The EU’s new tool to create a level playing field

A bold initiative is intended to meet head on the inherent trading incompatibility caused by unpriced emissions from companies outside Europe

 

This summer the European Commission is set to propose two major add-ons to its international carbon-saving showpiece,the Emissions Trading Scheme (EU:ETS).

The first will be to extend its reach beyond European heavy industry, air transport and electricity generators to cover surface transport and buildings. The second will have even wider implications. It will increase the traded cost within Europe for the 80 per cent of global goods not subject to carbon pricing.

When European Commission President Ursula von der Leyen first floated the idea in July 2019, she called it a carbon border tax. The concept has evolved since then, earning a new name: carbon border adjustment mechanism. Or CBAM.

Whereas a tax could draw the ire of the World Trade Organization, which doesn’t like protectionism, a border adjustment mechanism will spare products produced in the small minority of countries that already put a price on emissions.Effectively, this initiative is intended to meet head on the inherent trading incompatibility caused by unpriced emissions from many companies based outside Europe.

The CBAM will function like a mirror image of the EU:ETS, for the past 15 years the world’s biggest carbon market. In such a “notional ETS,” importers of emissions-intensive goods will pay a charge linked to what they would have paid – had they been covered by Europe’s carbon-reduction laws in the first place. The price of emissions allowances in the EU:ETS is already surging in anticipation of stricter climate goals.

Designing the CBAM in a way that would make it compatible with the World Trade Organization (WTO) is difficult but doable, according to EU policymakers. Yet there are more challenges Europe needs to address to implement the mechanism, ranging from major political issues to technical factors such as how to determine the precise amount of carbon embedded in a product, and how to credit countries like the UK outside the bloc.

This won’t happen immediately. While the Commission will unveil draft regulations in June, the scheme needs approval from the European Parliament andthe 27 EU governments to become law. That process will involve long and tedious negotiations. Meaning the CBAM realistically won’t take effect until 2023.

The Commission has repeatedly stressed that the introduction of the CBAM will mean an end to—or at least a phasing-out of—the free carbon allowances currently given to sectors like aluminium currently most disadvantaged by imports. Retaining such freebies would definitely make the CBAM incompatible with WTO rules.

Inevitably, some sectors want to have their cake and eat it too, expecting that free allocation of permits continue. This issue is sure to be one of the noisiest sticking points in negotiations about the final shape of the instrument.

Europe’s plans are already causing diplomatic unease in countries from Ukraine to Ghana to India to China. Last month, a three-cornered virtual conference between Merkel of Germany, Macron of France and Xi of China ended with the latter issuing dire warnings about possible trade implications. In that context, even America’s high-profile climate envoy John Kerry describes the CBAM as a “last resort.”

The planned levy will be proposed just five months before the crucial COP26 climate summit in Glasgow, where coalition-building will be key to ensuring major emitters step up their efforts to reduce emissions. Threading that needle will be tricky, but possible, at least in theory.

Money from the border adjustment is a potential new source of EU budget revenue—from €5bn to €14bn per year, the Commission estimates. The decision on what happens to that revenue could be a big problem, particularly if it ends up being pocketed by certain European governments. Making it a tax by any other name. Ideally, revenues should be channelled towards developing countries for climate abatement purposes.

The scope of the measure at the outset will be limited to a few sectors, with power, cement, steel, aluminium, and fertilisers the likeliest candidates. But the border adjustment mechanism will be designed to enable a gradual extension into other industries over the coming years.

Europe imports electricity from Russia, the Ukraine, and the western Balkans. The biggest sources of cement imports are Belarus, Colombia, Turkey, and Ukraine, while steel is brought in mainly from China, Russia, Turkey, and Ukraine. And from the UK.

On May 19 the first ever auction of allowances available under the fledgling UK:ETS will occur. Those involved are the same sectors as were involved in the EU:ETS until this January. While the number of allowances will be proportionately 5 per cent lower, the system is basically a mirror image of its originator. So the chances are that steel imported from the UK will be able to avoid the EU’s “adjustment mechanism.”

Whether the UK will follow suit with trading schemes for buildings and surface transport, plus carbon surcharges for certain imports, has yet to be confirmed.As of now, London is simply an interested bystander.

Effectively, the EU is seeking a level playing field for its businesses while encouraging more climate action from countries outside the bloc. But if other nations step up, or if the proposal escalates irreconcilable trade tensions, the CBAM may wind up being a tool the EU wields,rather than something that is applied across the board.

If the debate leads to a more ambitious implementation of climate policies globally, the best CBAM may yet prove to be the one that is never rolled out in full.