30 Nov 2020, 12:26

Emission reduction panacea or recipe for trade war? The EU's carbon border tax debate

The European Union is inching towards introducing a carbon border tax, an instrument that has been hailed as a stimulus for climate action but also branded as a way to spark new trade disputes between the bloc and its trading partners. As the EU is in the process of pursuing a new, higher climate target and a green overhaul of its entire economy, the mechanism that has importers pay if their product has a larger carbon footprint than their European counterparts, leaves many industries and non-EU governments concerned. But as Europe has set its mind on decarbonising what is left of its energy-intensive industries while keeping them competitive at a global level, the question will more likely not be "if" but "how" such a complex, politically contentious and legally delicate system can be established. This factsheet explains the design options for a European carbon border levy, outlines the potential problems associated with this instrument and sums up the opinion of the stakeholders in and beyond Europe.

What does a carbon border tax do and why have it?

The European Union wants to become “climate-neutral” by the middle of the century, an objective that should turn the bloc into “a modern, resource-efficient and competitive economy, where there are no net emissions of greenhouse gases.” To achieve this, the EU has set up a carbon emissions trading scheme (EU ETS) and is introducing increasingly tougher climate and environmental standards for businesses. Should the bloc decide on an even more ambitious medium-term target of a 55 percent reduction in greenhouse gas emissions by 2030, all sectors would have to do even more to meet that goal.

Putting a price on emissions gives an incentive to domestic companies to work and produce in an increasingly climate-friendly manner, but the European Commission is worried that this would lead to a competitive disadvantage and “carbon leakage” if the EU’s trading partners are not pricing carbon in a similar way.

What is carbon leakage?

Carbon leakage occurs when companies shift their carbon-intensive production activities from regions with tough emission reduction policies (e.g. a high carbon price) to a place with laxer policies. The same happens, when companies in countries with strict emission rules reduce production due to high costs, while the output from foreign installations in regions of less stringent regulation increases. As a result, the emissions saved in the place with tight emission regulations are instead emitted in another country (leakage), meaning there is no greenhouse gas emission reduction overall.  

While almost all nations are signatories to the Paris Agreement and are therefore theoretically on a similar pathway to net-zero emissions, the actual price for CO2 and the environmental standards in manufacturing differ widely across countries. The term “carbon leakage” describes emissions occurring when European companies transfer their production sites to countries with less stringent emission reduction rules or when formerly domestically produced goods are replaced by more carbon-intensive imports. Overall emissions would then not be reduced, despite the European efforts.  

Another concern is the potential loss of competitiveness of the European industries, whose manufacturing costs for the same product, e.g. steel, are higher because of CO2 pricing. This could lead to them being outpriced on the world market and eventually to their demise.

This issue could be alleviated by a so-called carbon border tax. Simply put, such a levy would add the same CO2 costs to a product when it crosses the border into the EU that the manufacturer of a domestically produced item would have to pay.

The EU is referring to this instrument as "Carbon border adjustment mechanism" or CBAM.

The carbon pricing gap measures how much countries fall short of pricing carbon emissions in line with a 30-euro benchmark value, the low-end estimate of carbon costs today. The difference between the benchmark value and the actual effective carbon rate is presented as a percentage. If the effective carbon rate on all emissions is at least as high as the benchmark, the gap is zero. Countries with a low gap tend to emit fewer emissions than countries that hardly price any carbon emissions. Data and Chart: OECD, 2018.

Some researchers have pointed out that carbon leakage is only a “perceived” threat for which there is too little evidence. Opponents of the tax have therefore highlighted the minimal benefits and many trade-offs that a carbon border adjustment mechanism (CBAM) would entail.

To which goods would an EU carbon border levy apply?

