The Future of Carbon Pricing in the Global Economy
On October 1, 2023, the European Union launched the Carbon Border Adjustment Mechanism (CBAM) policy. The CBAM is a complementary program to the EU’s Emissions Trading System (ETS), a cap and trade approach that deters firms from emitting greenhouse gas emissions within the EU. The policy puts in place a tariff on goods with the highest risk of carbon leakage and will later expand the scope of the policy to include all imports. After the EU’s implementation of the landmark CBAM policy, other countries must act swiftly to enact similar policies to mitigate climate change.
Emissions Trading System
The Emissions Trading System operates in all European Union countries, as well as closely associated countries such as Iceland, Liechtenstein, and Norway. The purpose of the ETS is to decrease the amount of emissions in the European Union (EU) every year. The ETS requires polluters to pay for certain greenhouse gas emissions above an annual limit, which decreases emissions and generates revenue to finance the green transition. Since 2013, the EU ETS has generated over €152 billion in revenue — this money is used to support energy efficiency improvements, renewable energy investments, and the EU ETS funds for energy transition and low-carbon innovation (European Commission 2023a). The ETS is currently in phase IV, which spans from 2021 to 2030. The three goals of phase IV are to improve energy efficiency by at least 27%, increase the share of renewable energy to 27%, and to decrease greenhouse gas emissions by at least 40% compared to 1990 levels (European Commission 2021).
The ETS does not tax all production, as it only covers sectors and gasses where emissions can be easily measured and verified with a high level of accuracy. Around 40% of total EU emissions are taxed by the ETS (European Commission 2023a). The current ETS includes greenhouse gas emissions from carbon dioxide, along with nitrous oxide and perfluorocarbon emissions from production of specific goods. These greenhouse gas emissions are measured and evaluated against the ETS in the energy sector, the manufacturing industry, and aircraft operations flying within the EU and arriving in the United Kingdom and Switzerland (European Commission 2023b).
The ETS utilizes a cap and trade system, which is a market based approach to emissions reduction. Polluters receive a yearly European Union Allowance (EUA) for carbon dioxide equivalent emissions. Firms can purchase additional allowances on the EU carbon market, or trade allowances if needed (Appunn 2019). In theory, a firm trades emissions allowances until it reaches a quantity of permits such that its marginal cost of emissions reduction is equal to the marginal cost of emissions reduction of the other firms in the market. The cap and trade system is a cost-effective environmental policy, as it leads to an outcome that has the lowest possible cost. The EU reduces the number of emissions allowances in the market at the beginning of every calendar year. The annual emissions reduction percentage is set at 2.2% for phase IV, to align with the goal of reducing greenhouse gas emissions decreasing greenhouse gas emissions by at least 40% by 2030 compared to 1990 levels (Appunn 2019). If firms do not submit enough emissions allowances to correspond to its annual emissions, they receive a penalty of €100 per ton of carbon dioxide emissions (or nitrous oxide and perfluorocarbon equivalent) not covered by allowances (European Commission 2023c).
Carbon Border Adjustment Mechanism
The Carbon Border Adjustment Mechanism is an import tax that equalizes the price of carbon in the EU for domestic goods set by the Emissions Trading System and goods imported by firms outside of the EU. The purpose of the CBAM is to ensure that the EU’s climate objectives are not undermined by carbon leakage. The CBAM is expected to generate more than $9 billion in revenues annually by 2030, which will go towards the EU’s general budget (Belletti, Han, and Pérez 2023). The CBAM functions slightly differently than the ETS. The CBAM is based on a certificate system, rather than cap and trade. The certificates are sold on a common central platform, at a price based on the weekly average auction price of EU ETS allowances (European Commission 2021).
In the current phase-in period, spanning from October 1, 2023 to December 31, 2023, the CBAM puts a tariff on the goods most at risk for carbon leakage. Carbon leakage occurs when firms transfer polluting production to other countries with lower carbon pricing, or when EU products are replaced by more carbon-intensive imports. The current goods in the scope of the CBAM policy include iron, steel, aluminum, cement, fertilizers, hydrogen, and electricity imported into the EU (Rorke, Porterfield, and Hoenig 2023). By 2030, all goods will be subject to the CBAM policy.
