In search of a WTO-compatible carbon border adjustment mechanism

The Paris Agreement initiated a cooperative approach to tackling climate change, but the movement is running out of steam – hence the call for an international carbon price floor differentiated by income level (Parry et al. 2021). However, even if such a solution were envisaged, international carbon price differences would still imply carbon leakage through European emitting industries moving part of their production to countries with less strict climate policies, and imports substituting for European production. Falling demand for fossil fuels in Europe depresses the price of these fuels, leading to higher consumption and greenhouse gas emissions by unconstrained countries, adding indirect leakage.

The European Commission proposed a “Fit for 55” package in July 2021, which includes a Carbon Border Adjustment Mechanism (CBAM) that aims to prevent carbon leakage (Tanabe 2022). On March 15, 2022, the European Council agreed on the overall design of the mechanism. In a recent article (Bellora and Fontagné 2022), we address three questions raised by the CBAM:

1. How much will it actually reduce carbon leakage induced by EU climate policy?

2. In a world of global value chains (Baldwin and Freeman 2021), will this restore a level playing field for European producers who pay for the carbon they emit?

3. Is it designed to minimize the likelihood of WTO panels or even the prospect of retaliation from trading partners?

Currently, the allocation of free allowances to sectors (i) covered by the European Emissions Trading System (ETS) and (ii) exposed to trade (Boehringer et al. 2012) addresses direct leakage. The “Fit for 55” package plans to reduce direct leakage with the CBAM. However, the mechanism will only reduce indirect leakage if it incentivizes non-European countries to further reduce their emissions – hence the German proposal to create a club of countries sharing the goal of reducing their emissions (Bundesministerium der Finanzen 2021 ).

Carbon offsetting at the European border

The CBAM complements the central tool of EU climate policy – the Emissions Trading Scheme (EU ETS). The scheme, set up in 2005, covers 40% of EU emissions generated by EU-based companies in certain sectors. It sets a cap on these emissions to reduce them by 61% by 2030, compared to 2005 levels. The CBAM will add a carbon price on imported products whose production-related emissions have not been taxed ( or not at the same level as in the EU) by the exporting country.

More specifically, the mechanism envisaged by the Commission combines:

  1. the purchase of allowances by importers on a specific market, price taker vis-à-vis the EU ETS
  2. a tax base equal to the exporter’s emissions, possibly including indirect emissions linked to the energy mix of the electricity consumed in the production processes
  3. a net compensation of the carbon price paid by the exporter in his own country
  4. the gradual abolition of free quotas over ten years
  5. the absorption in the European budget of the resources generated by the CBAM.

The 22 March European Council agreement on the mechanism keeps the discussion open on the thorny issues of the end of free allowances – which must be WTO compatible and necessary to make climate policy effective – and compensate for losses in competitiveness exporters.

The carbon border adjustment mechanism replaces free allowances

Let’s try to quantify the environmental and economic effects of such a compensation system. Our modeling presents a reference trajectory for the global economy until 2040. The nationally determined contributions of all countries are carefully considered, as well as the European emissions trading system and free allowances. Our general equilibrium modeling traces production shifts between sectors and countries and therefore accounts for carbon leakage. We explicitly consider global value chains, as pricing emissions related to intermediate consumption affects downstream competitiveness. We use the Mirage-VA model calibrated using the GTAP 10.1 MRIO database.

For clarity, we assume that the CBAM covers the same industries as the EU Emissions Trading System. This goes well beyond the proposed regulations, which are limited to cement, aluminum, fertilizers, power generation, iron and steel. Our hypothesis is consistent with the Commission’s longer-term objective and facilitates the identification of the main mechanisms at play. It also avoids exposing the EU to legal challenges at the WTO for having “selected” who will continue to receive free allowances. Our results concern the long-term impact of CBAM extended to all industries in the emissions trading system.

Here we consider two scenarios. In Scenario 1, the CBAM is designed to offset the direct emissions of the EU ETS sectors. The reference emissions are the European average. Free allowances are being phased out over ten years as the CBAM comes into effect. There is a differential treatment for the least developed countries in order to facilitate the acceptance by the WTO of the new European regulation and to align with the recommendation of the European Parliament.

Scenario 2 reproduces scenario 1 but uses the emissions of the exporting country as a reference for the adjustment. It is more ambitious in terms of offsetting emissions and encouraging non-participating countries. The downside is the (moderate) risk of being challenged at the WTO, as the compensation would be different for different exporters. The administrative burden of collecting information on foreign broadcasts is also a potential source of difficulty. This scenario most closely resembles the one envisioned for the EU regulation.

