What is The European Union Carbon Border Adjustments Mechanism?

The European Union (EU) is at the forefront of international efforts to fight climate change. The European Green Deal sets out a clear path towards realising the EU's ambitious target of a 55% reduction in carbon emissions compared to 1990 levels by 2030, and to become a climate-neutral continent by 2050. The Carbon Border Adjustment Mechanism (CBAM) is a climate measure that should prevent the risk of carbon leakage and support the EU's increased ambition on climate mitigation, while ensuring World Trade Organization (WTO) compatibility.

Climate change is a global problem that needs global solutions. The EU realizes that as they raise their own climate ambitions, less strict environmental and climate policies prevail in non-EU countries. This creates a strong risk of so-called ‘carbon leakage'. For example, companies based in the EU could move carbon-intensive production abroad to take advantage of lax standards, or EU products could be replaced by more carbon-intensive imports. Such carbon leakage can shift emissions outside of Europe and therefore seriously undermine EU and global climate efforts. The CBAM will equalise the price of carbon between domestic products and imports. Thus, ensuring that the EU's climate objectives are not undermined by production relocating to countries with less ambitious policies.

How is it different from carbon leakage addressed by the Emissions Trading System?

The EU's Emissions Trading System (ETS) is the world's first international emissions trading scheme and the EU's flagship policy to combat climate change. It sets a cap on the amount of greenhouse gas emissions that can be released from industrial installations in certain sectors. Allowances must be bought on the ETS trading market, though a certain number of free allowances is distributed to prevent carbon leakage. That system has been effective in addressing the risk of leakage, but it also dampens the incentive to invest in greener production in EU counties and abroad. The CBAM will progressively become an alternative to this. Under the European Commission's new proposal for a revised ETS, however, the number of free allowances for all sectors will decline over time so that the ETS can have maximum impact in fulfilling our ambitious climate goals. Furthermore, for the CBAM sectors, the free allowances will gradually be phased out as from 2026.

How does CBAM Work?

The CBAM will mirror the ETS in the sense that the system is based on the purchase of certificates by importers. EU importers will buy carbon certificates corresponding to the carbon price that would have been paid, had the goods been produced under the EU's carbon pricing rules. Conversely, once a non-EU producer can show that they have already paid a price for the carbon used in the production of the imported goods in a third country, the corresponding cost can be fully deducted for the EU importer.

The CBAM aims reduce the risk of carbon leakage by encouraging producers in non-EU countries to green their production processes. The idea of CBAM is to use the size of the EU market to impose regulatory control beyond its borders. The EU has been able to set standards in other areas to the sheer scale of its markets which is part of its economic soft power. If the EU only accepts certain standards for products and services companies will implement them because of the huge potential of the EU market, considering the EU’s massive role in global trade importing 14% of all goods worldwide. These would affect countries that export the most in Europe such as, United States, China, and Russia and will later trickle down to other countries.

Response from Trading Partners

The EU’s proposal for a carbon border levy to combat climate change has triggered a sharp response from trading partners such as Russia. Russia criticised the proposal and calculated that it stood to lose $7.6bn from it, making Moscow potentially one of the biggest losers from the measures. Dmitry Peskov, President Vladimir Putin’s spokesman said, “The prospect of an additional financial burden for our economy and our companies is extremely unpleasant,”. EU leaders say the policy is aimed at companies not countries, and emphasise they want to co-operate as widely as possible with other governments on carbon pricing.

China’s President Xi Jinping also condemns the European Union’s plan for a carbon border levy. According to the president, “Tackling climate change is a shared responsibility and should not become a geopolitical bargaining chip or used to attack other countries (or impose) trade barriers,”. He believes that developed countries should “set an example in reducing emissions” and help poorer nations to deal with the fallout from the climate crisis by sharing technology and increasing funding for green projects. Efforts in Europe to pressure China into being more ambitious in tackling climate change have to some extent paid off. In 2020, the world’s biggest polluter announced plans to peak carbon emissions before 2030 and become carbon-neutral by 2060.

Democrats in the US this week advocated a carbon border tax, even though the country lacks a national carbon pricing mechanism. A number of countries such as Canada and Japan are planning similar initiatives.

Involvement of Developing Countries

The effects of the CBAM will depend on trade patterns, carbon intensity of production processes of countries, and carbon policies of European Union’s trade partners. Studies show that carbon tariffs can create adverse distributional effects for countries subject to the measure and exacerbate regional inequality. Exporters of fossil fuels are negatively affected by carbon border measures due to downward pressure on fuel prices as global fuel consumption falls. In comparison, importers of emissions-intensive trade-exposed (EITE) sectors from the group of countries imposing the adjustment suffer from higher EITE import prices. Estimates indicate that if the CBAM is applied to all the goods covered by the ETS, up to $16 billion of developing country exports to the European Union could face an additional charge.

CO2 imported from these economies only represents a small proportion of the CO2 embodied in the total imports of the European Union. For instance, imported CO2 from India only represents around 1 per cent of total imports. The application of a CBAM could impact the development of poorer countries and reduce their opportunities for export led development, particularly if countries with carbon taxes and greener production processes are exempted from the CBAM.

To provide businesses and other countries with legal certainty and stability, the Carbon Border Adjustment Mechanism will be phased in gradually and will initially apply only to a selected number of goods at high risk of carbon leakage: iron and steel, cement, fertiliser, aluminium and electricity generation. A reporting system will apply as from 2023 for those products with the objective of facilitating a smooth roll out and to facilitate dialogue with third countries, and importers will start paying a financial adjustment in 2026.

References

1) European Commision. (2021).  Carbon Border Adjustment Mechanism. Retrieved from : https://ec.europa.eu/commission/presscorner/detail/en/qanda_21_3661 

2) European Commision. (2021).  Carbon Border Adjustment Mechanism: Questions and Answers. Retrieved from : https://ec.europa.eu/commission/presscorner/detail/en/qanda_21_3661 

3) Eurostat. ( 2019 ).  Main trading partners for imports of goods, EU-27, 2019. Retrieved from : https://ec.europa.eu/eurostat/statistics-explained/index.php?title=File:Main_trading_partners_for_imports_of_goods,_EU-27,_2019.png 

4) Euractiv. (2021).  Chinese president slams EU carbon border levy in call with Macron, Merkel.  Retrieved from : https://www.euractiv.com/section/energy-environment/news/chinese-president-slams-eu-carbon-border-levy-in-call-with-macron-merkel/ 

5) Financial Times. (2021).  EU plan for world’s first carbon border tax provokes trading partners. Retrieved from : https://www.ft.com/content/de7d12e2-0d04-43d4-b38c-cf795854a4a2 

6) United Nations Conference on Trade and Development. (2021). A European Union Carbon Border Adjustment Mechanism: Implication for Developing Countries. Retrieved from : https://unctad.org/system/files/official-document/osginf2021d2_en.pdf