The phase-in period is designed to be a learning period for all stakeholders involved. For authorities, it is a period of data collection to understand what regulations are realistic, and to make informed policy decisions for the definitive period which begins in 2025. In the phase-in period, firms that import goods into the EU must submit a quarterly report to the CBAM transitional registry, which indicates the quantity of goods imported, the embedded and direct emissions, and carbon price in the country of origin (Rorke, Porterfield, and Hoenig 2023).
The permanent system will begin January 1, 2026, which is when the financial adjustments for importers begin. During the permanent system, firms will submit an annual report on May 31 to declare the number of imported goods and embedded emissions from the previous year (Rorke, Porterfield, and Hoenig 2023). The CBAM will only apply to the proportion of emissions above the ETS free allocation level. When the permanent system moves into full effect, EU producers will lose their free emissions allowances, until domestic and imports pay a full carbon price on their emissions (Belletti, Han, and Pérez 2023). Carbon adjustment paid outside of the EU will be deducted from the total adjustment to avoid a double carbon price charge. The cost of carbon will be significant for producers. For most of 2023, the EU ETS price traded above $100 per ton of carbon dioxide for most of 2023, which is around four times the global average cost of carbon (Belletti, Han, and Pérez 2023).
Economic Implications
The European Union’s Carbon Border Adjustment Mechanism Policy is the most advanced cross-border carbon pricing scheme by far. Currently, 49 countries have carbon pricing schemes, and 23 are considering them (“How Carbon Prices Are Taking over the World” 2023). Researchers have considered the potential implications of cross-border carbon pricing policies.
When the CBAM is fully implemented, commodity and product prices will rise due to the cost of the carbon import tax (Belletti, Han, and Pérez 2023). The CBAM will incentivize investments in carbon reducing technology, as new producers have an opportunity to collect revenue from higher margins in the EU. Additionally, the CBAM incentivizes EU importers to pass domestic carbon pricing policies. If countries importing goods into the EU pass carbon pricing policies, they can collect carbon pricing revenue for their own, rather than the EU taking it.
Economists Kimberly A. Clausing and Catherine Wolfram anticipate counterproductive effects, due to the CBAM measuring carbon based on embedded emissions, rather than a more aggregated measure (Clausing and Wolfram 2023). The researchers propose that a “reshuffling” will occur. Non-carbon intensive products will be imported into the EU, while carbon intensive products will be imported into countries with no carbon pricing at a lower price, increasing demand for these products in countries with no carbon pricing (Clausing and Wolfram 2023). As a result, the impact in decreasing emissions from a global scale will be small. To avoid reshuffling effects, other countries must follow the lead of the EU, and institute carbon pricing policies.
The combination of the CBAM and the removal of free ETS allowances for domestic producers is expected to increase the price of steel, a carbon-intensive commodity, within the EU. Additionally, domestic producers and importers will face pressure to invest in high-cost energy efficient production practices. The CBAM creates an opportunity for firms investing in low-carbon technologies to take advantage of the EU imports market, as carbon-intensive importers diverge away into other countries. The UK and other countries with high domestic carbon prices are not affected by the CBAM. India, China, South Korea, and Vietnam are expected to engage in reshuffling, by importing steel to other countries, or using it domestically. The US may increase exports to the EU, as the CBAM has a low impact on low emissions goods. It is estimated that the CBAM fees could increase the cost of importing steel to the EU by 56% for India and about 49% for China in 2034 (Belletti, Han, and Pérez 2023).
It is important to consider the potential CBAM implications for the EU’s smaller trade partners. Many developing countries are at risk due to their high dependence on exports of CBAM products to the EU. The main determinants of exposure include the share of exports to the EU, the portion of exports covered by the CBAM, and the carbon intensity of the economy. Additionally, if the taxed sector is an important source of employment, it could lead to unemployment and a decrease in wages. Of these determinants, the most vulnerable countries are either developing nations in EU neighboring countries, Least Developed Countries (LDCs), and Low Income Countries (LICs). Bosnia and Herzegovina, Mozambique, Serbia, Ukraine, and Zimbabwe, are countries listed as most vulnerable in almost every category (Ülgen 2023).
