Climate change and the adverse effects of the accumulation of plastics in the ocean are global externalities. As was the case with ozone-depleting chemicals, these processes threaten to change the way the atmosphere and the oceans function and the functioning of these ecosystems would be better if a way could be found to prevent climate-laggard nations from acting in ways that undermine the efforts of climate progressive nations to encourage progress in the elimination of these externalities. In common parlance, these undermining processes are defined as ‘leakage’.
In political circles, leakage is said to occur when an increase in an environmental standard causes a decline in domestic production and an increase in imports of a good or service from a dirtier source. Perversely, this can cause a net increase in global emissions and, hence, a worsening the extent of the externality. In the worst case, no progress is made.
When it comes to dealing with leakage, however, the World Trade Organisation (WTO) has found it difficult to find a solution (Cheng and Ishikawa 2021).
In an attempt to find a way to prevent such perverse outcomes, economists have been proposing that global externalities be internalised by requiring importers to pay a levy or charge in a manner that cancels out the competitive advantage that, otherwise, would flow to factories in the laggard country. After considerable reflection in expediting progress in the reduction of greenhouse gases, this is what members of the EU are now trying to do (Bellora and Fontagné 2022).
The EU’s proposed carbon border adjustment mechanism
The structure of the EU’s proposed carbon border adjustment mechanism (CBAM) is now in the final stages of development and the EU claims it will be WTO compatible.
In essence, EU importers will be required to pay a pollution levy or charge equivalent to the payment that would be required if the emissions associated with a product were emitted within Europe.
Conceptually and provided full account is taken of direct and indirect price signals, the result is a first-best economic solution. This is providing, of course, that transaction costs are minimal and product coverage is wide.
Rather than dealing with all sources of greenhouse gas, however, the EU has been proposing, initially, to apply its CBAM only to four heavy industries – iron and steel, cement, fertiliser, and aluminium production – and to electricity.
From a theoretical viewpoint rather than a political one, it is surprising that gas-industry emissions have been excluded and, also, that no attempt is being made to place any charge on imports of products that contain significant amounts of CBAM imports. Cars and many household goods, for example, contain a considerable amount of steel. Most food production involves the use of fertilisers. The result is an arrangement that could result in a significant number of perverse outcomes.
One of the reasons for the extent of the risk of perverse outcomes arises not from European ambitions to reduce emissions at a faster rate than others, which it could achieve, using it current emission trading system (ETS) but rather from its desire to phase out the provision of free allocations. That is, the EU aspires to make polluters pay and use this mechanism as a source of revenue.
Political support for the introduction of the EU’s proposed CBAM and phase-out of free allocations is strong. In June, 73% of the members of the European Parliament voted for implementation and only 19% voted against implementation (9% abstained). The EU Parliament is also recommending that the list of CBAM products be expanded to include organic chemicals, plastics, hydrogen, and ammonia. They also propose to extend coverage to include so-called ‘Scope 2’ emissions – those associated with the production of products used to produce heat and other forms of energy used in the manufacture of CBAM products.
Differing from the situation in many other countries, for many years the EU has been setting a limit on total greenhouse emissions from 66 sectors and using an emissions trading system that mixes the granting of free allocations to some sectors with a requirement for others to purchase emission certificates. The resultant mixed approach has proven to be effective but, as it moves forward, the EU is proposing to shift from its current mixed approach to one that requires all polluters to pay.
As summarised in Figure 1, the EU Parliament is proposing to start the free allocation phase out a year later but complete it a little earlier.
Figure 1 The European Parliament’s and the European Commission’s preferred schedule for the reduction in the proportion of free allowances given to heavy industry
Towards international agreement
To date, there has been little international debate on the nature of principles that should guide the development and use of border adjustment mechanisms. Surprisingly, while there is growing interest in the formation of clubs of nations willing to expedite progress, the only clear response from exporting nations, like my own country’s previous government, has been to announce that they intend to mount a WTO challenge and seek to overturn the EU’s proposed CBAM. The European Commission, however, is adamant that their proposed approach is WTO compatible.
In an attempt to make a constructive contribution to the development of the EU CBAM, my recent paper sets out a set of ten principles for the design and use of global environmental border adjustment mechanisms (Young 2022).
The role of exemptions in expediting progress
Pragmatically and in an attempt to keep arrangements simple, the first principle recommends that mechanism use be limited to global externalities that affect the functioning of the world’s atmosphere and/or the oceans and are underpinned by an international agreement that has been ratified by a majority of WTO members.
The second principle focuses on the EU’s stated policy goal, namely, its desire to enable it to expedite greenhouse gas emission reduction.
The EU’s “Fit for 55” package and when measured against a 1990 benchmark seeks to achieve a 55% reduction in greenhouse gas emissions by 2030. Consistent with WTO thinking, it is proposed no CBAM levy or payment should be required for imports from any country that has made an equivalent cumulative contribution to the elimination of the externality. That is, there should be open competition in the search for the most cost-effective way to reduce a global externality. No country should be allowed to require any country that is equally or more successful in the pursuit of the overall environmental goal to change its preferred strategy. Unless, of course, its approach involves the use of grants and subsidies that violate WTO requirements.
Amendment of the EU Council’s and the EU Parliament’s proposal to include such an ‘Equivalent Contribution’ clause, among other things, would do much to expedite international progress and, in particular, favour the import of products from climate-progressive countries because emissions associated with the production of such imports would not have to be assessed.