The European Commission has not yet published details about which goods would be included in a carbon border adjustment scheme. It highlights, however, that carbon leakage from sectors regulated under the EU ETS has so far been addressed by giving certain companies free allocations of emission allowances. The current list of sectors deemed at risk of carbon leakage can be an indicator of which products would be included in the new border adjustment scheme, e.g. steel, cement, aluminium, rubber, pulp, glass, leather clothes, fertilisers and nitrogen compounds. According to the Commission, a study is underway to identify the sectors that are under the largest threat of carbon leakage. A Commission official said in October 2020 that steel, cement and electricity could be the first sectors to be subjected to a CBAM, followed by aluminium, fertilisers and chemicals at a later stage.

How important is the long-term CO2 price for investments by your company? (2016; n= 58). Chart by UBA, 2020 with data from Thomson Reuters “Carbon 2016”.

What types of carbon border tax does the EU consider?

The European Commission is considering different kinds of carbon pricing to prevent carbon leakage, such as a carbon tax on selected products (both imported and domestic); a carbon customs duty or tax on imports; or the extension of the EU ETS to imports.

- Customs duty or tax on imports of selected products:

Carbon-intensive products, such as steel, aluminium or cement, would be subject to a duty or tax payable by the importer when crossing the border. The tax would be linked to the CO2 price that European companies pay under the EU ETS.

- Extension of the ETS:

The EU ETS could be extended to imported goods either by requiring foreign producers or importers to purchase emission allowances under the EU ETS or by making them buy allowances from a specific pool of allowances dedicated to imports but outside of the actual ETS. The pool price would mirror that under the ETS.

The EU would have to carefully balance this scheme with the free allocation of EU ETS allowances.

- Tax on products sold in Europe:

An EU-wide carbon tax (VAT or excise duty-style) could be applied to products at risk of carbon leakage, both imported and produced in the EU.

For this approach to work, the EU will have to determine the carbon intensity of the products it imports. One way to do this could be to use of the existing system of EU-wide benchmarks for CO2 emissions from industrial processes under the ETS. This benchmark value would apply unless the exporter certifies a lower carbon content and/or a higher carbon cost at origin. But the Commission will also look into other ways of defining the carbon content of products, it said. “Ancillary verifications, controls and audits of installations in third countries may be needed,” a Commission document reads, calling these an “administrative burden.” A study supported by the German and French governments also finds that relying on default values for imported goods could help reduce this burden, while the challenges would include crediting foreign climate policies.

Legal issues when implementing a CBAM

One major challenge for the mechanism is designing it within World Trade Organisation (WTO) rules. The WTO’s free trade principle of “non-discrimination” by which the European Union must abide (contained in the General Agreement on Tariffs and Trade – GATT) would be breached if the bloc differentiated between low and high-carbon products that are otherwise alike.

The GATT provides for exceptions to this rule for environmental reasons, but the CBAM would have to be designed to exactly meet the requirements. Jennifer A. Hillman, a senior fellow at the Council on Foreign Relations, a US non-profit think tank, told Reuters the EU could strengthen their case by ensuring that revenue from the mechanism goes to climate action.

Should the CBAM require importers to hold EU ETS allowances, changes would have to be made to the allowance stock and the market stability reserve, observers have pointed out. The current practice of giving free allocations to industries that are in danger of carbon leakage when a CBAM is in place or paying EU exporters their CO2 costs back as part of a CBAM could both be judged an export subsidy, which is prohibited under the WTO’s Agreement on Subsidies and Countervailing Measures (SCM), a paper published by European Roundtable on Climate Change and Sustainable Transition (ERCST) states.

What other options are there to stop carbon leakage?

The EU's main mechanism to prevent carbon leakage from industry is the allocation of free CO2 emission allowances under the EU ETS. Under the ETS, free emission rights are given to energy-intensive companies that meet product-related benchmarks and are at risk of carbon leakage. In addition, member states are permitted to return some of the ETS revenue to electricity-intensive businesses. Instead of introducing a carbon border fee, these practices could be continued and/or strengthened.

Another option would be to promote low-carbon technologies and production through large-scale public support programmes, e.g. in the areas of green steel, green cement and green aviation. These could take the form of quotas for green products, “carbon contracts for difference” or by giving companies access to remuneration from a fixed fund if they exceed certain benchmarks with their low-carbon production. With these incentives, sectors could become both low-carbon and achieve long-term competitiveness, the think tank Bruegel suggests.

