How Carbon Border Adjustments Might Drive Global Climate Policy Momentum

How Carbon Border Adjustments Might Drive Global Climate Policy Momentum

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Abstract

1. Introduction

The world has a powerful new climate policy tool - the carbon border adjustment mechanism (CBAM)-but its most impactful aspect is also its most overlooked. Climate change is the world's largest global collective action problem. But without coordination, countries may free ride on each other's efforts since the costs of policy action are borne at home, while the benefits are shared worldwide. Before CBAM, global climate efforts focused on voluntary commitments, which invite free riding. The CBAM encourages coordination, in part by offering an important mechanism for overcoming the free-rider problem.

The CBAM is a new policy device, first introduced into law in the European Union in October 2023. Beginning in 2026, the CBAM will impose a levy on select imported non-EU industrial goods that adjusts for the differences between the EU Emission Trading System (EU ETS) carbon price and the carbon price paid in the producing countries. The United Kingdom has followed suit with a CBAM that is scheduled to be implemented in 2027. Governments around the world are trying to understand how a CBAM will impact their exports and what policy responses they should take before 2026 to mitigate potential negative effects.

While much of the discussion of CBAM focuses on its ability to prevent production and the associated emissions from migrating to countries that do not price carbon (a phenomenon called "leakage") See Elkerbout (2024). , the potential policy spillovers are an underappreciated component of the discussion. See Clausing and Wolfram (2023). Most directly, because the EU and UK CBAMs credit imports for carbon prices already paid, they provide incentives for other governments to impose carbon prices. They can also encourage governments to take other steps to help their industry reduce emissions, including subsidies or direct investment in decarbonization. These considerations are spurring discussions about linkages across the multiple components of countries' climate policies, including measurement, innovation, and industrial policies.

This policy brief outlines the possible policy spillovers from CBAMs and offers evidence of their impacts to date. Our findings suggest that the EU CBAM has had important spillover impacts, encouraging governments around the world to consider carbon pricing and instigating conversations about broader coordinated climate policy action. We will discuss examples of policy spillovers, including countries that have expanded existing emissions trading schemes (ETSs), others that have introduced new carbon taxes or ETSs, and several that have considered their own CBAM-like policies.

2. How the EU and UK CBAMs will work in practice

The EU's CBAM is in its implementation phase, following the law's adoption in 2023. The design of the EU CBAM can be best understood with reference to the domestic climate policy that it complements-the EU emissions trading system (ETS). The EU ETS is a cap-and-trade system in place since 2005, which covers the electric power and industrial-sector greenhouse gas (GHG) emissions in the European Union. Many energy-intensive industries produce internationally traded commodities. The combination of energy (and for now, GHG intensity) with trade intensity creates a risk of carbon leakage: if foreign competitors do not face similar carbon costs to producers in Europe, imports may displace domestic production and/or production may move offshore. Concerns about industrial competitiveness have historically been addressed by giving producers free ETS allowances, but this approach has limitations. With a rapidly declining cap, only a limited number of allowances are available. Further, free allocation dampens the carbon price signal and reduces auction revenues. Such considerations prompted EU legislators to move to the CBAM as an alternative. The CBAM design can thus be seen as an extension of the EU ETS to imported industrial goods in ETS sectors.

At its inception, the CBAM will apply only to some of the largest industrial EU ETS emitters, such as steel and cement production. Due to the complexities of, and lack of experience with, implementing a CBAM, many industrial sectors are not yet included in the CBAM scope. However, the included sectors account for a majority of EU industrial emissions. An analysis of the proposed CBAM in 2021 showed that four industries account for about 55 percent of EU industrial carbon equivalent emissions, which themselves are about 25 percent of EU carbon equivalent emissions. See Figure 7 of European Commission 2021.

Practically, importers of CBAM-covered goods are asked to submit data on the carbon embedded in the goods (based on actual data, although default values can be used as a fallback). For every ton of embedded emissions, a CBAM certificate needs to be purchased and surrendered (once a year). The CBAM certificates act as the equivalent to an EU ETS allowance. They are sold on a continuous basis, tracking the recent EU ETS price. As with ETS allowances, importers can strategically buy certificates based on market circumstances.

The charges under the CBAM can be adjusted for two reasons (European Commission 2023). First, free allowances are phased out only gradually, between 2026 (when the implementation phase ends and charges begin) and 2033. To the extent that free allocation continues, the CBAM charges will be reduced commensurately so that EU producers do not receive a preference relative to imports. CBAM charges will also be reduced when "a carbon price has already been paid in the country of origin."

The crediting provision has the potential to create powerful policy spillover effects, as jurisdictions have an incentive to apply carbon pricing to mitigate CBAM charges. Questions remain about how this provision will be applied in practice since the European Commission still needs to develop guidance. While the principle of this so-called Article 9 provision is straightforward-to avoid charging the same GHG emissions twice-several important implementation details are not yet finalized. There are many ways to design carbon pricing policies. For example, the European Union will not credit free allocation methods, such as full output-based allocation. But what if the carbon price only applies to exports-or even only to EU-bound exports? Also, should energy taxes be credited based on the carbon content of taxed fuels?

