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EU presses ahead with tariff on embedded emissions

The EU wants its Carbon Border Adjustment Mechanism (CBAM) to increase carbon prices at home and drive climate ambition abroad.

In its 16th year, the European carbon market is growing up, with prices for pollution permits reaching record highs of €50 per tonne of carbon dioxide. And its parents have big plans for the market’s 18th birthday in 2023: it should go out into the world and announce its arrival with a CBAM. Its neighbours, however, would prefer it stayed at home.

The Carbon Border Adjustment Mechanism would essentially extend the EU’s carbon market to the rest of the world by putting a price on imports to reflect the carbon embedded in them. As well as pushing up carbon prices in Europe, the EU hopes it will encourage its partners to raise their climate ambition. While the CBAM is not expected to take effect until 2023, it is already possible to see the outlines of what is Europe’s flagship climate and trade policy.

The EU has considered various options for the design of the CBAM, including a carbon charge similar to value added tax. But it now appears it will decide to (notionally) extend the EU emissions trading scheme (ETS) to imports by applying a carbon levy that mirrors the price of carbon in the EU’s ETS.

Which goods will the CBAM cover? In March, the European Parliament called for the immediate inclusion of all sectors covered by the EU ETS, including electricity, “cement, steel, aluminium, oil refining, paper, glass, chemicals, and fertilisers… whether embedded in intermediate or final products”.

Some member states, such as Poland and France, argue for starting with a smaller pilot phase covering just steel, cement, and possibly fertilisers. An EU Commission press officer told China Dialogue that the main sectors currently under consideration are “iron, steel, cement, and fertiliser”.

Negotiations between EU member states and institutions will heat up after the Commission presents its CBAM proposal and impact assessment on 14 July. The proposal will be accompanied by reforms to the ETS meant to allow the EU to achieve its new greenhouse gas emissions target for 2030 (of a 55 per cent fall on 1990 levels), which could in turn affect the cost of CBAM permits.

Prices in Chinese carbon markets have hovered at €1-13/tonne, a ‘fraction of the current €50/tonne carbon price in EU ETS…

Yan Qin, lead analyst, Refinitiv

The cost of free allocation

The March debate in the European Parliament revealed divisions over one of the trickiest CBAM issues: what to do with existing measures that aim to prevent “carbon leakage”, when stricter climate policies in one place lead to higher production and emissions in another. 

The head of the European Steel Association, Axel Eggert, praised Parliament for approving a “workable carbon measure.” But Eggert was complimentary mainly because Parliament had voted to remove a sentence from the draft report that called for the end of free allocation of carbon permits to EU industry.

Free allocation is the main way the EU has helped its manufacturers stay competitive despite its carbon pricing measures. Whereas power plants must buy permits for all the carbon they emit, manufacturers in sectors considered exposed to carbon leakage have faced few direct costs.

In fact, according to the European Court of Auditors, the cement, chemicals, and iron and steel industries were all handed more than enough permits to cover their emissions from the ETS’ inception in 2005 until at least 2017. This meant they were able to make “windfall profits” to the extent they could pass on supposed carbon costs to customers or sell bonus permits on the market.

The pool of free allowances has shrunk somewhat in recent years, and in March the steel industry claimed it is now “short of free allowances by 20 per cent” a year. Still, under current plans these exposed sectors would continue to get free allowances until 2030, which is what makes the upcoming reform of the ETS so important for the CBAM. Unlike a majority of Parliament, the Commission envisions the CBAM as an “alternative to the current free allocation of allowances”. It wants to avoid “double protection” for EU manufacturers.

One argument for maintaining some free allowances is to help EU industry export goods abroad. Let’s say the CBAM levels the playing field by making an EU importer of Turkish steel pay the same price for carbon emissions as an Italian steelmaker pays.

The EU importer then has no incentive to buy steel from Turkey, which might be cheaper but is usually more carbon intensive. But the less-efficient Turkish steelmaker would still be able to sell into, for example, the US market without paying for carbon emissions, giving it an advantage over its Italian competitor. So EU producers could lose market share and global emissions could actually increase.

