On the Way to Fit-for-55: The Carbon Border Adjustment Mechanism
14 May 2021 – Written by Lorenzo Faggiano
Summary
The European Commission will present a mammoth policy package containing 12 policy proposals needed to reach the emissions reduction targets enshrined in the recently approved Climate Law. The proposal of a carbon border adjustment mechanism, or CBAM, has been given particular attention given its ambition and complexity.
Currently, the risk of carbon leakage within the EU ETS is addressed through several measures, the most notable being free allocation. However, this measure has proven to be inefficient throughout the years, as several heavy-emitting industries have consistently been overallocated with CO2 permits.
The CBAM proposal comes as an alternative to the current carbon leakage framework. The proposal aims at making sure the price of products exported to the EU takes into account their carbon content, thus leveraging the competition field with European producers. However, several methodological and political challenges will need to be solved before the policy can reach wide implementation.
On 21 April, at the end of an exhausting round of negotiations, the European Council and European Parliament finally reached a deal on the Climate Law (Timmermans, 2021). The legislation represents a landmark achievement for Europe, as it legally binds the EU’s decarbonisation efforts to two major targets: a 55% reduction in CO2 emissions by 2030 compared to 1990 levels, and climate neutrality by 2050. Not everyone rejoiced, as several NGOs and environmental organisations criticised the insufficient ambition of the agreement (Greenpeace European Unit, 2021; Bloss, 2021). However, the Climate Law will nonetheless provide a solid regulatory guidance for future decarbonisation efforts within the EU.
It is now up to the European Commission to come up with suitable legislation to reach the two emissions reductions goals. In July 2021, it will present a mammoth policy package called “Fit-for-55”, containing 12 policy proposals or revisions to step up the current decarbonisation efforts within the continent and meet the standards set by the Paris Agreement.
Among the several policy options that will be presented, the most discussed proposal is the Carbon Border Adjustment Mechanism, or CBAM, a tool to allow European industry to compete on an equal footing with foreign firms. Indeed, the EU is home to the biggest carbon market in the world in terms of size and sectors covered, the EU Emissions Trading Scheme (EU ETS). The main conceptual foundation of the scheme is quite intuitive, and it was already discussed in a previous IDRN article (Biggins, 2021). Simply put, the EU ETS puts a price on emissions which is fully driven by the market. Installations covered by the scheme, which mainly includes power utilities, raw materials industries, and aviation, have to buy each year a number of emissions allowances (also called permits) that covers their level of CO2 emissions. This provides a clear price signal and incentives to decarbonise in order to incur fewer costs.
The current Emissions Trading System
While the logic of emission trading schemes is simple, its implementation is much more complex. Above all, since we live in a globalised economy, imposing excessive burdens on an industry carries the risk of pushing firms to relocate to countries where emissions are not priced, and environmental regulations are relaxed or non-existent. This would be counterproductive: not only does it lead to the loss of domestic jobs, but it also would result in a consequent increase in overall global emissions. This phenomenon, within climate policy, is known as carbon leakage. It is important to underline that there is no evidence of carbon leakage up do date (Verde, 2020). However, it is a reality that must always be taken into account. The possibility that industry will relocate abroad following impulsive legislation, with negative consequences for the environment, is an unfortunate but constant looming threat upon European lawmakers.
The EU currently tackles the risk of carbon leakage through several measures, the most notable being free allocation. The sectors deemed at risk of carbon leakage, such as iron, steel and aluminium, receive part, if not all, of their CO2 allowances for free. This mechanism reduces the incentive to relocate production abroad by lowering the cost that industry faces for its emissions. However, free allocation has long been rightfully criticised by several NGOs and environmental organisations both from a conceptual and operational viewpoint. First, providing industry with free allowances corresponds, for many, to institutionally subsidise emissions. Second, many sectors have historically been overallocated with free allowances in the past. For example, figure 1 shows that, until 2013, the number of free allowances was above real emissions for industrial installations. In 2018, the iron sector in Europe received 116% of their allocations for free (Healy et al., 2019). This not only eliminated any incentive to decarbonise, but effectively allocated extra-resources for high-emitting industries.
The proposal for a Carbon Border Adjustment Mechanism
The proposal for a carbon border adjustment mechanism (CBAM) stems from the inefficiencies of the current system, and it is often presented as an alternative measure to free allocation. The CBAM is a border measure, aimed at ensuring that the cost of foreign products imported to the EU reflects their carbon content. Under a CBAM, firms willing to export to the EU would have to buy CO2 allowances equal to the quantity of CO2 emitted during the production process in the respective foreign country. Ultimately, this would ensure that both European and foreign producers incur the same environmental costs per ton of CO2, thus re-establishing the conditions that allow for fair competition, incentivising decarbonisation and disincentivising carbon leakage.
