Between Ambition and Delusion
The European Union is adamant about the fact that climate change is a global problem that calls for global solutions. An important cause of climate change are greenhouse gas (GHG) emissions associated with carbon-intensive production. Left to their own devices, firms typically do not consider the negative impact of their emissions on climate when making their production decisions. Hence, the idea of using a tax on GHG emissions (aka carbon tax) which imposes a "fair price" on firms and forces them to internalize the damage that carbon-intensive production causes to climate.
Unfortunately, not all countries tax carbon. As a result, according to the World Bank, less than 25% of global emissions are taxed, and only 5% of them lead to a carbon price compatible with the Paris Agreement's goal of keeping the rise in global temperatures below 2 degrees Celsius with repsect to pre-industrial levels this century. Moreover, countries with higher carbon taxes face the risk of "carbon leakage", which occurs when their domestic companies move their carbon-intensive production abroad to countries which have lower or no carbon taxes, or when their products are replaced by more carbon-intensive imports.
Due to its ambitions in terms of carbon taxation, the European Union would be particularly exposed to that risk. For this reason, it has planned the introduction of a Carbon Border Adjustment Mechanism (CBAM) whereby a carbon tariff is imposed on imported carbon intensive products that are at risk of carbon leakage (such as cement, iron and steel, aluminum, fertilizers, electricity, hydrogen). As part of the EU Green Deal, the CBAM entered into force last May and will take effect in 2026.
By requiring that certain imports pay a price for the carbon emissions embodied in their production, the objective of CBAM is to make sure that the carbon price of imports is equivalent to the carbon price of EU domestic production. This way, by putting a "fair price" on the carbon emitted in the production of goods entering the Single Market, the CBAM should aling the pursuit of EU's climate ambitions and the incentives for domestic firms and, hopefully, encourage cleaner industrial production in non-EU countries that pay less attention to emissions. The "fair price" of CBAM will be linked to price of the EU allowances as determined within the European Union Emissions Trading System (ETS) and its gradual introduction will parallel the phaseout in the allocation of such allowances.
As highlighted in a recent review by the French economists Lionel Fontagné and Katherine Schubert, while there is broad agreement that the risk of carbon leakage is real, it is a matter of debate whether the CBAM will succeed in removing it.
Two main aspects among others have been stressed by critics. The first is that taxing imports to ensure that their carbon price is equivalent to the carbon price of domestic production may well succeed in leveling the playing field in the EU domestic market. It does little, however, to help EU firms compete in foreign markets with respect to producers from countries that do not tax carbon. For this aim an export subsidy would be needed, but this is hardly compatible with the rules of the World Trade Organization.
A second aspect is that the EU might overestimate the incentive CBAM creates for countries that do not have one to introduce adequate carbon taxation. The idea is that access to the Single Market is important enough to incentivize such countries to also price carbon and avoid compensation through the CBAM. In a changing world economy, in which trade relations are reorganizing around geopolitical fault lines, for several countries with low or inexistent carbon taxation the attractiveness of the Single Market is fading, and with it also the incentivizing leverage of the CBAM.
In this respect, a briefing by the European Parliamentary Research Service stresses the importance of tighter coordination with the US. As one of the world's largest markets and emitters, the US should be a key partner in bringing the world closer to reaching the goals of the Paris Agreement. However, so far the world's #1 economy has largely gone its own way, especially since the Inflation Reduction Act (IRA) invested billions of dollars in public funds to favor "made in America" clean energy and technology.