In 2005, the European Union introduced the emissions trading system, more commonly referred to as the “carbon market”. Fifteen years later, it is poised to introduce an adjustment mechanism: a carbon border tax. This is the last column in our series “Fifteen years of the carbon market: what’s the point?”.
If the price of carbon were applied to every country, without borders, we would all be playing by the same rules. On the other hand, a carbon price applied to a single area would have an impact on trade. Rather than reducing their carbon footprint, it could tempt companies to move their emissions to areas without carbon pricing. This risk of “carbon leakage” raises the question of the connections between the European Union’s climate and trade policies.
The search for carbon leaks
Empirical studies on the European emission allowance system have not found any evidence of carbon leakage. This is not surprising considering the level of CO2 prices thus far and the magnitude of financial transfers to emitting industries in the form of free allocations.
The comparison between EU territorial emissions and its consumption footprint confirms this assessment. Since the introduction of the allowance system, the consumption footprint has even decreased at a slightly faster pace than territorial emissions (see graph below).
Source of data: Global Carbon Budget (2020).
The risk of carbon leakage could become more of a reality, however, in light of the plans to ramp up the emissions trade system. To prevent this, the EU adopted the Green Deal in late 2019, which provides for the introduction of a border adjustment mechanism. This type of mechanism could take one of two forms.
Border adjustment mechanism: two possible forms
William Nordhaus described the first possibility in his article on the “Climate Club” formed by the countries involved in carbon pricing. Nordhaus recommends protecting the borders by avoiding the inherent complexity involved in implementing a carbon pricing system. He suggests introducing a uniform customs tariff for all products imported from countries outside the club. The tariff level must be calculated based on the economic damage their lack of carbon pricing has caused for the club’s member countries. Based on this approach, the border mechanism would become a trade policy instrument aimed at encouraging other countries to join the club due to a threat of retaliation.
The second way was outlined by the European Parliament in a report adopted in March 2021. This report aimed to create a bridge between global prices for products established without carbon pricing and the EU price incorporating the cost of allowances: upon importation, a carbon tax calculated in proportion to the amount of CO2 emissions incorporated would be applied to goods produced without carbon pricing. Exporters would benefit from a nearly symmetrical refund to compensate for the expenses the allowance system adds to their production costs (see the diagram below).
The import levy calculated based on the amount of imported emissions would raise the global price (€100) to the European price (€150). An export subsidy of the same amount would allow the EU to continue to operate in the global market.
This second mechanism is reminiscent of one long practice by the Common Agricultural Policy (CAP), which disconnects European guaranteed prices from world prices. One of the major lessons learned involved processed products. While the CAP succeeded in protecting grain producers, it significantly disrupted livestock feed industries. It widened the European protein deficit (soy bean) and encouraged poultry farms (one chicken = 2.5 kilos of processed grains) to set up outside the EU, and even buy exported grain with export refunds.
The carbon border tax could lead to similar issues by protecting European producers subject to allowances to the detriment of the client industries buying their products. For example, it could protect steel producers to the detriment of automotive supply chains, or force wind turbine manufacturers to move to areas with cheaper steel prices.
Who foots the bill?
The carbon border tax has created a strange consensus in the political sphere. In France, it is supported by ecologist Yannick Jadot, who pushed for the issue in the EU Parliament, and by Emmanuel Macron, who did away with the domestic carbon tax following the “yellow vest” movement.
This consensus is based on a more or less intentional ambiguity with an eye on public opinion: the carbon border tax would be paid by the Chinese, Russians, Americans or Turks. None of it would come out of European pockets!
However, the EU’s trading partners would not be the ones paying the carbon border tax, instead it would be the European companies using the goods in question as intermediate consumption. These end-user sectors will likely be the ones to bear the expenses. Located in the downstream segment of the supply chain, they often hold a more strategic position for European competitiveness than upstream sectors.
Anticipating the impacts for different economic sectors
Before introducing a new mechanism, it is important to thoroughly assess the future impacts for these downstream sectors, taking into account the highly diverse situations in different sectors.
The introduction of a tax as early as 2023 involving the surrender of an allowance at the border seems advisable for three strategic sectors for the transition to a low-carbon society: electricity, fuel refining and cement. The weight represented by foreign trade in these sectors is not substantial. For the electricity sector, a mechanism even exists to cushion the impacts of increases in electricity prices caused by carbon pricing for client sectors.
In the other sectors, introducing a border tax is probably not the best way to end the free distribution of allowances without creating carbon leaks. We could certainly consider expanding the tax to include the CO2 incorporated in processed products, such as in the sheet metal used in auto manufacturing or in imported wind turbines. But one thing is certain – the EU allowance system does not need any additional complexity!
In these sectors, auction proceeds should be used to fund low-carbon transition plans for the industries concerned, with a non-amendable timetable for the phase-out of free allowances by 2030. For steel, this would mean paving the way for carbon-neutral primary steel production using green hydrogen; for fertilizers and chemistry, the conversion of existing facilities through a transition to biosourced products; for nonferrous metals, pairing the border adjustment mechanism with a plan for reducing the carbon footprint of the batteries and other components of the electrical sectors of the future.
What is an “inclusive tax”?
As William Nordhaus points out, a carbon border tax is not an end in itself. It is an instrument used to serve a policy that includes both an environmental and trade component. Its introduction aims to include as many members of the carbon pricing club as possible.
So far, the expansion of the EU carbon market has been limited to relatively low emitters – Norway, Australia, Switzerland – and was handled by technicians. With the border tax, there is truly a need to shift gears by clearly communicating the political conditions for inclusion.
Inclusion must be nonconditional for less advanced countries. Protectionism in any form must be avoided. Rather than offering tax exemptions for these countries, the principle should be applied by returning the tax, with a multiplying factor if the amounts returned are invested in the low-carbon transition.
It would be wise to include Southern Mediterranean countries in the introduction of a carbon tax in the electricity sector. This tax could help fund the investments needed to enable the EU market to tap into its solar energy potential.
For a major breakthrough in international climate action, a carbon club should be created that brings together the EU, China and the United States. China is poised to introduce its own national emissions trade system. President Biden was elected on a platform that promised (albeit vaguely) to introduce domestic carbon pricing and a border mechanism. The EU, which has maintained its lead in this area, must firmly stipulate the conditions for increasing ambitious global climate goals by interconnecting the various initiatives.
In the midst of the global cacophony created by increasing trade disputes between the United States and China, the EU must make its voice heard. It must communicate a new doctrine that breaks with its old positions linked to liberalist dogmas leftover from the 1980s. Given the climate emergency we are facing, the freedom of trade must become subject to higher climate standards.
This text was published in partnership with the European think tank Confrontations Europe.
Our series “Fifteen years of the European carbon market: what’s the point?”
The opinions expressed on this blog are those of the authors and do not necessarily reflect the official position of their institutions or of AFD.