The EU’s new climate policy will spark international cooperation on carbon pricing

EU importers will need to purchase carbon border adjustment mechanism certificates for each ton of carbon emitted during production.

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As countries begin to ramp up their climate ambitions, climate policy packages are becoming more comprehensive and ambitious, such as the ‘Fit for 55’ package that the EU has introduced as part of the European Green Deal. This strategy outlines policy instruments to cut greenhouse gas emissions by 55% by 2030 and achieve net neutrality by 2050, which includes ramping up its carbon pricing strategy. 

However, climate change is a global problem, requiring a coordinated response between states, and the US has taken a different tactic for decarbonising its economy. Instead of putting a price on carbon, the US is subsidising its domestic clean energy industry. There have been debates about which approach is better. However, what is important is that they both have the potential to prevent less wealthy countries from capitalising on weak climate policies.

The impacts of carbon leakage

Carbon pricing is a cost applied to carbon pollution. Polluters, therefore, pay the external costs associated with the carbon they emit. However, when high-polluting firms are faced with escalating carbon prices, they may shift their operations to a jurisdiction with a more lax climate policy to avoid these costs. 

This is called carbon leakage, and firms have been known to move their operations outside of the EU, taking their carbon emissions with them. The Carbon Border Adjustment Mechanism (CBAM) is a landmark tool proposed by the EU to prevent carbon leakage by putting a fair price on imported carbon-intensive goods. 

The CBAM is the EU’s new carbon border tax. EU importers will need to purchase CBAM certificates for each ton of carbon emitted during production. Initially, it will cover imports of high-emitting carbon goods, such as aluminium, iron, steel, electricity, cement and fertilisers, and plans are in place to extend it further. 

The price of carbon will be aligned with the EU Emissions Trading System (ETS), which is also set to be reformed under the Fit for 55 packages. The ETS operates using a cap-and-trade principle, where emitters obtain emissions allowances to meet emissions targets without actually cutting their carbon production. In principle, companies are faced with two choices: either reduce their emissions, or spend money on allowances, enabling them to continue polluting, but at financial cost. 

In the past, high-polluting industries received free allowances under the EU ETS to prevent carbon leakage. Plans for the EU include reducing its cap and phasing out the allocations. This is where the CBAM will be instrumental. The transitional period of the CBAM will be in line with the phase-out of free allocations in the EU ETS. 

EU imports will become subject to carbon tariffs and importers will need to purchase and surrender CBAM certificates, equal to the carbon price under the ETS. This levels the playing field for the domestic industry by improving the competitiveness of domestic goods subject to carbon pricing with EU imports.

Sparking fears of protectionism

Non-EU countries have pushed back on the CBAM, accusing the EU of protectionism, and using climate action as a disguise for measures to exclude external markets. Brazil, China, South Africa and India expressed a joint “grave concern” that the EU is discriminating against non-EU imports by effectively placing a levy on them. The CBAM could result in a greater administrative burden on those exposed to the CBAM and raise the price of products within the EU. 

Developing economies, such as many within Africa, would likely take a hit from the CBAM. For example, Morocco is responsible for 13.3% of fertiliser imports, and the CBAM will therefore damage the country’s export earnings. How the CBAM will impact African economies and their ability to industrialise should be considered, especially as the industrialisation in other states has escalated the impacts of climate change for those countries most at risk that have not had the same opportunity to fully industrialise. 

The EU has responded to this by suggesting that the revenues drawn from the CBAM will be put toward climate finance for developing countries. However, instead of just focusing on the potential trade implications, the wider picture should be remembered. This EU-based policy can have positive implications beyond the EU, by encouraging non-EU countries to strengthen their climate policies.

Now, instead of poorer countries capitalising on having weaker climate policies through carbon leakage, the CBAM should incentivise other counties to implement their own carbon border mechanisms or strengthen their carbon pricing measures. Support for countries impacted by the CBAM is crucial, but assessing impact on trade will require an open dialogue and cooperation across borders.