Graphite and diamonds: take a single element – carbon – and put it together differently, and you get a very different result. The same could be said of carbon pricing. While the concept is widely accepted as a key part of the net zero push, the way these carbon pricing initiatives are put together can lead to very different administrative and financial results.

Earlier this year, the European Commission proposed the world’s first carbon tariffs on imported goods that are not subject to carbon equivalent prices: the Carbon Frontier Adjustment Mechanism (EU CBAM). You would be forgiven for thinking that this cannot be the first; as Angus pointed out almost a year ago, 64 carbon pricing initiatives are being implemented around the world. So what is really changing?

Isn’t there already a carbon tax?

One of these existing carbon pricing initiatives is the EU Emissions Trading Scheme (ETS). The ETS was introduced in 2005 and operates on a market-based ‘cap and trade’ principle: a cap is set on the number of ‘units’ of gas emissions allowed in the EU. For each unit that an affected business issues, it must surrender a permit.

The European Commission issues some permits free of charge. If this quota is not sufficient to cover a company’s emissions, it must buy more permits, either from the European Commission or from companies which have permits in reserve. Companies that can reduce their emissions at a cost below the price of the permit are thus encouraged to reduce their emissions and sell permits.

This incentive diminishes over time as more companies reduce their emissions, resulting in more permits in the market and lower permit prices. To counter this trend, the EU is reducing the number of permits available on the market, pushing up prices while increasing scarcity.

NIMBY: cross-border competition and carbon leakage

While carbon pricing is certainly gaining ground, implementation is far from global, covering only around 21.5% of global greenhouse gas emissions. Carbon prices also vary widely from jurisdiction to jurisdiction.

These differences in carbon pricing and the lack of policy coordination between jurisdictions can lead to ‘carbon leakage’ across geographic boundaries, where a country’s carbon pricing initiative reduces emissions in that country. while simultaneously increasing emissions elsewhere, with a net neutral or even net negative result on global emissions.

In practice, this occurs when foreign competitors are able to compete with domestic firms, or when it is less costly for domestic firms to restructure their operations (i.e. by importing more carbon-intensive products at lower cost. , either by outsourcing production processes to other countries where climate policies are more lax) than buying permits or investing in clean technologies.

The European Commission has sought to minimize these unwanted economic incentives and counter any disadvantage for EU producers by issuing free ETS allowances. However, while some industries – such as the electricity sector – have halved their emissions since the ETS was launched, in the manufacturing industry – which initially received 80% of its allowances for free – emissions have largely fallen. stagnated.

How does the EU CBAM approach this?

As part of the “Fit for 55” proposal – aimed at reducing the bloc’s emissions by 55% from 1990 levels by 2030 – the European Commission would gradually withdraw free allowances for aluminum and cement producers. , fertilizers and steel at a rate of 10% each year from from 2026 (with the phasing out of all free allowances by 2035).

Instead of free allowances, the Commission proposes to gradually introduce an import tariff calculated on the basis of the carbon content of each product. Importers would be required to apply for permission to import goods within the scope, report total goods imported and total integrated emissions, and submit enough pre-purchased CBAM certificates to cover those emissions. It is important to note that the proposal would not allow participants to trade CBAM certificates, unlike EU ETS quotas.

How is the UK reacting?

The EU ETS applied in the UK until the end of the Brexit transition period, with the UK launching its own ETS on January 1, 2021.

At the end of September, the House of Commons Environmental Audit Committee (the CAE) launched an investigation into the role CBAMs could play in achieving UK environmental goals and preventing carbon leakage, following recommendations it made in February. The UK Climate Change Committee has also recommended the introduction of a CBAM to take advantage of trade agreements to incentivize other jurisdictions to decarbonize, particularly in the context of trade in agricultural and industrial products. However, the Board of Trade called on the UK government to challenge so-called “green protectionism”, including refraining from recommending a CBAM.

While the EAC believes the UK government “appears to be in eavesdropping mode”, the government has yet to suggest what action it might take. Internally, policies to tackle carbon leakage are theoretically led by HMT, although other agencies such as BEIS, FCDO, DIT and DEFRA have interests that may diverge considerably from each other.

So what is the problem?

Obviously, reducing emissions and pushing towards net zero is a good thing. Why, then, have CBAM’s proposals been so controversial?

The answer, as always, is that these things are complicated and very charged politically and philosophically. As EU Green politicians criticize the proposals as being too slow and too narrow, a group of Republican senators have written to President Biden expressing “serious concerns” that the United States “should not allow. EU to define a climate and a trade norm that it has not helped to shape “. They report predictions that “non-OECD economies will account for over 100% of global growth in GHG emissions by 2050”.

On the flip side, critics (including Brazil, South Africa, India and China) argue that this imbalance means that the EU’s CBAM can simply penalize developing countries that do not have again the technological capacity to reduce emissions – in violation of the principle of “common but differentiated responsibilities and respective capacities” enshrined in international climate law.

National carbon pricing and border tariffs can also lead to a consumption gap, with potentially regressive social effects: if producers in “carbon-lax” jurisdictions have a competitive advantage, more sustainably manufactured products will need to demand. a higher price. . On the other hand, if the EU CBAM leads to a market-wide price increase for carbon-intensive products, the risk is that these will become a luxury available only to the most end consumers. well-off.

Critics of the CBAM may also have a real ability to put a spoke in the wheels. While the Commission has said the proposals are designed to comply with WTO non-discrimination rules, if challenges are raised the EU would likely have to rely on environmental exceptions under the General Agreement on tariffs and trade. That’s a high threshold to reach – and if not, it’s a return to diplomacy.

Even if the proposal is approved and implemented without resistance or retaliation, it remains to be seen how the EU CBAM would interact with policies elsewhere. In the United States, Democrats have hinted at an “import tax for polluters,” while a few carbon pricing policies have started to emerge at the state level. The Canadian government also intends to launch a consultation on carbon border adjustments. It also seems likely that the EU’s biggest trading partners, like Russia, Turkey and China, are at least considering doing the same. However, Tax Commissioner Paolo Gentiloni has suggested that only a “very limited number” of countries will have a system similar enough to that of the EU to qualify for an exemption – and the Director General of Taxation and the Union customs officer Gerassimos Thomas told the European Parliament’s Environment Committee that such exemptions are not legally permitted.

The scope of the EU CBAM is also not entirely clear. Even before the initial proposal was fully sketched out, there are already hints that the scheme could expand to cover additional sectors, such as refineries, polymer manufacturing and vehicle manufacturing, or indirect emissions from power generation, heating and cooling.

A silver lining?

As always, this kind of patchwork regime will inevitably create separate administrative and compliance costs for importers, not only for the carbon audit of their supply chains and the implementation of monitoring and reporting systems, but also for understand exactly how the different regimes interact.

Even then, businesses will face the ongoing cost of keeping abreast of legal and policy developments across their global footprint. As policies are implemented and their impact investigated, and as research and reflection on climate change progresses, carbon pricing initiatives are bound to be changed, updated and outright replaced. . To extend the analogy, other carbon allotropes are waiting to be discovered.

While CBAM won’t be implemented for several years, the mere act of offering it has opened up a whole new front for business confrontations. The perspective of CBAM raises many questions about its consistency with global trade rules. […] The EU’s CBAM would be the first climate-related trade restriction. This new proposed European restriction will not be the last, however.

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