By the time the CBAM charges start binding in 2026, the answers to these questions should be clear. However, in crafting an answer, the European Commission will have to balance strict interpretations that might protect its own producers more (by not crediting) versus being perceived as forcing its own policy design onto other countries.

The United Kingdom is on track to be the second country implementing a CBAM, for reasons similar to the European Union. The United Kingdom has an ETS that, despite some post-Brexit divergence, still very much resembles the EU ETS. However, in some cases, the United Kingdom might choose slightly different policy design options. The UK CBAM intends to cover the aluminum, cement, ceramics, fertilizer, glass, hydrogen, iron, and steel sectors. This differs slightly from the EU CBAM, as it adds glass and ceramics and excludes electricity. The United Kingdom similarly intends to limit the introduction of CBAM charges to sectors most at risk of leakage but acknowledges sectoral coverage will continue to be reviewed as new information comes to light. Charges will include direct, indirect, and certain precursor emissions and will be based on the effective carbon price, which is defined as "the price paid by producers after accounting for the impact of free allowances and other support mechanisms" (UK Government 2024). In keeping with a nondiscriminatory approach, charges will be significantly lower than the UK ETS price, to reflect free allowances provided within the United Kingdom.

3. How CBAMs Create Policy Spillovers

The EU CBAM will start with small fees in 2026, increasing more steeply starting in 2030 as free allowances are phased out. As CBAM levies increase, CBAMs will create incentives for governments to consider adopting carbon pricing, and those incentives are particularly strong for some countries. For instance, when countries export substantial energy-intensive products to Europe, carbon pricing can convert European tariff revenue into domestic revenue. Since the European Union and the United Kingdom both "credit" existing carbon pricing regimes, countries that levy equivalent carbon prices can "turn off" the border adjustment. If carbon pricing regimes abroad have lower prices than those in Europe, then the CBAM levy will still be reduced by the amount of the carbon price. Likewise, exports from countries with emissions trading systems can receive credit for the carbon price associated with purchasing emissions allowances, if such allowances are not given away.

Important questions remain about how crediting will work, but at present, only true carbon pricing regimes will be credited. One proposed alternative would allow credits for purchases of carbon offsets, as a way to encourage flows of climate finance (Sandler and Schrag 2022). Others have suggested allowing credits for cost-imposing regulations or for subnational efforts. Many of these suggestions raise vexing implementation issues, even beyond those raised by the EU CBAM.

In most cases, the incidence of a tariff falls on consumers in the market that levies the tariff, and the same would be expected in markets that implement CBAMs, such that European consumers (directly or indirectly) pay higher costs for steel, iron, aluminum, fertilizers, cement, and electricity. Since these goods would be more expensive in Europe, that would generate higher costs for goods produced in Europe that use these goods as inputs. The consumer burden from tariffs arises because world supply to any particular country is close to perfectly elastic, so the consumer side of the market bears the entire tax burden. In theory, large countries can drive down the world price of goods when they levy tariffs, by lowering worldwide demand for such goods and raising worldwide supply of such goods. In practice, these "terms of trade effects" have not been observed in the multiple studies that have considered the case of recent US tariffs on Chinese goods; see Clausing and Lovely (2024).Based on the early implementation experience, the European Union will consider expanding the scope of CBAM. This includes expansion to other EU ETS sectors currently left out, but also the inclusion of downstream goods. The latter would alter the character of the policy, as the policy design would shift away from closely mirroring EU ETS policy elements. In considering expansion, the European Union will want to balance impact on emissions and carbon leakage with the administrative costs necessary to extend the scope of the mechanism.

Although consumers bear the ultimate burden of most tariffs, these tariffs typically entail large transfers from consumers to both domestic producers and the state (in the form of tariff revenue). In the case of European producers, the higher domestic price that consumers pay merely compensates them for (some part of) the cost of purchasing emissions allowances.

An exporting country facing a CBAM can convert the transfer from European consumers to the state (in the form of tariff revenue) into local revenue instead of European revenue by adopting carbon pricing. For example, consider the case where Mozambique-which exported over 95 percent of its aluminum to the EU in 2019-levies an aluminum-sector carbon price equivalent to the EU CBAM charge (World Bank 2023). Because Mozambique firms will likely face the carbon price in either case, they will be indifferent about the collection of the carbon price, but where the revenue ends up (in the hands of the European or Mozambican tax authorities) will depend on whether Mozambique has a carbon price in place. This gives the Mozambique government a powerful incentive to levy a carbon price on the aluminum sector. If Mozambican firms are cleaner than the marginal European supplier, they may benefit from the CBAM; if they are dirtier, they may be harmed by it. In general, the cleanest suppliers will see price increases that exceed their carbon fees, while the dirtiest suppliers will pay more in fees than the price premium, or divert their product to other markets, facing higher transportation and logistics costs.

