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EU carbon border tax makes economic sense
The European Union’s carbon border tax, while imperfect, is a justified measure that is unlikely to do significant damage to the global trading system. But it could stoke tension among friends – particularly between the EU and the US, though perhaps not in the way one might expect
Daniel Gros 11 Oct 2023

October has already brought a significant change to the global trading system: for the first time, a major trading power has placed an import tax on carbon. Since using the word “tax” (or “tariff”) would have been awkward, the European Union went with “carbon border adjustment mechanism” (CBAM). But a tax is what it is, and the economic rationale for it is straightforward.

The EU already levies an internal tax on carbon. Under the emissions trading system (ETS), power stations and large industrial installations pay for each ton of carbon dioxide (CO2) they emit. With emissions permits or “allowances” costing around €90 (US$95) per ton, the ETS should create a powerful incentive for firms to emit less within the EU’s borders.

But the ETS does not stop Europeans from buying their carbon-intensive products from other countries – in particular, those that lack domestic carbon taxes. Such substitutions – known as “carbon leakage” – mean that the ETS alone is not well-equipped to bring about a significant reduction in global CO2 emissions. The CBAM is supposed to fix that, by requiring importers to pay – at ETS allowance rates, adjusted to reflect carbon taxes paid in the country of origin – for the emissions embodied in the goods being imported.

Beyond neutralizing carbon leakage, the CBAM is supposed to protect EU industry. So far, EU industry has received most of its allowances for free; this explains why the ETS has yet to make much of a dent in European industrial emissions. To strengthen the system’s impact, the EU is now planning to phase out the free allowances over several years, starting in 2026. The CBAM is scheduled to come into effect over the same period.

For now, the CBAM is in its initial transitional phase, during which EU importers are not yet paying a carbon tax but are adjusting their policies and reporting the emissions embedded in the production of the goods they bring into the bloc. Beyond giving importers a chance to prepare, this phase gives European leaders space to soften political opposition from their major trading partners.

Of course, those partners can also use this time to challenge the CBAM at the World Trade Organization. But once the EU ends free allowances, it seems that the tax will be WTO-compatible. Moreover, it should not constitute a major impediment to trade. After all, it will apply only to a small and rather disparate selection of carbon-intensive products that are prone to carbon leakage: cement, iron and steel, aluminium, fertilizers, electricity and hydrogen. And, for the most part, these are not widely traded goods.

Electricity, for example, is traded only across short distances; it was included in the CBAM to ensure coverage of the highly carbon-intensive power produced in the Balkans. Cement and fertilizers are also imported mainly from close neighbours like Turkey and North Africa. Hydrogen is barely traded at all, at least for now.

All told, the CBAM covers only around 3% of all goods imported into the EU, with a total value of just €50 billion to €60 billion annually. While the EU’s trading partners will complain, especially about the inclusion of steel products, for most countries the CBAM will be a minor irritant at worst.

For some climate-change researchers, this is precisely the problem: the CBAM does not cover a wide enough range of products or a large enough share of emissions. But although the CBAM covers a small share of total imports, these products account for nearly half (47%) of the free emission allowances currently given to European industry.

The CBAM will thus be good for the public purse. It has been estimated that the imports covered by the CBAM embody direct emissions of about 80 million tons of CO2. At an ETS price of €90 per ton, this would imply annual revenues of about €7.2 billion, which would go directly into the EU budget and provide much-needed space for other expenditure, such as support for Ukraine.

The revenues collected from the CBAM would be equivalent to 15% of the value of the imports covered, making the mechanism similar in size to the various tariffs on steel and aluminium products imposed by former US President Donald Trump on the pretext of protecting national security. For the CBAM’s detractors, it is worth noting that these tariffs, which have since been superseded by other forms of managed trade, had only limited success in protecting the US steel industry.

The EU’s carbon border tax, while imperfect, makes economic sense, and is unlikely to do significant damage to the global trading system. On the contrary, it might encourage other countries – possibly even China – to introduce carbon pricing, so that their national governments, instead of the EU, can collect the revenues. But that does not mean that the CBAM poses no risks. Notably, it could stoke tension among friends – particularly between the EU and the United States, though perhaps not in the way one might expect.

The US has opted against a carbon tax on industry, instead providing incentives for carbon capture and storage (CCS) under the Inflation Reduction Act. The benefits US firms receive for CCS – US$85 per ton of CO2 permanently stored – is not far off the current ETS price. This implies that US steel producers could use the CCS subsidy to produce low-carbon steel more cheaply than their EU competitors, which would face the same incentive to decarbonize, but would have to bear the cost themselves. This would draw investment towards the US, and leave the EU steel industry complaining about unfair competition.

So, it is not the EU’s CBAM, but US policy that threatens to generate trade tensions among allies. This is just one of the unintended consequences of America’s belated embrace of climate policy without a carbon tax.

Daniel Gros is the director of the Institute for European Policy-Making at Bocconi University in Milan, Italy.

Copyright: Project Syndicate

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