Industry representatives have suggested that working towards a globally harmonised emission trading or pricing system would be more suitable to support the low-carbon transformation.

What are the major issues in carbon border tax implementation?

Depending on the exact design and the actual carbon cost used for the mechanism, the following risks have been mentioned by researchers and stakeholders:

  • If the cost of carbon is too low, it will give little impetus to invest in low-carbon technologies and carbon leakage will not be stopped
  • If the EU’s emissions regime is joined by other large economies, such as the US and Japan, high barriers between this trade bloc and the rest of the world would shut out emerging and developing economies. This could be in contradiction to the principle of “common but differentiated responsibilities and respective capabilities” laid down in the United Nations Framework Convention on Climate Change (UNFCCC), i.e. that developing nations should not face the same mitigation burden as richer countries
  • If Europe alone implements a high carbon tax, only very low-carbon producers would be able to trade with the EU, high-carbon trade would continue but bypass the EU, and eventually European producers would have to increase their output
  • Apart from the actual carbon content of a product, just complying with the new EU rules and standards set up by the CBAM could lead to discrimination of producers from less developed countries
  • A CBAM needs to specify the exact amount of emissions linked to each product, ideally including emissions along its entire value chain – this is difficult, especially if a product is manufactured using electricity, e.g. aluminium
  • Trade deviation and carbon leakage: Exporters from high-carbon countries could sell their products to other countries, e.g. to the US, which does not have a carbon border tax, thereby replacing less carbon-intensive domestic production
  • Distorting trade and damaging EU industry: If a CBAM prevents EU manufacturers from importing raw materials, e.g. steel, from a high-carbon country, the EU will likely import manufactured products (e.g. nails) instead from those countries – making life difficult for European producers of such downstream products
  • Trade war: Depending on its design and the impact a CBAM will have on industries in different countries, their response may be to push back with their own tariffs (read more below)

What do Europe’s trading partners think about a carbon border tax?

With a carbon border tax, the EU’s aim is to avoid carbon leakage and “motivate foreign producers and EU importers to reduce their carbon emissions, while ensuring that we have a level playing field in a WTO-compatible way,” Commission president Ursula von der Leyen said in September 2020.

In this sense, the CBAM is part of Europe’s climate diplomacy and even before a proposal has been adopted, observers credit it with having helped change attitudes towards climate action in other countries. With more countries having national climate policies and greenhouse gas reduction measures for industry in place, they are faced with their effect on competitiveness and with the issue of carbon leakage as well. This makes them more understanding of the EU’s carbon border adjustment approach, researcher Michael Mehling from the Centre for Energy and Environmental Policy Research (CEEPR) at the Massachusetts Institute of Technology (MIT) told Euractiv.

But while the EU wants to exert its power to “do good” and promote climate action in countries around the world it trades with, these same trading partners may not like to see their hands forced in this way and “reflexively push back against the CBAM,” an ERCST paper says.

Some even consider unilateral carbon border adjustments “the latest form of economic imperialism” that is “antithetical to the principles of equity enshrined in the Paris Agreement.” A similar opinion is voiced by Oxfam Kenya, which suggests that other policy instruments could be used to avoid carbon leakage that would not be so harmful to developing countries, e.g. import standards regulation.

Large trading partners, such as Russia, India and China, could introduce countermeasures, i.e. import tariffs of their own. Some have therefore warned of a trade war, unleashed by the EU introducing a CBAM.

Overall, it is important to note that the effect of the CBAM on trade with a certain country depends very much on the goods and sectors chosen to be included in the mechanism and the particular manufacturing conditions and climate measures in place in this country. Countries with relatively clean energy mixes (e.g. Costa Rica, Switzerland) would not have to fear the border tax. while others with high shares of coal power and carbon-intensive industries, such as South Africa and India, would likely have reason to oppose such a measure.

