This is a guest post from trade lawyer Bixuan Wu of the Hiways law firm:
The EU’s CBAM
On June 22, the European Parliament adopted its “first reading” position on the regulation establishing a Carbon Border Adjustment Mechanism (CBAM). After the vote, rapporteur Mohammed Chahim said the CBAM would incentivize the EU’s trading partners to decarbonize their industries “as no matter where you pollute, you will now have to pay for it, if you want to export to the European market.”
Polluters pay, that sounds right. But Mr. Chahim’s words are only half right. If he wanted to describe the EU’s measure more accurately, he would have said: “no matter where you pollute, you will now have to pay for it, at EU’s price.”
But that would have revealed a logical flaw in the EU’s CBAM – it leaps from requiring other countries to charge polluters to requiring them to charge polluters the EU’s carbon price.
The EU’s CBAM aims to prevent carbon leakage, a situation that EU businesses, to avoid high emission costs within the EU, transfer production to other countries with laxer emission constraints. The EU’s solution to this is to put a charge on each ton of carbon embedded in imports. In essence, the charge equals the difference between the carbon price of the EU ETS and that of the exporting county, if any. For example, suppose a Chinese producer exports 100 tons of steel to the EU, and the steel is produced through the EAF (electric arc furnace) method and has 60 tons of embedded emission (0.6 ton carbon per ton of steel). So basically, those imported steel are as “green” as EAF steel made in the EU. In this case, will the Chinese steel be exempted from paying the carbon levy? Nope. For the 60 tons of embedded carbon, the importer still has to buy 60 CBAM certificates, at a price that is equal to the average EU ETS carbon price of the previous week, which we assume is €100 (to avoid overcomplication, we assume that free emission allowances have completely phased out in the EU). Thus, the total CBAM charge will be €6,000. Let’s further assume that when the steel is made, China’s ETS covers the steel sector and its average carbon price is €10. Thus, to avoid double charge on the embedded carbon, the importer is allowed to subtract the carbon price already paid in China, which is €600. At the end, for the 100 ton of Chinese EAF (green) steel, the CBAM charge will be €5,400. In short, being as “green” as the EU’s like product does not save the imports paying the carbon levy.
Now let’s consider a second scenario. This time the imported Chinese steel is much less green – it is made through the blast furnace (BF) method and has 200 tons of embedded emission (2 tons carbon per ton of steel). Nevertheless, in this scenario China’s ETS carbon price has raised to the same level as the EU’s, i.e., €100. In this case, what will be the CBAM charge for the dirtier 100 tons of steel? Surprisingly, zero. Because the difference between the EU’s and China’s carbon prices is zero.
See the problem? While the EU CBAM to a certain degree incentivizes foreign producers to decarbonize, it is primarily about pressuring other countries into raising domestic carbon prices. It does not necessarily penalize imports with high carbon content, but it certainly penalizes goods from countries with lower carbon prices.
The problem arises from a logical flaw in the CBAM’s design. The EU simply equates a country’s carbon price with the strictness of its emission constraints. The assumption is, if a country has emission constraints as stringent as those of the EU, then its carbon price must be at about the same level as the EU. This is not necessarily true. It’s quite probable that a country makes no less effort to decarbonize its industries than the EU, but its domestic carbon price is much lower than the EU’s. That’s because carbon price reflects not only the strictness of domestic emission polices, but also the cost and efficiency in achieving emissions reduction at economy-wide level. A 2019 IETA report shows that the cost of emissions reduction (shadow prices of CO2) varies significantly among countries, and the cost in the EU tops all other countries.
Source: IETA
Let me explain by an example, the EU’s decarbonization now largely depends on replacing coal power with gas power, so its carbon price is closely corelated to the coal-to-gas switching price. Currently, China’s power generation is dominated by coal, therefore arguably, the foremost cost-efficient decarbonization option is to replace low-efficiency (dirtier) coal power with high-efficiency (cleaner) coal power. This dirty coal-to-clean coal switch is less costly than the coal-to-gas switch. To be clear, the example is not advocating for coal, it is just to illustrate that other countries may have more room than the EU to decarbonize in a less costly manner, especially countries at the beginning of the decarbonization process.
