What is a “carbon border adjustment mechanism”?

Topic
John_Martin_New_Energy_SolarJohn Martin26 March 2021

In early March this year the European Parliament approved the development of a carbon border adjustment mechanism (CBAM). The European Commission is expected to present details of the CBAM in June this year, with a view to having a pilot scheme in place by the start of 2023.

Details of the CBAM are under consideration, but the mechanism could operate as an impost reflecting the amount of carbon emissions attributed to goods imported into the 27-nation EU region, that is, imported goods would pay an amount per metric tonne of CO2 emissions. Alternatively, the EU could extend its emissions trading scheme, in which producers in carbon-heavy industries buy and trade permits to emit greenhouse gases, to European importers or to foreign producers that export to the EU. Producers in countries with a carbon-pricing mechanism equivalent to or compatible with that of the EU would be exempt1.

Why is the EU Contemplating a CBAM?

There are arguments for and against the imposition of CBAM exploring the burden on consumers2 and developing countries3 and the economic efficacy of CBAM formats4. A strong advocate for the CBAM and adviser to the EU in formulating its Energy Roadmap 2050 initiative is Professor Dieter Helm, professor of economic policy at the University of Oxford. He believes the most effective tools to reduce carbon need to focus on carbon consumption, rather than territorial emissions, and that carbon border taxes will bring about the technological changes required to achieve a sustainable energy transition.

"The UK’s Committee on Climate Change states, erroneously, that when we get to net-zero emissions we will no longer be contributing to climate change. That’s utterly wrong, unless every country in the world is at net zero in 2050. We will continue to buy petrochemicals from abroad, steel from abroad and cars from abroad. Given we have less coal in our energy mix than most of the countries from which we import these products, the risks of climate change will go up, not down, as a result of pursuing net zero domestically without a border adjustment. …. A carbon border tax has the potential to encourage genuine economic cooperation through the spreading of carbon prices globally."5

Protection or a Levelling of the Playing Field?

In the US, carbon pricing proposals are also circulating, and all include border adjustments designed to protect American companies from imports not burdened by a carbon price in their country of origin. A corresponding refund of the carbon price on American exports would help ensure that American goods sold overseas are not priced out of foreign markets6. A form of CBAM operates in California and Quebec where adjustments are made to electricity imports from neighbouring states7.

Border adjustments like CBAM have a protectionist character but are also intended to reduce the temptation for industries to transplant production overseas to avoid higher costs, thereby preserving domestic jobs. Desire for the protection offered by a CBAM is emerging to combat the perceived ‘last mover advantage’ for producers and industry in countries not implementing climate policies. This is particularly pertinent for European manufacturers who have been paying for carbon emissions since 2005 through the EU’s emissions trading system.

Which Countries are Ready for Carbon Pricing?

The OECD published analysis in 2018 based on carbon pricing data collected in 2015 of the ‘carbon gap’ country to country. Based on taxes and tradeable permits that put a price on carbon emissions, the carbon gap measures the extent to which countries fall short of pricing carbon emissions, in line with a benchmark value for carbon prices. A low carbon gap is thought to indicate that industry in that country is well-positioned to operate in a low-carbon economy. Conversely a higher gap indicates that carbon mitigation efforts in that country are limited or not cost-effective and that firms in these countries will find it more difficult to seize opportunities that arise in low-carbon economies and will face higher transition risks8.

Unsurprisingly, European countries exhibit the lowest carbon gaps, having climate policies and a greenhouse gas emissions trading system in place.

Broader Impact on Trade Patterns

Not only would a CBAM impact the profits available to foreign producers trading with the EU, the impact may also change the nature of global competitive advantage and by extension, trade patterns. For example, steel production is very carbon-intensive, but this intensity varies with production methods. Analysis indicates that the carbon intensity of blast furnaces and basic oxygen furnaces is about five times that of electric arc furnaces using recycled inputs. Countries using blast furnaces and basic oxygen furnaces to produce steel include China and Ukraine. Accordingly, products from these countries could be more highly taxed than steel-producing countries such as Turkey and the US, where the use of more carbon-efficient methods like electric arc furnace minimills is prevalent.

Even for processes like car manufacturing that require rolled steel that can only be produced in blast furnaces, a CBAM could change the current producer cost hierarchy. EU steel producers expect to be advantaged by a CBAM because they have already lowered their carbon footprint through investment in environmentally friendly and energy-efficient technology.

Another example of where changed trade patterns may result from CBAM implementation is the global petroleum trade. Russia is currently the largest oil supplier to the EU, accounting for more than one-quarter of its imports. However, Russian petroleum has nearly twice the carbon footprint of petroleum from Saudi Arabia. Similarly, Canadian oil extraction involves significant “off-gassing” making it amongst the world’s most carbon-intensive petroleum, with four times the carbon footprint of Saudi extraction processes. A CBAM is likely to be disadvantageous for Russian and Canadian oil producers, relative to producers in Saudi Arabia, when selling into the jurisdictions with a CBAM. It is hoped that such mechanisms also have the effect of prompting producers to invest in improved extraction methods in order to remain competitive.

Conclusion

The introduction of a CBAM faces considerable hurdles, not just in terms of devising an easily implementable system that operates consistently and fairly, but also in terms of potential backlash from trading partners of the EU. Russia, for example, has made it clear that it views the potential CBAM as an attempt to ‘use the climate agenda to create new barriers’9.

The efficacy of the CBAM would be improved by broader support for the policy and the EU has discussed the establishment of a transatlantic climate alliance with the US. Such ‘climate clubs’10, whereby a uniform tariff is imposed on all imports from countries that don’t have a carbon price, are argued to be more efficient and simpler to implement. In response, the US climate envoy John Kerry has urged the EU not to implement a CBAM before the November 2021 COP 26 UN Climate Change Conference, on the basis that global consensus on emissions targets is preferable11.

Regardless of whether the EU succeeds in imposing a CBAM, the resulting debate about the merits and implications of the EU’s climate agenda has alerted business and corporations globally to the need to prepare to operate in a low-carbon world in order to maintain competitiveness. Countries and industry that cannot adapt quickly by reducing their carbon footprint, risk losing market share either to EU-based competitors or those in other nations that are more carbon efficient.

Australia is in the category of nations that continues to decry measures like CBAMs12 and to resist the clamour to implement climate policy and prepare for the transition to a low-carbon economy. Accordingly, resource and other exports from Australia are likely to be vulnerable to a form of CBAM. Australian industry needs to determine if resistance is an appropriate and realistic response given that countries that are addressing climate change and where industry is already paying for carbon emissions appear intent on progressing their agenda and ensuring domestic industry is not disadvantaged by that agenda. The text of the 2020 Democratic Party Platform encapsulates the sentiment of active jurisdictions toward countries hoping to capitalise on the ‘last mover’ or ‘free rider’ advantage:

"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."13

The above sentiment is unlikely to be unique, although possibly more smoothly expressed, such as in a BCG paper advising EU businesses that a CBAM offers an opportunity to capitalise on the investment and experience accrued in operating for over 10 years in an environment requiring carbon efficiency: ‘Technologies, processes and strategies aimed at minimising greenhouse gas emissions that may have seemed like burdens previously may become strategic advantages.’14

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