To mitigate the effects of the CBAM in smaller countries, researchers have proposed three potential solutions. First, countries can institute domestic carbon pricing and completely exempt exports from the CBAM tax if their carbon price level is equal to the CBAM price level. Collecting support for carbon prices may be more difficult in developing countries because voters will bear a larger marginal cost as a fraction of their income, compared to individuals from developed countries (Ülgen 2023). Secondly, the European Union can exempt some developing countries from the CBAM tax. Exempting LICs and LDCs from the CBAM policy would improve the welfare of the countries, but it will increase carbon leakage and be contradictory to the objective of the CBAM. Third, the European Union can redistribute the CBAM revenue to trade partners. Research conducted by Sigit Perdana and Marc Vielle indicates that without support measures, the CBAM policy may lead to welfare loss of 0.9% for LDCs, and rising up to 1.6% for African countries (Perdana and Vielle 2022). CBAM revenue allocation can finance clean investment in production, subsidize renewable energy, and promote energy efficiency measures in residential energy consumption (Ülgen 2023).
The European Union, always at the vanguard of climate policy and trade strategy, is leading the way with its innovative CBAM and ETS policies. These groundbreaking strategies are not only significant in their own right, but also lay down an imperative precedent for other nations to emulate in the global fight to reduce carbon emissions. Undeniably, the CBAM, as a multi-faceted and complex policy, has wide-ranging implications for international trade that need careful consideration. It is both an opportunity and a challenge for the European Union to consistently evaluate and make necessary modifications to the CBAM during subsequent phases of its implementation. The notion is to not only adjust where necessary, but also to showcase the potency and effectiveness of a well-orchestrated carbon pricing scheme to the global stage, encouraging other nations to join the quest towards decarbonization.
References
Appunn, Kerstine. 2019. “Understanding the European Union’s Emissions Trading System.” Clean Energy Wire. January 9, 2019. https://www.cleanenergywire.org/factsheets/understanding-european-unions-emissions-trading-system.
Belletti, Elena , Nuomin Han, and Iván Pérez. 2023. “Playing by New Rules: How the CBAM Will Change the World.” Www.woodmac.com. September 21, 2023. https://www.woodmac.com/horizons/how-the-cbam-will-change-the-world/.
Clausing, Kimberly A., and Catherine Wolfram. 2023. “Carbon Border Adjustments, Climate Clubs, and Subsidy Races When Climate Policies Vary.” National Bureau of Economic Research. June 1, 2023. https://doi.org/10.3386/w31310.
European Commission. 2021. “Carbon Border Adjustment Mechanism: Questions and Answers.” European Commission. July 14, 2021. https://ec.europa.eu/commission/presscorner/detail/en/qanda_21_3661.
European Commission. 2023a. “What Is the EU ETS?” Climate.ec.europa.eu. 2023. https://climate.ec.europa.eu/eu-action/eu-emissions-trading-system-eu-ets/what-eu-ets_en
European Commission. 2023b. “Scope of the EU Emissions Trading System.” Climate.ec.europa.eu. 2023. https://climate.ec.europa.eu/eu-action/eu-emissions-trading-system-eu-ets/scope-eu-emissions-trading-system_en.
European Commission. 2023c. “Monitoring, Reporting and Verification of EU ETS Emissions.” Climate.ec.europa.eu. 2023. https://climate.ec.europa.eu/eu-action/eu-emissions-trading-system-eu-ets/monitoring-reporting-and-verification-eu-ets-emissions_en.
“How Carbon Prices Are Taking over the World.” 2023. The Economist. October 1, 2023. https://www.economist.com/finance-and-economics/2023/10/01/how-carbon-prices-are-taking-over-the-world.
Perdana, Sigit, and Marc Vielle. 2022. “Making the EU Carbon Border Adjustment Mechanism Acceptable and Climate Friendly for Least Developed Countries.” Energy Policy 170 (November): 113245. https://doi.org/10.1016/j.enpol.2022.113245.
Rorke, Catrina, Matthew Porterfield, and Daniel Hoenig. 2023. “Assessing the EU CBAM: Reporting Rules for the World’s First Carbon Import Fee.” https://clcouncil.org/reports/CBAM_White_Paper.pdf.
Ülgen, Sinan. 2023. “A Political Economy Perspective on the EU’s Carbon Border Tax.” Carnegie Europe. May 9, 2023. https://carnegieeurope.eu/2023/05/09/political-economy-perspective-on-eu-s-carbon-border-tax-pub-89706.