Carbon Critical

January 06, 2021

Flexing the Regulatory Muscle

The European Union is getting ready to introduce a so-called carbon border tax. But such a mechanism will not be easy to implement and has some pitfalls.

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A graph showing CO2 embodied in exports, balance 2015

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The European Union is not a military superpower, with France the only EU member state that can be deemed a major military power. Nor is it a technological superpower. Of the world’s 15 largest digital firms, not a single one is European.

No, if the EU is a superpower at all, it is a regulatory one. Most companies cannot afford to ignore this large, wealthy market and thus must follow the rules set by “Brussels.” EU regulations “stipulate how timber is harvested in Indonesia, how honey is produced in Brazil, and what pesticides cocoa farmers use in Cameroon,” according to Professor Anu Bradford of Columbia Law School, the author of The Brussels Effect. Even tech giants like Amazon and Facebook have to comply with stringent EU data regulations known as the GDPR, and European regulators continue to fight an uphill battle to make these firms pay taxes where they earn profits.

Brussels now wants to add another arrow to its regulatory quiver: a carbon border tax.

Watch Out, It’s Leaking

A carbon border tax, officially described as a carbon border adjustment mechanism (CBAM), is a mechanism that puts a price on carbon dioxide emissions embedded in imported goods. In a sense it is the external version of intra-EU carbon pricing measures such as the Emissions Trading Scheme (ETS). That carbon market requires European manufacturers to buy ETS permits for each ton of CO2 they emit, which encourages them to use more climate-friendly production methods in order to keep costs down.

Unfortunately, the ETS also makes it harder for European manufacturers to compete with producers in other countries that do not have a similar carbon pricing mechanism. The phenomenon of production being outsourced to countries with laxer climate regulations is known as “carbon leakage.” According to OECD data, around 25 percent of emissions for which EU consumption is responsible are embodied in imports, with China the largest source (see graph).

A CBAM seeks to plug the leak by adding to imported products the same CO2 costs that domestic producers have to pay. The EU already takes steps to protect firms in vulnerable sectors (notably metals, chemicals, and cement) by giving them ETS permits for free, so they don’t have to pay for all the carbon dioxide they emit. But the EU is tightening the rules for free permit allocation from 2021, and the cost of ETS permits—like EU imports of cement—has been rising for years. The EU CBAM is meant to protect EU producers and prevent EU “efforts to go climate-neutral by 2050” being “undermined by lack of ambition by [its] international partners.”

Who Regulates the Regulators?

All in all, a very sensible idea, and one that climate economists have advocated for a long time. In 2009 major US climate legislation called the Waxman-Markey Bill, which died in the Senate, contained a CBAM. Then French President Nicolas Sarkozy called a CBAM a “natural complement to a domestic carbon tax” and “vital for our industries and our jobs.” But in international climate talks in Copenhagen, developing countries expressed worries about how the measure would hurt their exports, while trade experts debated whether it would comply with World Trade Organization (WTO) rules.

When in 2012 the EU included international flights to and from Europe in the ETS—taxed carbon-intensive trade in passengers, if you will—it became clear that other countries would resist EU regulators’ efforts to expand their remit. In the face of pressure from the United States, China, India, and the international airline industry, the EU gave in and agreed to stop taxing the flights.

There is presently only one example of a CBAM that operates across international frontiers, the emissions trading system in Quebec that applies to electricity imports from the north-eastern US. Most domestic emission trading schemes give industry free carbon permits, which protects against leakage but doesn’t solve the underlying issue of planet-warming emissions.

Bordering on Overcomplicated

The EU, then, is moving into new territory. Three varieties of a CBAM are on the table. First, a customs duty on carbon-intensive products; the level of the tax would be linked to the price of emission permits in the EU ETS. This option might be the easiest of the three to implement as it could build on existing customs infrastructure and could be adopted by qualified majority vote in the European Council. Second, an extension of the EU ETS to imported goods: either importers or foreign producers themselves would have to buy ETS permits, perhaps from a special, separate pool of ETS permits dedicated to imports. If it chooses this option, the EU will have to adapt existing plans for the ETS “phase 4” (from 2021 to 2030), which rely heavily on free permit allocation. Third, an EU-wide carbon tax applied to selected products regardless of whether they are imported or produced domestically. It could operate like a value-added tax, paid by importers and refunded to exporters. This option, too, would be complex to reconcile with existing carbon pricing mechanisms at EU and member-state level.  

Each of these options has its pros and cons and unique knock-on effects, which is why Brussels is proceeding deliberately. Having held a public consultation in 2020, the Commission hopes to approve a CBAM in 2021 and implement it in 2023. (The EU must also determine which sectors the CBAM will apply to; electricity, cement, metals, chemicals, and petroleum products are the main candidates.)

Does This Make Me Look Protectionist?

But all options face some common challenges, similar to those that arose in 2009 and 2012 when the EU and US were considering CBAMs.  

Any CBAM should comply with WTO rules. The principle of non-discrimination is key: trade measures must not differentiate between like products or treat imports from fellow WTO members less favorably than domestic products. If the EU wants to depart from this principle, for example by granting exemptions to countries that have ratified the Paris Agreement, or applying different taxes based on a trade partner’s emission intensity, it will probably have to make recourse to an exemption clause covering rules “relating to the conservation of exhaustible natural resources.” And it would have to demonstrate that a CBAM is a bona fide environmental measure rather than protectionism in disguise. An EU official told IPQ that a CBAM is “an environmental instrument, not a revenue-generating tool,” but plans to use CBAM revenues as “own resources” for “financing the EU’s future budget” in the wake of the pandemic could give critics ammunition.

Even if the EU does clear the WTO hurdle, it risks provoking retaliation from trade partners like the US or China. At the latest UN climate conference in Madrid in December 2019, members of the Chinese delegation argued that there was no need for a CBAM because all Paris Agreement signatories have agreed to implement appropriate emissions policies. Indeed, with the WTO already in crisis—its appellate body no longer functions—other countries might respond with unilateral retaliatory trade measures rather than counting on a WTO legal process, so the EU will have to buttress its legal case with a diplomatic campaign.

Well-Adjusted Policymaking

Calculating how many emissions are embodied in a delivery of steel or cement is not easy nor cheap, especially if the product contains inputs from several different countries. While the EU could use default values for carbon emissions from industrial processes, and then require exporters to prove that their product has a lower carbon content or that they have already paid a higher carbon cost at home, small businesses and small countries in particular could still struggle with the administrative burden. The authors of an IASS Potsdam study argue that the EU should give some of the CBAM revenue to developing countries to help them cut emissions and avoid dividing the world into high- and low-carbon trade blocs. 

A CBAM is not easy to design or implement. But it is necessary in the absence of ambitious globally coordinated efforts to mitigate climate change—and will hopefully help spur them. Having the ability to influence the behavior of others by passing new domestic rules? That’s the very definition of regulatory superpower.

Noah J. Gordon is INTERNATIONALE POLITIK QUARTERLY’s climate columnist.

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