WHEN THE European Union established its cap-and-trade scheme for pricing carbon emissions in 2005 it faced a tricky design problem. Making polluting firms buy permits puts them at a disadvantage in global markets. Companies might respond to the scheme by moving their dirty activities offshore, causing “carbon leakage”. And if producers in places with lax environmental standards outcompeted European firms, global emissions would go up. The EU solved the problem by offering subsidies and free pollution permits to some dirty industries exposed to trade.
Those handouts, however, have always had a target on their back. On July 14th EU officials set out a plan to phase them out and replace them with a “carbon border-adjustment mechanism” (CBAM). Between 2025 and 2035, producers of aluminium, cement, fertilisers and steel will gradually lose their subsidies. But importers of these goods will have to buy a new category of pollution permit. How many they need will depend on the amount of carbon estimated to have been emitted during the production of the goods. The policy is in effect a tariff, intended to compensate for the fact that foreign firms may face no carbon price, or one that is lower than Europe’s.
The switch will please those who suspect that subsidies have blunted the impact of carbon prices. In theory free permits do not affect the incentive to reduce emissions, because at the margin the financial reward for doing so is the same: firms that get greener can sell their surplus entitlements. In practice the freebies have sapped ambition. Michael Grubb of University College London points out that companies know that if they sell their permits today, they might receive fewer handouts in future. Compared with the industries that have received support, the power sector, which has not, has decarbonised more quickly. Victoria Irving of Morgan Stanley, a bank, says that some subsidised polluters have made green investments, but “they have a long way to go”. Withdrawing the subsidies without a new scheme would bring back the danger of leakage.
Officials estimate that by 2030 the CBAM and the suite of environmental policies announced alongside it will reduce emissions in the affected sectors by 14%, compared with a scenario in which nothing changes. However, imports would be 12% lower, because tariffs depress trade. Though totemic, the scheme’s scope is relatively small. It would raise about €9bn in revenues in 2030 (although that figure may nearly double once the policy is fully phased in). The carbon embodied in trade flows is typically less than 10% of countries’ total emissions, according to the IMF, and the proposal covers only a handful of sectors. In 2019 the imports in question were worth only €29bn ($33bn, or 1.5% of total trade in goods for the bloc).
Tariffs do not have to be large, however, to provoke a response. Perhaps it will be a good one: with the CBAM in place, foreign countries might as well price carbon at home and keep the revenue for themselves (the EU will grant discounts for carbon taxes already paid). As the scope of the CBAM increases, so will other governments feel a greater pull towards pricing emissions. A more likely consequence, however, is a brawl over whether the policy is protectionist. Australia and India, both exporters to the EU, are already grumbling that the tariff could be discriminatory and regressive. In March America warned the EU that border levies should be a “last resort”. It has also said it is considering one of its own despite not pricing carbon itself, other than through an incomplete patchwork of state schemes in which prices are too low.
There is also a danger of unintended consequences. Foreign companies could redirect their greenest exports to Europe and send their dirtiest output elsewhere, rather than cutting overall emissions. This phenomenon, dubbed “resource shuffling”, has troubled California, which has a CBAM for its electricity market—the only existing comparable scheme. Firms could also adjust their supply chains to exploit the limited scope of the policy. A carmaker that would have to buy permits to import steel may prefer to buy a car chassis made with steel overseas, to which the CBAM would not apply.
The risk of such carbon leakage rises in tandem with the carbon price. A study published in January by DIW Berlin, a think-tank, found that a price of €75 per tonne would leave as much as 15% of the EU’s manufacturing vulnerable to being undercut in this way. (European carbon prices are hovering between €50-60 per tonne, and projected to increase.)
Steel yourself
These problems, however, will be reduced to the extent that carbon prices are adopted everywhere. The power of incentives means carbon-intensive production will always try to find its way to where emissions are cheap, but that does not mean it is futile to try to plug all the holes. The best argument for the CBAM is that it is a first step towards a world in which emissions cannot escape carbon prices. Were they sufficiently widespread, the CBAM would be rendered unnecessary.
Long before that happens, though, the EU must overcome opposition to the CBAM at home. One problem is that trade will be adjusted on the way in but not on the way out. Exporters, having lost their subsidies, will still find themselves competing in markets outside Europe’s borders against firms that can ignore the cost of carbon. (Around 8% of the EU’s cement production, and 18% of steel, is exported.) Already some lawmakers in the European Parliament, which must approve the proposal, are calling for border adjustment to exist alongside free permits, punishing foreigners while continuing to shield those at home. Bowing to them would turn a potentially useful policy for fighting climate change into naked protectionism—and an instructive example for other countries into a cautionary tale. ■
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A version of this article was published online on July 14th 2021
This article appeared in the Finance & economics section of the print edition under the headline "At the coalface of climate policy"
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