The EU’s Carbon Border Adjustment Mechanism (CBAM) and Decarbonization
This article analyzes whether the European Union (EU) should continue to decarbonize considering the risk of weakening industry and the rest of the world’s inaction on decarbonization. Since 2005, the EU Commission has pushed industries to decarbonize through its Emission Trading System (ETS), a cap-and-trade mechanism through which member states allocated a fixed number of permits on the market. Market forces determine the price of each allowance, which is efficient because companies who value the right to pollute most are willing to pay a higher price to pollute. To avoid carbon leakage — when EU businesses transfer their production to other countries with laxer emissions policies — the member states have issued free allowances to energy intensive and globally competitive industries. As a result, although installations covered by the ETS reduced emissions by about 35 percent between 2005 and 2019, there is still room to improve.
The EU’s Carbon Border Adjustment Mechanism (CBAM), which was proposed in July 2021 and should come into effect by 2026, is the next appropriate step to substantially reduce carbon emissions, prevent carbon leakage, and protect domestic industry. The CBAM plans to tax carbon-heavy products imported to the EU — electricity, cement, fertilizer, iron, steel, and aluminum — while simultaneously phasing out free allowances for these sectors within the EU. In theory, this mechanism internalizes carbon emissions because it forces carbon-heavy domestic industries to innovate or lose out to foreign companies that would pay for their carbon emissions. The remainder of this article explains why the EU is justified in implementing the CBAM, refutes the arguments that the CBAM will be ineffective at combating carbon leakage and that it breaches international trade law leads, and suggests a mechanism through which the CBAM can help developing countries.
The EU is right to implement the CBAM because it creates more competition between carbon-intensive and carbon-free industries domestically and abroad, which will in the long run drive down carbon emissions. Historically speaking, most countries have lower import tariffs and non-tariff barriers for dirtier than clean industries, so carbon-heavy industries already have an advantage in internationally traded goods. Moreover, of the worldwide $634 billion in energy-sector subsidies in 2020, nearly 70 percent went to fossil fuels and only 20 percent to renewable energy sources. Combined with the ETS’s free allocation of allowances to EU carbon-intensive industries since 2005, it is fair to conclude that carbon-emitting companies have had an advantage over non-carbon emitting companies for decades. Thus, implementing the CBAM would only help correct what is an already unbalanced playing field and reduce the carbon footprint.
European steelmakers wrongfully claim that the CBAM will likely lead to carbon leakage. They point to different policy simulations, such as the Energy Modeling Forum’s computable general equilibrium models, that predict leakage rates for industrial countries between 5 and 30 percent, and other sector-specific situations that find leakage rates between 20 and 70 percent. However, there is little empirical evidence to back up these predictions: a thorough 2019 study, which used data from the Global Trade Analysis Project and the EU’s Transaction log to track import flows and bilateral trade flows, found that the EU’s more stringent emissions policy did not lead to carbon leakage from 2004 to 2011. A 2020 report by the Organization for Economic Cooperation and Development (OECD) also concluded that although carbon leakage poses a major threat in theory, the ETS has not significantly impacted foreign emissions. Thus, it is unfair to argue the CBAM will cause EU domestic industries to relocate.
Critics also wrongfully dismiss CBAM based on its supposed incompatibility with international law. They argue that even though the Commission insists the CBAM was “designed in compliance with WTO rules,” there is no way the EU can even implement it legally for three reasons. First, the CBAM discriminates amongst different WTO member countries based on their products’ carbon content, possibly violating the national treatment rule. Second, the CBAM might lead to higher charges on imported goods than the WTO-established customs duty ceiling. And third, even if the EU strictly adheres to its proposal to phase out free ETS emissions permits to domestic firms, domestic industries that have been historically granted free allowances will have an advantage over foreign firms. However, WTO member countries can legally breach these clauses to protect “human health.” Thus, given the link between carbon dioxide and respiratory diseases, cancer, development disorders, and mental and physical effects from more intense and more frequent floods, wildfires, and extreme temperature fluctuations, critics of the CBAM should not dismiss it based on its legality.
Despite the CBAM’s benefits, there are valid concerns that it can hurt developing countries. In the short term, poorer countries lack the incentive and financial means to undertake emission reductions. For example, it is estimated the CBAM will cost the Russian metal and fertilizer industries roughly 8 billion euros in exports and severely hurt Mozambique’s aluminum industry, which accounts for 7 percent of the country’s GDP. Brazil, India, and China have already expressed “grave concern” about the border tax’s impact on their development; furthermore, countries who rely on CBAM exports to the EU will likely implement their own protectionist trade measures in response, which will lead to less cooperation and increases the difficulty of curbing emissions worldwide. Thus, although it might not be politically viable, the EU should quell foreign concerns of protectionist trade policy by adding a “protection-neutral” clause to its CBAM for developing countries: in addition to stopping the allocation of free allowances, the EU should implement the CBAM with an equivalent reduction in other tariff barriers in cleaner sectors. A clause like this does not hurt foreign countries in the aggregate, and encourages countries that conduct trade with the EU to decarbonize or risk losing a significant market share.
The EU’s CBAM is a bold step in the right direction to seriously combat carbon emissions. Given the advantage that carbon intensive industries have held for decades, it is only fair to introduce more competition into the system. Additionally, it is not likely that the CBAM contradicts WTO law and will lead to carbon leakage. However, one recommendation to avoid disproportionately hurting developing countries is to accompany the hike in import tariffs against carbon-intensive industries with an equivalent drop in import tariffs against non-carbon intensive industries. All things considered, the EU should continue to decarbonize because its CBAM will not likely weaken domestic industry or hurt global competitiveness.