China

China produces half of the world’s steel and would thus be very exposed to a CBAM, which will likely include this commodity in its initial scope. The Chinese government voiced its concerns over a carbon border tax as early as 2019, saying it would damage the global fight against climate change. But within the country reactions are more mixed, China Dialogue reported, as there are businesses that already produce with small carbon footprints. These could use the CBAM as an opportunity to do business with Europe. Others, however, would have to adapt quickly and could be helped by the government implementing emissions trading for goods that would be covered by a CBAM. According to Dimitri de Boer, head of ClientEarth’s China office, it hangs in the balance whether a CBAM would spark a trade war with China or motivate the country to increase its own efforts in emission reduction from industry.

Russia

The EU is Russia’s largest trading partner, and Russia is the EU’s fifth largest trading partner. Main EU imports from Russia are raw materials, oil, gas and metals (iron/steel, aluminium, nickel). With this track record and being the world’s fourth largest emitter of greenhouse gases, Russia is concerned about the EU “using its climate agenda to create new barriers.” Russia’s economic development minister warned in July 2020 that the bloc’s carbon border tax would have to abide by WTO rules and that the mechanisms suggested by the European Commission were not in line with these rules. In Russia, the introduction of a CBAM is mainly perceived as being a measure to protect European industry rather than a climate action instrument.

Ukraine / Turkey / India

Ukraine’s main exports to the EU are iron/steel, mining products, agricultural products, chemical products and machinery. In its response to the European Commission’s impact assessment consultation, Ukraine’s Ministry of Economic Development, Trade and Agriculture voiced concerns about the CBAM’s effects on the steel industry in particular. The Ukrainian steel industry association UKRMETALURGPROM pointed out that the country’s own carbon tax and willingness to integrate into the EU’s Green Deal initiatives mean that “trade in steel goods […] should not be subject to any CBAM.” The Ukrainian think tank GMC Center has calculated a high risk for a decline in the country’s power, chemicals and steel exports to the EU, coupled with a subsequent job loss and the deterioration of trade relations.

The Turkish Business and Industry Association (TUSIAD) and Ukraine’s Ministry of Economic Development have both expressed an interest in aligning their policies with the EU standard and asked for a mechanism and funding to facilitate this approach.

The EU’s imports from India are manifold, with textiles, chemicals and metals all playing a role. The Boston Consulting Group has pointed out that, for example, India’s (and Turkey’s) steel industries would probably pay less tax than other sectors because of their higher share of minimills, which are generally more carbon-efficient.

US

The EU is not the only world power mulling the idea of introducing CO2 fees at its borders. According to the 2020 Democratic Party Platform, approved by the Democratic National Convention in August 2020, the US could do the same. “We will apply a carbon adjustment fee at the border to products from countries that fail to live up to their commitments under the Paris Climate Agreement because we won’t let polluters undermine American competitiveness,” the document states. Likewise, the Democratic Party’s president-elect Joe Biden has also included in his campaign a climate plan with the aim of imposing “carbon adjustment fees or quotas on carbon-intensive goods from countries that are failing to meet their climate and environmental obligations.”

At the same time, many politicians and industry are keeping a wary eye on the EU’s plans, criticising that new trade disputes could be triggered if a CBAM should penalise US companies for not having a carbon price when they are reducing emissions through other measures.

California and Quebec are the only two regions in the world that actually have a CBAM in place. Electricity traders have to surrender allowances when importing electricity into these jurisdictions.

What do European and German industries think about a carbon border tax?

European industries’ perception of a carbon border fee depends very much on the type of industry and the design of a carbon tax. German industry association BDI has complained that too little is known about the actual design of the border adjustment that the Commission is preparing. In general, the BDI agrees with the notion that a stricter European climate regime will need a carbon border tax, as the system of free allocations would not suffice to prevent carbon leakage. Their biggest fear is retaliation measures by trading partners. They also stress that the system of free allocations under the EU ETS must under no circumstances be substituted by a carbon border fee.

