM will be concentrated around a small number of bloc’s trading partners. In particular, Russia and China are likely going to be hit by the introduction of the CBAM due to their large exports of iron, steel and aluminium (see chart 4).

The implementation of the CBAM will have important implications. Firstly, exporting companies/countries that are not subject to a carbon pricing scheme could witness a reduction in demand and therefore lower production. The potential job loss could trigger a response from populist governments, with the introduction of countermeasures, i.e. import tariffs of their own, initiating a trade war.

Large trading partners of the EU could retaliate against what they perceive as European protectionism. The CBAM will also affect the cost of production, raising input costs and putting upward pressures on inflation. Finally, it is also worth highlighting the CBAM in the EU is only an initial step towards stricter global regulation. Other developed countries could mirror the EU and adopt their own carbon border tax.

This represents a realistic scenario that could force higher carbon pricing elsewhere. Key markets such as Canada and the UK have started exploring this policy option in order to protect their industrial competitiveness as domestic carbon prices keep rising. The formation of a “climate club”, a region of key importers surrounded by a carbon price at their borders, is set to further accelerate global climate mitigation.

We think that this scenario could have dramatic implications for economies heavily reliant on exports that are still lagging behind in terms of mitigation policies. Transition costs for these economies will be high, as they will have to quickly adjust to rapidly increasing emissions costs.

Conclusions:

• CBAM looks like it will be effective at countering carbon leakage, and could prompt other countries to follow suit.
• Exporting companies/countries that do not match EU targets could see a loss of business as demand is diverted away.
• CBAM could spur some reshoring to the EU as the cost of production is equalised once carbon prices are factored in.
• The mechanism could prompt a negative response from other countries, leading to reciprocated tariffs, and a rise in protectionist policy.
• Overall, CBAM is likely to structurally raise the cost of production, adding to the inflation pressures in the global economy which central banks are trying to tame.