If designed correctly, a modified system of free allowances could help EU exporters stay competitive. Experts at the Roundtable on Climate Change and Sustainable Transition propose applying the CBAM only to the share of emissions embedded in imported goods for which the average EU producer has to purchase allowances. The EU has also debated offering export rebates for CBAM costs, but this option risks violating WTO rules, a real obstacle for the CBAM.  

Trade partners, trade competitors

Even at this early stage, the EU’s plans have run into opposition from trade partners. US climate envoy John Kerry has said the CBAM should be a “last resort”. Michael Mehling, deputy director of the MIT Center for Energy and Environmental Policy Research, says: “Domestic political constituencies in the US will, I suspect, not allow the administration to just remain passive or supportive of the CBAM.” As for whether trade disputes could derail the EU’s plans, Sam Lowe, a senior research fellow at the Centre for European Reform, warns that “things could degenerate quickly” if the US is not on board.

Chinese President Xi Jinping recently warned his French and German counterparts that “tackling climate change should… not become an excuse for… trade barriers.” And at an April meeting of the BASIC group (Brazil, South Africa, India and China), climate ministers from those countries “expressed grave concern regarding the proposal for introducing trade barriers, such as unilateral carbon border adjustment, that are discriminatory and against the principles of Equity and [common but differentiated responsibilities]”.

Asked about the criticism from BASIC, an EU official said: “The EU CBAM will be designed to be compliant with the WTO rules and with the Paris Agreement. From the very beginning of the initiative, we have been engaging with partner countries.” The official added that the EU’s public consultation had “offered exporters in partner countries the opportunity to make their views heard.”

If the CBAM is judged to be discriminatory against foreign goods despite Brussels’ efforts, the EU will hope to make use of WTO exceptions for trade measures related to the protection of human life and the conservation of natural resources.

To pass this hurdle, Brussels must ensure that the CBAM is seen as a climate protection measure and not a trade defence or revenue-generating measure, despite plans to funnel CBAM revenues into the EU’s general budget. The Commission’s website unhelpfully lists the CBAM as one of several “new sources of revenue to help repay the borrowing” done as part of the EU’s pandemic recovery.

New WTO leader Ngozi Okonjo-Iweala said in April that her organisation will set up a working group to examine the CBAM. One way for the EU to accommodate developing countries, says Sam Lowe, would be to unilaterally exempt them from CBAM charges as the EU already does for various tariffs.

But if the CBAM starts with only cement and steel, as many expect, it is a smaller group of middle-income countries that would be most affected at first. Turkey is by far the largest source of EU imports of cement products. Most EU imports of steel products come from Russia, although Turkey, Ukraine, China and South Korea also enjoy significant market share.

Of course, not every EU trade partner would face the same costs at the EU border. To avoid double carbon taxation, the Commission will exempt imports from countries that tax carbon domestically at a similar level to the EU. This is easiest in cases like Switzerland, whose emissions trading scheme is already linked to the EU ETS.

It will be harder for countries with weaker or no emissions trading. Yan Qin, lead analyst at Refinitiv, explained the challenge with regard to China. Prices in Chinese carbon markets have hovered at €1-13/tonne, a “fraction of the current €50/tonne carbon price in EU ETS…” and there is a risk of “trade disputes if the EU requires Chinese steel exporters to pay for the vast €40/tonnene price difference.” Qin adds that steel is likely to be one of the last sectors included in the new national Chinese ETS, perhaps not until 2025.

A delayed milestonne

The EU’s proposal in July will just be the beginning of its efforts to tax the carbon emissions embedded in foreign goods. But the proposal will also mark the end of a decades-long period in which climate policymakers knew that climate change was a free-rider problem but could not or did not impose economic costs on climate laggards. If the world’s major economies are to form what economists call a “climate club”, with rules on emissions within and coordinated tariffs on imports from outside, someone has to start dancing first. 

This article was originally published on China Dialogue under a Creative Commons licence.

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