What are carbon border taxes and why should you care?

Global warming is the world’s greatest market failure, and the European Union is trying to come up with a market solution. This week, the European Parliament approved a proposal to create a carbon border tax, placing a tariff on goods imported into the EU based on their associated carbon emissions, also called embedded carbon emissions. The carbon border tax–called the Carbon Border Adjustment Mechanism (CBAM)–is the first rule of its kind and will have ramifications for the global trading market, from consumers to non-EU manufacturers trying to sell their products in the EU.

What is a carbon border tax, and why does the EU need one? To figure this out, we first take a look at another EU policy, the EU Emissions Trading System. In 2005, the ETS set up a cap and trade-style carbon trading market in the European Union, in which manufacturers in the EU need to buy a permit for every ton of CO2 they produce. The prices of these permits are set according to the EU’s carbon pricing market, which essentially pins a price on carbon emissions to account for the negative externalities associated with emitting carbon. The EU’s carbon price at the time of writing was around 85 Euros per ton of CO2.

The problem with this sort of cap and trade system is that foreign manufacturers operating in countries without climate regulations are able to emit carbon free of cost, drastically reducing their manufacturing costs compared to their counterparts subject to stricter regulations. This places EU manufacturers at a cost disadvantage, resulting in “carbon leakage,” or the losing out of sales to cheaper imports from countries with more lax climate rules. Similarly, the emissions trading system runs the risk of EU manufacturers simply relocating offshore, enabling them to avoid the cost of carbon in the manufacturing process. The EU currently provides some free carbon permits to its manufacturers to compensate for these forms of leakage, but it’s phasing out these free permits and trying to long-term correct for carbon leakage by carbon-taxing manufacturers from countries without climate regulation.

All this means that while carbon pricing is a familiar concept in climate regulation, CBAM is the first policy to apply carbon pricing to imported or traded goods, essentially turning the price into a tariff to level the playing field for EU manufacturers.

Why you should care

How does the carbon border tax impact you as a consumer? In their economic analysis paper, UChicago’s Sam Kortum and David Weisbach argue that in a carbon adjustment mechanism, a lot of the tax burden will be passed from producers to consumers, with unclear welfare implications. This is perhaps by design: the carbon border tax is designed as an economic lever not only to make manufacturers more competitive but also to change consumer behavior, making it more expensive to buy higher-carbon imported goods. If a carbon border tax were passed in the US, this would equate to reducing pressure on high-emitting industries like oil and gas–and transferring that pressure to consumers.

Furthermore, since a border adjustment mechanism would refund the price of carbon pricing from manufacturers exporting high-carbon goods to other countries, a border tax would “shift the tax off of foreign consumers and put it on [domestic] consumers,” writes Weisbach. BCG’s analysis of the rule estimates that the EU’s carbon border tax on steel and aluminum will collectively add €500 to the price of an average automobile. EU consumers should expect many carbon-intensive goods to cost disproportionately more after the CBAM is implemented fully over the next few years.

CBAM draws criticism from China, Russia, and the U.S.

The current carbon border tax applies to five major sectors: iron and steel, cement, fertilizers, aluminum, and some chemical manufacturing. Unsurprisingly, the biggest critics of CBAM right now are large exporters of these high-carbon products, notably China and Russia, where manufacturing relies heavily on coal. U.S. industry and policymakers are also concerned about the impact to American manufacturers, and the White House has (thus far unsuccessfully) been lobbying the EU for an exemption for American imports.

But CBAM is also drawing the ire of some major nonprofits concerned about the impact of such a trading tax on poorer countries that trade with the EU. The global poverty alleviation nonprofit Oxfam International raised concerns last week that the tariff punishes low-income, exporting countries while funneling money from these countries to the EU budget. “Forcing the poorest countries to pay this tariff is unfair,” asserted Chiara Putaturo, Oxfam’s EU Tax Expert. “This decision allows rich countries to pass the buck to those least responsible for the climate crisis.” In the chart above from Energy Monitor, those could be lower-income producing countries like India, Brazil, and smaller Asian countries.

John Kerry, the U.S. Special Envoy on Climate, has also criticized CBAM for its ability to shut down multilateral climate negotiations. “We don’t want to do something that pushes people away,” he warned, as the U.S. tries to talk climate with high-emitting countries like China.