The German Chemicals Industry Association (VCI) strongly opposed the idea of a CBAM, saying the “risks and burdens that come with carbon border adjustments by far outweigh the opportunities.” The export-oriented chemicals industry would bear the brunt of trading partners responding with “tough countermeasures.” Defining the CO2 content of products would be costly and would require the disclosure of sensitive information. “Carbon border adjustment must not replace existing instruments to prevent carbon leakage (free allocation, indirect cost compensation). These must be maintained and expanded even if carbon border adjustment should be introduced – because only these instruments protect competitiveness for exporters,” they write.

The German steel federation (WV Stahl) says border adjustments could be used to supplement – but not to replace – the existing system of free emission allowance allocation. The federation suggests that revenues from the mechanism could be used to support the low-CO2 transformation of steel production in Europe.

The Association of German Chambers of Industry and Commerce (DIHK) and the German Engineering Federation (VDMA) both voice the concern that distortions in trade flows would negatively affect the competitiveness of companies that process products subject to a carbon border tax. The German economy, which is highly dependent on international trade, would particularly stand to suffer, the DIHK argues.

The organisation Fertilizers Europe is in favour of a carbon border levy that arises from the difference between the product (e.g. ammonia, fertilizers) benchmark set in the EU ETS and the actual carbon intensity of imported products.

Eurometaux, representing the European non-ferrous metals industry, does not want to be included in a CBAM. As a very electro-intensive industry (e.g. aluminium), the sector does not believe that a CBAM could reflect the indirect CO2 costs of EU power prices in comparison to other countries’ power mix.

In a summary of the public consultation that ended in October 2020, the ERCST found that “stakeholders remain positive towards the border adjustment, but worried about the impact on the current domestic measures to address carbon leakage and the functioning of the EU ETS at large.” Some are also worried about the irreversibility of the process.

How much revenue could be generated by the tax and what will the money be used for?

A CBAM could bring in revenues ranging between 5 and 14 billion euros, a document from the European Parliament states. To make the mechanism comply with WTO rules, this revenue should be dedicated for climate action, legal experts have said (see above). Others have suggested that the money should be used to help low-carbon innovation in European industry, which foresees competitiveness issues and carbon leakage despite a CBAM. Think tank Bruegel proposed that the revenue should be “sent back to developing countries affected by the tax.” 

A European Commission representative has said that the revenue is not the reason why the EU is thinking of introducing a CBAM.

Which EU countries are most likely to promote/resist a border carbon tax?

Germany and France, the two largest EU member states, are supporting the European Commission’s CBAM proposal , as long as it is in line with WTO rules. Positive remarks have also been heard from Italian and Spanish officials, and Poland is also a supporter of a CBAM. However, only the actual design of the mechanism would elicit detailed responses from the member states, e.g. on elements such as replacing the free allocation of emission allowances and depending on which sectors would be included. Depending on what commodities a member state imports – e.g. Germany natural gas from Russia, or Spain electricity from Morocco – positions would also likely differ on how the carbon content of a product should be calculated.

Is it realistic for the EU to impose a CBAM?

The EU has come up with three proposals for a CBAM since 2007 but none of them made it through the legislative process, either because the system of free allowance allocations under the ETS was favoured or because concerns over WTO challenges were too strong.

Once the European Commission proposes a carbon border adjustment measure, the member states (European Council) and the European Parliament will have to agree on the proposed policy – or introduce changes to it. The European Parliament’s Committee on Budgets  and the Committee on the Environment, Public Health and Food Safety have both signalled their general approval of a CBAM.

At a more general level, Commission officials have stated that an EU carbon border tax becomes less important as more countries commit themselves to similar CO2 reduction schemes. But since even the recent climate target announcements by China, Japan and the Republic of Korea will not immediately and completely alleviate European industry’s carbon leakage concerns, the Commission continues to pursue the mechanism.

What is the timeframe for Europe’s implementation of a CBAM?

After the recent completion of its public consultation and taking into account the ongoing impact assessment studies, modelling exercises and internal consultations, the Commission wants to adopt its proposal for a CBAM in June 2021. The CBAM could then enter into force in January 2023.

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