This suggested amendment would make it easier for the EU to expand product coverage and make it easier for interested nations to negotiate climate-progressive forms of free trade agreement.
I also recommend that the benchmark date for the measurement of progress be the date that the international agreement, allowing for the use of a ‘global environmental border adjustment mechanism’, was ratified by the implementing country so that there is no opportunity to choose a more favourable implementation. In the EU’s case, its agreement to implement the Paris Agreement was ratified on 5 October 2016.
Concerned about the risk of perverse outcomes, I also propose a requirement that all close input substitutes associated with the production of imported goods be included in the mechanism. As noted earlier, imported gas is an obvious example that the EU should consider including in its mechanism. Otherwise, the resultant CBAM-induced shift from electricity to gas production could result in an increase rather than a decrease in global greenhouse emissions.
Having set out the case for the inclusion of an equivalent contribution exemption, I then consider rules for the use of price-signalling mechanisms to reflect the cost of any externalities associated with the production and import of a good or service. Learning from the role that producer subsidy equivalents played in the development of freer agricultural trading arrangements (Cahill and Legg 1989-90), I suggest that the role of indirect pricing mechanisms as well as direct pricing one should be recognised. This would allow recognition of impact on production costs of, for example, Australia’s requirement that a proportion of all electricity sold is sourced from a “renewable” (zero-emission) source.
An equivalent pricing arrangement, rather than the EU’s narrower approach, could significantly reduce opportunities to oppose CBAM implementation in the WTO. It could also make it much easier for countries that have found it politically difficult to impose what is in effect the equivalent of a carbon tax on emissions.
The next issue that my paper addresses is associated with the use of the revenue from global environmental border adjustment mechanisms. At present, the EU Council is proposing that CBAM revenue be treated as the same manner as most other sources of revenue. That is, it be treated as a source of revenue that becomes part of a normal budgetary process. The EU Parliament, however, is proposing that the CBAM legislation require that all CBAM revenue be directed to arrangements that seek to increase the capacity of least developed countries to reduce greenhouse gas emissions.
Disagreeing with both of these approaches, I suggest that, as the primary aim of any border adjustment mechanism should be to expedite progress in the reduction of the relevant externality, climate progressive countries could be expected to require that CBAM revenue be used to reduce the extent of the externality. That is, the focus should be on the reduction of an externality and focus on international opportunities to offset emissions which has the added advantage of encouraging trade in certified emission permits and global competition in the search for the most effective cost emission reduction technologies. Least developed countries could be part of this arrangement but only if they make an actual contribution to emissions reduction and these contributions pass implementing country audit requirements.
Assistance for the least developed countries and alternative arrangements
The last two principles of my paper consider the case for the provision of objective forms of assistance to developing countries and, also, the question of whether or not implementing countries should be able to negotiate alternative arrangements. With regard to assistance for the least developed countries, I suggest that CBAM legislation should be objective and offer the same opportunity to all countries via the use of threshold or formula-based arrangements.
With regard to other, possibly, more controversial arrangements such as the idea that the US and the EU might agree to an arrangement involving the exchange of low-emission technologies, such arrangements should be allowed if and only if this does not result in exemptions not available to all other countries.
By moving unilaterally to set up its proposed CBAM, the EU has secured a significant first-mover advantage in the use of border adjustment mechanisms. In doing so, it deserves considerable praise and respect for expediting progress on an issue that WTO members have been struggling to resolve. In doing so, however, it is important that all countries consider the nature of the precedents being set, particularly in the EU. When analysed objectively, among other things, the current framework has features that discourage the emergence of climate-friendly trading arrangements.
In particular, the lack of equivalent contribution exemption arrangements means that the formation of a club of nations interested in encouraging the widespread use of border adjustment measures is less than otherwise would be the case. This suggested equivalent contribution exemption mechanism would enable coverage to be expanded to include most traded goods and services without impeding trade among climate progressive nations. Exporting nations would be free to choose between adoption of an emission reduction program that is as ambitious and effective as the EU or exposing its economy to both a levy on the emission content of exports and the costs of shipload by shipload and planeload by planeload assessment of the greenhouse gas emissions associated with exports to the EU.
Arguably, one of the most surprising dimensions of recent CBAM negotiations has been the lack of consideration of mechanism detail by like-minded climate-progressive and export-orientated countries. Especially, those that may find it politically impossible to bring in a climate tax or make polluters pay for emission permits. Such input is urgently needed. Modification of the current CBAM legislation to include an equivalent contribution provision and recognition of the role of indirect as well as direct pricing mechanisms, arguably, would do much to ensure international progress in the search for ways to reduce greenhouse gas emissions.
Bellora, C and L Fontagné (2022), “The EU in search of a WTO-compatible Carbon Border Adjustment Mechanism”, VoxEU.org, 26 March.
Cahill, C and W Legg (1989-90), “Estimation of agricultural assistance using producer and consumer subsidy equivalents: Theory and practice”, OECD Economic Studies 13, OECD, Paris.
Cheng, H and J Ishikawa (2021), “Carbon tax, cross-border carbon leakage, and border tax adjustments”, VoxEU.org, 16 September.
Tanabe, Y (2022), “Japan should lead the global effort to decarbonise: Reflections on the EU’s Carbon Border Adjustment Mechanism”, VoxEU.org, 23 January.
Young, M (2022) “Improving Border Adjustment Mechanisms”, Institute for International Trade Working Paper.