Countries may have other reasons to adopt carbon pricing in response to CBAMs, especially if CBAMs proliferate. For instance, for governments that find carbon pricing difficult to implement due to domestic political constraints, the external pressure of a CBAM can provide both impetus and a scapegoat, akin to pushing an open door, as policymakers can point out that exporting firms would have to pay these fees when they export regardless of domestic policy action.

However, the strength of all these incentives may be modest for many countries. Countries that export large quantities of energy-intensive products to the European Union, such as Türkiye and Ukraine, have far stronger incentives than countries that export far fewer quantities to CBAM jurisdictions. At present, the small scope of CBAMs and number of jurisdictions that impose them limits such incentives, but if CBAMs deepen and widen, such incentives would increase.

Even countries that already have carbon pricing policies in place might consider changing the parameters of their programs in response to the CBAM. An example is China, which is considering adding the steel, cement, and aluminum sectors to its ETS ahead of the 2026 start for CBAM charges (Reuters 2024).

CBAMs also may induce responses on other margins, even without a country adopting carbon pricing. For instance, CBAMs may provide incentives to locate energy-intensive production near clean energy sources or innovate cleaner production methods. Such responses also may be important in driving emissions reductions. However, countries may reshuffle energy use or underlying trade. For example, if a country uses more hydropower for fertilizer production while using dirtier energy sources for other needs, its response to the CBAM will merely relabel existing energy use. Likewise, if cleaner sources of production go to CBAM markets, whereas dirtier sources are diverted elsewhere, the extent of industrial carbonization will be more limited than if CBAM markets became more widespread.

Even when governments adopt carbon pricing, their adoption may be far from an economy-wide carbon price. Instead, they may focus on CBAM sectors, or even solely on exports from CBAM sectors. While export taxes are not permissible under the US Constitution, no World Trade Organization (WTO) rules prohibit them. Levying an export tax solely on exports destined for CBAM markets, however, may be impractical. Exporters would simply divert trade to non-CBAM markets when feasible, and trade would reshuffle as a result. Whether the European Union would credit such a regime also remains unclear.

Further, both broader export taxes and carbon pricing would continue to raise competitiveness concerns in markets without carbon pricing, absent a system of export rebates. Thus, industrial opposition to such policies would be expected, although policymakers might consider other ways to reduce negative effects on industry, including lowering other taxes, more infrastructure support, or other policy tools.

One implementation question is whether to credit for carbon prices enacted by sub-national governments, such as US states, Canadian provinces, or Chinese cities. This approach could incentivize climate policies at a sub-national level, which may be more politically viable and which may be a precursor to national action in the long run. Still, the approach could invite gaming. Similar to the reshuffling issues identified above, highly localized jurisdictions that include factories that export to the European Union may enact carbon pricing. Also, crediting sub-national carbon prices increases the administrative burdens by adding more policies to review and evaluate. The conditions are still uncertain under which the European Union will credit for carbon prices already paid. It will presumably want to strike a balance between offering sufficient protection against loopholes and avoiding overly burdensome restrictions that other countries may perceive as infringing on their own policy space.

Carbon pricing systems based on carbon intensity targets pose another challenge. Notably, the Chinese ETS is based on reducing the carbon intensity of covered sectors over time, without necessarily capping the absolute quantity of emissions. The price discovery that takes place under such a policy design is different from what could be expected under a normal cap. This might affect judgments on equivalency.

At a high level, the hope is that the EU and UK CBAMs lead to a virtuous cycle, where more and more countries adopt carbon pricing as part of their fight against climate change. If, for example, Thailand, Brazil, India, and other countries now discussing domestic carbon pricing also implement border adjustments, additional countries will see the direct advantage of carbon pricing to avoid tariffs on exports and the political benefit of joining the momentum. As the carbon pricing wave gathers more countries, it becomes stronger, and ultimately can draw in even the most reluctant governments.

Coordinated action on carbon pricing and CBAMs will in turn make the policies more streamlined, lowering compliance and administration costs. For example, countries can work together to develop similar approaches to measuring carbon emissions as well as protocols for monitoring and verifying reported emissions. Coordination will help individual countries build capacity domestically by leveraging lessons from elsewhere and build confidence in the global system. For example, more than a dozen countries have already begun a process to coordinate on measuring, monitoring, and verifying methane emissions from the oil and gas sector.

Importantly, global coordination to overcome policy reluctance has worked in other domains. The 2021 international tax agreement shows a recent precedent for global coordination on the long-vexing global collective action problem of tax competition (Clausing 2023). The incentives behind the international tax agreement are similar to CBAM: if countries do not adopt the agreed corporate minimum tax, their multinational companies operating in adopting jurisdictions are still on the hook to pay the tax. This creates incentives for countries to join the agreement to avoid losing fiscal revenues to other countries.

CBAM Spillovers in Practice

5. Policy Recommendations

Contents Abstract 1. Introduction 2. How the EU and UK CBAMs will work in practice 3. How CBAMs Create Policy Spillovers CBAM Spillovers in Practice 5. Policy Recommendations