The CBAM will ideally be implemented for the same sectors covered by the EU ETS, although most analysts believe that the European Commission will initially propose a pilot program limited to few sectors to test its reliability. It is worth pointing out that such a policy mechanism has never been tried before in the world, thus its success could carry important consequences for global decarbonisation efforts. However, several methodological challenges will need to be addressed in order for the CBAM proposal to be effective.
The first rests upon compliance with the World Trade Organisation (WTO). The European Commission has made clear, referring to the Fit-for-55 package, that it would only implement policies in compliance with international agreements. Several question marks have been raised regarding CBAM, given its explicitly discriminatory intentions and its potential to become a protectionist tool for EU industry. However, it is probable that such a policy, which carries a strong environmental motivation, could be defended of the basis of GATT art. XX, which lays out a number of specific instances in which WTO members may be exempted from GATT rules.
The second point to be solved rests upon downstream sectors. As initially mentioned, the EU ETS covers most raw materials industries. However, the price increase of raw materials due to carbon pricing is partly passed through to downstream sectors, which will face a higher price when buying such materials. Thus, an effective CBAM should also cover downstream industries: for example, the price of cars imported in Europe should take into account the CO2 content of their iron, steel and aluminium components. However, while technically feasible, this exercise would be extremely complex and administratively costly, potentially opening the door for many WTO challenges from foreign countries on how CO2 levels in manufactured products are measured.
The third challenge is, as just mentioned, complexity. Although logically sound, a CBAM would require sizeable bureaucratic efforts at EU borders. Thus, an effective proposal will be the one that carefully compromises between efficiency and fairness.
The fourth point lies on our relationship with international partners. Rules should be in place to determine which countries would face a CBAM when exporting to Europe and which countries would not. For example, a foreign producer who is already incurring in carbon pricing in its own country should be exempted from having to pay an extra fee when exporting to Europe and thus avoid a double environmental burden. Products from small developing countries should be rightfully exempted, in order to incentivise domestic industrial production. The question of how to spend funds raised through a CBAM is also extremely relevant. Some politicians have proposed to use such money for the EU’s own funds. This, however, is a politically unfeasible solution, and also unethical per se. Money raised through environmental regulations should always be aimed at improving environmental efforts in the countries where the goods themselves have been produced. Thus, any funds raised through a European border mechanism should be returned to producing countries as investments, grants or aid.
Finally, the question of exports. Indeed, while most of the discussion has focused on imports, few have proposed solutions that contemplate export compensations. Under a CBAM, European industries exporting abroad would still be facing higher production costs compared to foreign producers when trading in foreign countries. A potential solution would be to compensate the carbon costs at the border through export rebates, but this would almost certainly be struck down by the WTO as illegal subsidies to industry. Thus, the question of how to protect European exporters is still very much open.
The way forward
Overall, the CBAM has a sizeable potential and might play a major role in the EU’s decarbonisation efforts to come. It is a tool to protect European industry for carbon leakage, while also replacing the often-flawed mechanism of free allocation. It finally shifts the focus from domestic producers to the whole globe, reflecting the scale of the challenge that climate change is posing. A CBAM would leverage the soft power that comes from the size of the EU’s internal market to push foreign exporters to comply with its environmental standards. Moreover, several positive by-products would follow: foreign producers would have to publish data on industrial emissions to be able to sell their products in the EU. Such data could be used for research purposes, increase transparency, and even raise global consciousness about the environmental impact of certain industries and sectors. In Brussels, industrial associations have already started to voice their disapproval for the CBAM proposal, and are aggressively lobbying to maintain the status quo and free allowances. The road to implementation will not be smooth, as the current proposal raises some legitimate methodological concerns and will need vast political consensus. However, especially through pressure from citizens and the civil society on the need to step up European efforts on climate policy, it might end up delivering remarkable results.
References
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Recommended citation:
Faggiano, L. (2021) On the Way to Fit-for-55: The Carbon Border Adjustment Mechanism, IDRN, 14 May. Available at: https://idrn.eu/environment-and-climate-change/on-the-way-to-fit-for-55-the-carbon-border-adjustment-mechanism [Accessed dd/mm/yyyy].