Fewer leaks but loss of competitiveness

Since the objective of CBAM is to limit leaks, the reduction in leaks is the first measure of its effectiveness. We consider cumulative emissions (and leaks) over the period 2021-2040. The leaks here are increases in greenhouse gas emissions from third countries caused by European climate policy.

Implementing the European Nationally Determined Contributions without a leakage reduction instrument would generate cumulative leakage amounting to 18.5 Gt CO2-equivalent. Allowances freely allocated to industries exposed to leakage reduce leakage by a third. Replacing CBAM with free allowances, whatever its design, further reduces leakage by up to two-thirds in scenario 2, compared to the situation without any instruments to deal with leakage. Scenario 2 is more efficient than scenario 1, but the difference is second order (1 Gt). In other words, leakage compensates for 62% of the reduction in EU greenhouse gas emissions obtained through European nationally determined contributions in the absence of free allowances or the CBAM, 41% with free allowances and 22% with CBAM in Scenario 2. CBAM does the job.

However, achieving this environmental objective comes at an economic cost. Comparing the counterfactual scenario with the reference scenario, European imports of EU ETS products decrease, as expected, but so do EU exports. Exports of intermediate goods are decreasing because the producers of the emissions trading system now have to buy their quotas and therefore lose competitiveness on third markets. European exporters of final goods use EU ETS products as intermediaries that are now more expensive, whether they are imported or produced in Europe, which leads to a loss of competitiveness on the European market as well as on third markets. Here is the thorny issue of compensating exporters that the March 15 agreement left aside.

Finally, the expected impacts of the CBAM on third countries deserve attention. First, the EU – a large country – enjoys a positive terms of trade effect from the introduction of CBAM (+0.7% in scenario 1 and 0.9% in scenario 2 ). This is consistent with the theoretical prediction that the taxing country extracts a rent from exporters (Balistreri et al. 2019) and may pose challenges for CBAM to be accepted by WTO members.

Another potentially contentious issue is the impact of the CBAM on bilateral exports of major European trading partners of carbon-intensive products. Figure 1 shows the impact on bilateral EU exports to (in red) and imports from (in blue) selected countries, with a darker shade for final products. Absolute change in billions of US dollars is shown on the vertical axis, while relative percentage changes are shown on the bars. For the sake of brevity, we only report the results of scenario 2.

Figure 1 Impact of the Carbon Border Adjustment Mechanism on EU27 bilateral trade, in 2040 (scenario 2)

Interestingly, we see favorable trade imbalances in Canada, Japan and the United States. The United Kingdom and the European Free Trade Association are an extreme case: they benefit from a low carbon offset and therefore increase their exports, while this accumulates with the reduction in the competitiveness of EU exporters (this reduction is also significant in other markets). At the other extreme, CBAM is deeply affecting India, with a -26% drop in its exports of intermediates to the EU.

A final contentious issue with the WTO could be the lack of a clear allocation of the significant revenues generated by the CBAM (up to +51% of EU tariff revenues in 2040 in scenario 2) in favor of environmental policies .

To return to our three initial questions, the CBAM significantly curbs European carbon leakage but at a cost, and not only for the sectors covered by the mechanism and the European emissions trading system. At the same time, compatibility with the WTO requires (at least) the end of free quotas, the terms of which remain to be agreed between the Member States and with Parliament.

The references

Baldwin, R and R Freeman (2021), “Risks and Global Supply Chains: What We Know and What We Need to Know”, NBER Working Paper 29444.

Balistreri, EJ, DT Kafine and H Yonezawa (2019), “Optimal Environmental Border Adjustments under the General Agreement on Tariffs and Trade”, Environmental and Resource Economics 74(3).

Bellora, C, and L Fontagné (2022), “EU in search of a WTO-compatible Carbon Border Adjustment Mechanism”, CEPII Working Paper No. 2022-01.

Boehringer, C, JC Carbone and TF Rutherford (2012), “Unilateral design of climate policies: efficiency and equity implications of alternative instruments to reduce carbon leakage”, Energy saving 34.

Bundesministerium der Finanzen (2021), “Steps towards an alliance for climate, competitiveness and industry – the building blocks of a cooperative and open climate club”, August.

Parry, I, S Black and J Roaf (2021), “Proposal for an international carbon price floor among large emitters”, Staff Climate Note n° 2021/001, International Monetary Fund.

Tanabe, Y (2022), “Japan Should Lead the Global Decarbonization Effort: Thoughts on the EU Carbon Border Adjustment Mechanism”, VoxEU.org, 23 January.