The EU’s Carbon Border Adjustment Mechanism and the interplay of climate and trade policy

The EU’s Carbon Border Adjustment Mechanism and the interplay of climate and trade policy

The European Union’s Green Deal aims to ensure that the EU is carbon neutral by 2050. It contains an ambitious mix of policies. One such policy is the Carbon Border Adjustment (CBAM), which will impose a levy on certain carbon-intensive imports into the bloc.

The measure has attracted a lot of attention and generated a considerable amount of discussion both within the EU and internationally. This is to be expected. The introduction of a new tax on trade, especially of a kind not seen before, will have impacts that are both wide-ranging, and ones that are not always obvious at first sight. Recent modelling undertaken by Frontier helps us to step through some of these issues. 

The CBAM entered its transitional phase at the start of October. The scheme, which is due to start in full in 2026, marks a significant development in both climate and trade policy. The UK is contemplating a similar measure. 

The purpose of the CBAM is ostensibly to correct “carbon leakage”. This is the shifting of production from countries with more stringent Green House Gas (GHG) reduction commitments to those with less demanding green standards. If relocation fails to lower global emissions while adding to the economic burden on countries that are aiming high, then the outcome is economically inefficient with little or no environmental benefit. 

In practice, what the CBAM does is to correct for differences in actual emissions pricing between countries. The distinction is subtle but important. It is possible to pursue GHG reduction targets without a market-based mechanism which either prices emissions or taxes them directly. Non-market alternatives include regulation, moral suasion and subsidies for green investment. Indeed, such approaches are necessary to address the market failures associated with decarbonisation and will be required in addition to an emissions price. But many jurisdictions may prefer non-market methods as alternatives to emissions pricing.  

In theory, it would be possible to compute shadow emissions prices for all countries based on their abatement targets (which gives their demand for abatement) and the costs of their abatement opportunities (which gives their supply curve for abatement). In practice, though, this would be a complex undertaking. The underlying modelling requires a range of assumptions around which there is unlikely to be consensus. A formal emissions price is a more visible reference point.  

But perhaps a more fundamental issue is that emissions prices impose a particular structure of costs on certain emissions-intensive sectors that are also exposed to trade, such as iron and steel, cement, fertilisers and aluminium. The potential loss of competitiveness of these sectors worries the EU, in part because they are deemed to be of strategic importance. At the same time, Brussels is keen to retain emissions pricing, extending the principles of its existing Emissions Trading System (ETS), and not rely solely on non-market mechanisms. On the whole, these are less efficient and incur greater economic costs. The EU worries that its commitment to a more efficient form of reducing emissions may be undermined by countries that are unable or unwilling to tax carbon, usually for political reasons. 

The level of the CBAM is determined by the emissions, both direct and indirect, embodied in the products in question and the prevailing price on emissions under the ETS. For any product, we can estimate an ad valorem duty by multiplying the emissions price by the quantity of emissions and dividing by the value of imports. Seen this way, the CBAM acts in the same way as a tariff on imports. But unlike standard tariffs, it will fluctuate depending on the prevailing ETS price and will vary by trading partner depending on the emissions intensity of their production. It will also depend a lot on the breadth of the CBAM’s product coverage. 

What might be an indicative range of ad valorem rates generated by the CBAM? We consider scenarios in which the EU emissions price is around $90, which is broadly representative of its value in 2023, and another in which it is around $140 (respectively “low” and “high”). We also allow for a narrow product scope, reflecting the current CBAM configuration, and a more extensive reach (respectively “basic” and “wide”). This gives us four different scenarios: 1 - low/basic; 2 - low/wide; 3- high/basic; and 4 – high/wide.  The chart below reports the dispersion of CBAM rates, relative to ad valorem tariff rates currently in place (the “baseline”). 

The dispersion is very broad, reflecting the differences between the emissions prices of the EU and its trading partners, the structure of trade with the EU and the embodied emissions.  

What are the overall economic impacts? As is the case with standard tariffs, the main mechanism through which the CBAM plays out is via changes to the terms of trade and effects on relative prices. The two move in opposite directions. The CBAM improves the EU’s terms of trade, which in turn has a favourable, if limited, effect on its economic growth. At the same time, the CBAM raises the price of goods like cement and iron and steel that are primarily inputs into investment. This increases the cost of capital, which in turn reduces the capital stock, lowering economic growth. Which of these two effects prevails depends largely on modelling sensitivities. In our modelling, the negatives tend to prevail in the longer run. But for the EU they are relatively mild: we estimate that cumulative losses out to 2030 would be just 0.16% of GDP in real terms.  

What is clear, though, is that the CBAM reduces the EU’s exports outside the bloc. Total exports of goods and services in any one year are around 1.5% lower than they would have been.  As the CBAM covers a subset of products, it leads to a reallocation of resources to these sectors. It increases prices within the EU, making internal trade more attractive than external trade. The real exchange rate appreciation associated with improved terms of trade dampens exports generally. We thus have the paradoxical result that a measure enacted to safeguard the competitiveness of specific sectors has a negative impact on the EU’s external competitiveness.  

This outcome is largely in line with what we’d expect with standard tariffs: a tax on imports acts as a tax on exports. The implication is that while the CBAM may shelter some sectors from competitiveness shocks following the introduction of emissions pricing, it creates ripple effects that harm other parts of the economy, which in turn may require further measures. 

Like any tariff, the CBAM will also have consequences on the EU’s trade partners. For China, which is one of the main targets of the CBAM, effects are actually relatively muted – as with the EU, they could vary from mildly negative to mildly positive. China faces high ad valorem CBAM duty rates which leads to a substantial fall in its exports of CBAM products. However, the real exchange rate depreciation caused by this fall boosts the exports of non-CBAM products, which attenuates overall impacts. The main negative impacts fall on Sub-Saharan Africa. Ad valorem rates on their exports are high, and consequently terms of trade effects are also strong. 

One question that comes to mind is what the EU could do with the revenue it will raise from CBAM. The European Commissions estimates that by 2030, this will come to around 10 billion Euros. Given the adverse effects that the CBAM is likely to have on non-CBAM; sectors, one use would be to finance measures (e.g. cutting other taxes) that could support these sectors. This is different to proposals regarding the “export-leg” of the CBAM i.e. rebating ETS charges for CBAM sectors when they export. Other measures include more general ones  that support a low carbon transition, such as support to innovation. There have also been some claims from poorer counties that CBAM revenues should be used to offset some of the costs imposed on them. However, given the adverse effects generated by the CBAM itself on the EU’s own competitiveness and on domestic prices , it is likely that CBAM revenues will be deployed closer to home.   

In the final analysis, the CBAM should be seen as primarily an instrument of political economy. It is designed to meet some of the pressure that arise from implementing ambitious emissions reduction objectives and ambitious emissions pricing, in world where commitments to both vary widely. The CBAM is at heart a “second-best" policy response (the optimum being that there be a global carbon price). Like all second best responses, it generates various costs, both on trade partners and the EU itself. Assuming that it is in everyone’s interests for the EU to maintain a high level of ambition for its emissions reduction targets, and that measures such as the CBAM are needed maintain political support for such targets, the question then is what other measures are needed to manage some of the broader costs created by CBAM. 

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