EU Carbon Border Adjustment Could Facilitate a Global Climate Solution

The European Union’s Carbon Border Adjustment Mechanism (CBAM) has begun asking EU importers to report data on emissions of greenhouse gases by their foreign suppliers (direct, but also indirect, i.e., embodied in the electricity they use).  The first round of reports were due January 31 of this year.  European importers are required by July to have established access to the data on emissions embedded in their suppliers’ products. The full CBAM regime, with European penalties against imports from countries that don’t price carbon as the EU does, will go into operation on January 1st, 2026.   It will have a major impact on producers of carbon-intensive products among EU trading partners.

The new European regime may look like an unwanted source of international discord, another item on the world’s already overcrowded agenda of daunting international problems.  But closer consideration suggests that CBAM could in fact offer the most practical path toward achievement of the ambitious global climate goals of the Paris Agreement.

Thirty years ago, at the 1994 start of the UN Framework Convention on Climate Change, it was evident that:
(i) the road to getting countries to agree to, and comply with, limits on greenhouse gases (GHGs) would be long and difficult, in light of the substantial economic costs;
(ii) the way to minimize costs is market mechanisms like carbon pricing or tradable emission permits; but it was thought that Europe and most other countries would never agree to such mechanisms, because their public attitudes were less friendly to markets than American attitudes.
(iii) No plausible mechanism to incentivize or enforce carbon-cutting agreements across countries was on the table, it being understood that many countries would refuse the implied violation of their national sovereignty.  Considering the free-rider problem, international proclamations of ambitious climate goals would prove largely empty.

Thirty years later, the situation has changed.  Europe has successfully instituted a system of tradable emission permits, its Emissions Trading System (ETS), which dates from 2005.  (Meanwhile, it is the US where domestic politics have proven especially resistant to taxing carbon.)   One can now discern a possible path under which the carbon pricing regime might spread globally.  The key is the EU’s CBAM, designed to complement the burden of a carbon price on intra-EU trade, so as to forestall leakage to the rest of the world. (Leakage occurs when tight environmental regulation in one country induces the regulated industry to contract production there and to expand in countries with less stringent regulation.)   Countries that don’t price GHGs (expressed in tonnes of carbon equivalent) will in effect face tariffs on their exports to Europe in six carbon-intensive “pilot” sectors: aluminum, iron and steel, cement, fertilizer, hydrogen, and electricity, with other sectors to be added by 2030.

Technically, the importer has to buy import certificates (permits), the cost of which is equivalent to a fee or tariff. These fees will be substantial, equal to the contemporaneous market price of carbon within the EU’s ETS — 77 euros per tonne, as of May 23, 2024 (= $84), and expected to rise in the future[1]) — minus any carbon price the supplier is deemed to have paid in its own country.

CBAM will give Europe’s trading partners that export carbon-intensive products a powerful incentive to respond by implementing carbon pricing and CBAMs their own.  Joining the club will allow countries to collect revenue that is otherwise being collected by European governments.  That revenue can then be used to compensate domestic constituencies, or finance green development projects, or close pressing fiscal gaps. As more countries join, economic pressure on the holdouts to join will grow.

One might worry that such trade penalties are incompatible with existing international trading rules under the WTO; and there is indeed a danger that they could be implemented in a protectionist manner.  But the EU claims that its CBAM will be consistent with WTO rules and it may well turn out to be correct, given the EU’s non-discriminatory design.  There are precedents that use the WTO’s environmental exceptions, which are allowed under Articles XX so long as foreign firms are treated equally.  The trading rules have come a long way since 1991, when a US ban on Mexican tuna imports to help dolphins was torpedoed by the General Agreement on Tariffs and Trade.

Most foreign countries are only beginning to formulate their responses to the EU CBAM.  In December, the United Kingdom, which has its own domestic emissions market, decided to follow its continental neighbors and adopt a very similar CBAM.   Australia and Canada are  studying, and Turkey is developing, carbon border adjustment measures.

What about the US?  CBAM-type legislation has been proposed in the Senate. It could be a stepping stone in the right direction.  But, when not paired with the adoption of a domestic carbon price, it would be discriminatory.

American industry would like to think that it already pays a high implicit price for carbon, in that its average emissions are lower than those of some other major trading partners.  In the steel sector, for example, US firms mostly use electric arc furnaces, which generate much less carbon than the blast furnaces of many other exporting countries (notably, China, Russia, Ukraine, South Korea, India, and Canada).  But in the absence of an explicit national price on carbon, US carbon policy is unlikely to be judged as equivalent to Europe’s and its CBAM is unlikely to be consistent with international trade rules.

The CBAMs of the EU, UK, and any others who join, will have major impacts on the exports and GDP of Emerging Market and Developing Economies. Some (including China, India, and South Africa) have challenged the new European regime.  Nonetheless, it will put pressure on them to develop their own versions of carbon pricing.

CBAMs may turn out to be mere excuses for protection of industry from imports.  But if all goes well, countries that are on the receiving end of CBAM charges will, over time, however reluctantly, respond by adopting serious carbon pricing regimes of their own.  This, in turn, may offer the best hope of inducing in their economies the changes in technology, consumption and production that are needed to head off catastrophic climate change.

I would like to thank Kim Clausing, Rob Stavins, and Catherine Wolfram for useful comments.  An earlier version appeared at Project Syndicate and at the Korea Herald.   Comments can be posted at Econbrowser.

[1] The price of EU emission permits has been well above 50 euros a tonne ever since May 2021.  (“Tonne” signifies a metric ton.)