But that was then, and this is now: carbon border taxes could make their way into the United States soon as well. This month, Congressional Democrats led by Rhode Island Democrat Sheldon Whitehouse proposed a carbon border tax in the US, the Clean Competition Bill. The measure also has support from GOP senators in a rare bipartisan show of support for a climate policy. But that’s likely because of the protectionist role of a carbon border tax in protecting US industry and climate experts worry that a US implementation of the CBAM will have all the protectionist pieces of the EU CBAM and none of the EU’s emissions-reducing mandates.

With global adoption, the carbon border tax could be a significant policy lever in helping the global economy reduce its carbon emissions: a recent report by the bipartisan Climate Leadership Council assessed that the adoption of a carbon border tax by all G7 countries could reduce global greenhouse gas emissions by 5.5%. But it’s clear that the impact of such a regulation on low-income manufacturing nations and on domestic consumers remains to be seen.

Further reading: CBAM is just one part of the EU’s suite of climate regulations. The European Union has been rolling out three major pieces of legislation that it hopes will reduce carbon emissions levels by 55% from 1990 levels by 2030–among the most ambitious climate goals in the world. The other key pieces of legislation in the EU’s climate package:

  • The Corporate Sustainability Reporting Directive, which will require ~49,000 companies to make climate-related disclosures on emissions, climate-related governance practices, risk management strategies, climate targets, and more.
  • The Sustainability Finance Disclosure Regulation, which classifies investment products by their level of commitment to sustainability goals (also discussed in my 2nd climate blog here)
  • The EU Taxonomy, an EU-wide classification system for sustainable activities.

My Climate Top 5:

#1: If the upcoming recession is slowing down VC investment, climate tech hasn’t gotten the memo (yet). Climate tech investment continued to soar in Q1 2022, and the latest fund to arise from the new wave of climate VC is Kiko Ventures, which raised a $450 million fund to invest in climate technologies. Uniquely among its VC peers, Kiko Ventures’ climate tech fund is an “evergreen” fund sponsored by a listed entity, and it has access to public capital markets as well as traditional VC investments.

#2: A couple weeks after German financial regulators went after DWS for greenwashing, the SEC revealed it’s investigating Goldman Sachs over allegations of greenwashing. In the SEC’s crosshairs are four mutual funds that Goldman has labeled as ESG investment funds, which regulators say may not be as ESG-friendly as Goldman claims. For instance, in 2020 Goldman renamed its (relatively small) $18M Blue Chip Fund the U.S. Equity ESG Fund, but the fund’s major holdings–including Microsoft, Apple, Bristol Myers Squibb, and JP Morgan–have remained unchanged.

#3: The EU passed sweeping climate disclosure regulation, the Corporate Sustainability Reporting Directive (CSRD), alongside its carbon border tax expansion this week. The CSRD, also described above in the Further Reading section, incorporates guidance from the nonprofit EFRAG on the details of ESG disclosures that companies need to make, and they include everything from environmental topics like climate, pollution, biodiversity, and marine resource use to social and governance areas like worker treatment, diversity, and anti-corruption policies within companies. Our team’s work in partnership with ERM’s SustainAbility Institute on breaking down the EFRAG / CSRD disclosure rules can be found here.

#4: Canada has begun the process of banning single-use plastics, passing the Single-Use Plastics Prohibition Regulations Act this week. The regulations, which will come into effect starting at the end of 2023, will ban the manufacture and sale of products like plastic cutlery, grocery bags, delivery containers, and straws. As someone who feels physical pain when I see people drinking out of Poland Spring water bottles on a daily basis (carry a Nalgene, people!), I see this as a huge step forward, even though it doesn’t seem to apply to single-use water bottles.

#5: Yellowstone National Park has begun a gradual reopening after being shut down by catastrophic floods that inflicted severe infrastructural damage near the park’s northern entrance in Montana (Yellowstone covers parts of Montana, Wyoming, and Idaho). A combination of glacier-melting warm weather conditions and a narrow band of tropical moisture called an “atmospheric river” resulted in flooding conditions that flooded campsites, washed out entire roads, and caused massive rock slides, forcing the evacuation of 10,000 visitors. Last week, the park began a phased reopening process, letting in cars with even- and odd-numbered license plates on alternating days. But it could take years to completely restore the two most damaged stretches of road in the park, some of which were completely washed out by the floods.

Acknowledgments: Shoutout to my friend and former colleague Madeleine Goldberg at Insight Partners for our discussions on carbon border adjustment mechanisms which inspired this iteration of the blog.

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