It is often alleged that the CBAM violates the “common but differentiated responsibilities” principle enshrined in the Paris Agreement. That may not be right on the point. The CBAM does not directly touch on other countries’ differentiated climate responsibilities. Rather, it judges other countries’ fulfillment of their commitments – if you don’t raise your carbon price to the EU’s level, you are not bearing your responsibilities. It’s like saying, “if you don’t buy a gym card as expensive as mine, you must not be working out as hard as I do.” A bit absurd, right? Why do all counties, rich or poor, have to have carbon prices as high as the EU’s in order to be considered have borne their share of climate responsibilities?
The CBAM’s carbon price-climate responsibilities equation effectively protects economies with the highest mitigation cost. It’s a double-edged sword. It disincentivizes climate free-riding, but it also has the potential to disincentivize efforts to reduce emissions in a cost-efficient way. In this regard, the notion of carbon leakage itself may even be questioned. Assuming climate endeavors being equal, if a country is capable of cutting emissions at lower costs, that advantage should be recognized. Businesses are naturally inclined to move there. Not because the emission constraints there are laxer, but because it’s just easier and cheaper to meet the same stringent emission requirements. If that’s the case, should the relocation be allowed or even encouraged? If not, is it good for the reduction of global GHG emissions?
The U.S. Clean Competition Act
On June 7, 2022, U.S. Senator Sheldon Whitehouse (D-RI) introduced legislation titled “Clean Competition Act” (CCA). The bill proposes the establishment of a U.S. carbon border levy on imports. Significantly, unlike the EU’s CBAM, the proposed U.S. levy will hinge on the “greenness” of imports, rather than the carbon prices of the exporting country.
The CCA is well summarized in a press release by Senator Whitehouse and an article by Shuting Pomerleau. In essence, it is to use the average carbon intensity of U.S. products as a benchmark and to impose a carbon fee on both imported and U.S. products with carbon intensity that exceeds the benchmark. Let’s see how it works.
I continue use the steel hypothesis. Assume the average carbon intensity of U.S.-made steel is 0.6 ton of CO2 per ton of steel. This will be the benchmark. As long as imported steel’s carbon intensity does not exceed this benchmark, i.e., no dirtier than the average U.S. like products, it will not be charged a carbon levy, regardless of the carbon price of the exporting country. Likewise, U.S. producers also have to pay for the portion of emissions that exceed the industry benchmark, at a carbon tax rate equally applicable to imported and domestic goods.
The implication is that under CCA, foreign producers are more incentivized to decarbonize their production. From a foreign producer’s perspective, this is much more practical than trying to influence its home country’s carbon price.
The difference between the EU’s CBAM and the CCA is significant. Unlike the EU’s measure, which puts a charge on the total embedded emission of imports, the CCA only taxes the portion of emissions that exceed the U.S. benchmark. In other words, the EU taxes imports’ “absolute carbon content”, but the U.S. taxes only the “comparative carbon content”. The EU’s CBAM penalizes goods from countries with lower carbon prices, the CCA penalizes high emitters, foreign and domestic alike.
In designing the carbon-centered trade tool, U.S. lawmakers probably have more ensuring-a-level-playing-field in mind than their EU counterparts. Nevertheless, the CCA in its current form looks more competition-neutral than the EU’s CBAM. This is because the CCA is a clever move to circumvent the problem of lacking explicit carbon price in the U.S.
To charge a carbon fee on imports, its necessary to have a domestic reference (or benchmark). For the EU, this is simple – the allowances price of the EU ETS can be used. However, the U.S. lacks an explicit domestic carbon price – it has neither a nation-wide carbon market nor a carbon tax. Thus, finding a plausible reference becomes a real challenge. Initially, U.S. lawmakers were obsessed with determining the emission costs of U.S. producers. For example, a bill introduced last July (the “FAIR Transition and Competition Act”) proposed to use as reference the “domestic environmental cost” – the average cost incurred by U.S. companies to comply with all emission-control laws and regulations. This approach is not very persuasive, and to assign monetary values to a company’s compliance burden is quite challenging, if not impossible.
The designers of the CCA have stepped out the “EU mindset”. Who says a carbon boarder levy must have an explicit domestic emission cost? The CCA instead uses the average carbon intensity of U.S. producers, which is at least 1,000 times easier to be quantified than the emission costs of U.S. producers.
By going directly to the carbon intensity, the signal of CCA is clear: imports must be as “green” as U.S. products on average. Otherwise, a carbon tax would be imposed. In addition, because the tax rate is equally applicable to foreign and domestic producers, the measure incentivizes decarbonization both at home and abroad.
