Europe’s carbon border tax advances fight against climate change

CAMBRIDGE — The European Union’s Carbon Border Adjustment Mechanism (CBAM), officially launched in October 2023, now requires importers to report on the direct and indirect greenhouse-gas (GHG) emissions embedded in the goods they import. Beginning in January 2026, the EU will start imposing tariffs on imports from countries that do not price carbon at the bloc’s market rate, which could significantly affect carbon-intensive producers among its trading partners.

The EU’s new carbon-pricing regime may seem like a potential source of international discord, adding to the already overcrowded agenda of daunting global challenges. But a closer look suggests that the CBAM could represent the most effective global path toward achieving the Paris climate agreement’s ambitious emissions-reduction goals.

In 1994, when the United Nations Framework Convention on Climate Change entered into effect, it was clear that getting countries to agree to and comply with limits on GHG emissions would be extremely difficult, owing to the substantial economic costs. While market mechanisms like carbon pricing or tradable emission permits were viewed as a promising way to minimise these costs, many believed they could never work, because public opinion in most countries was far less supportive of market-based approaches than it was in the United States.

Moreover, there was no plausible way to incentivise or enforce carbon-cutting agreements, as it was assumed that many countries would simply refuse this implied violation of their national sovereignty. Given the free-rider problem, international proclamations of ambitious climate targets were widely expected to amount to nothing more than empty pledges.

Thirty years later, the situation has changed. In 2005, the EU successfully established its Emissions Trading System, which functions as an open market for trading emission permits. Now, the CBAM, designed to prevent “leakage” when regulated industries move production from countries with strict environmental regulations to those with more lenient ones, may hold the key to establishing a global carbon-pricing regime.

Under the CBAM, countries that do not tax GHGs will, in effect, face tariffs on their exports to the EU in six carbon-intensive “pilot” sectors: Aluminum, iron and steel, cement, fertilisers, hydrogen and electricity. More industries are to be added by 2030. Importers will have to purchase import permits, the cost of which will be equal to the market price of carbon within the EU, 77 euors ($83.9) per tonne as of May 23, minus any carbon price that suppliers pay in their own countries.

By taxing GHG emissions, the CBAM will effectively give EU trading partners that export carbon-intensive goods a powerful incentive to establish carbon-pricing mechanisms and CBAMs of their own. This would enable participating governments to collect revenue that would otherwise be collected by European governments, which they could then use to invest in domestic priorities, finance green-development projects and cover fiscal gaps. As more countries join, the economic pressure on holdouts to follow suit is expected to increase.

While some might argue that such trade penalties are incompatible with World Trade Organisation (WTO) rules and could be used to support protectionist policies, the EU claims that this will not happen with the CBAM. Specifically, the mechanism’s non-discriminatory design should render it consistent with WTO rules.

Most countries are just beginning to formulate policy responses to the CBAM. In December, the United Kingdom, which has its own domestic emissions market, decided to follow its continental neighbours and adopt a similar border-adjustment mechanism. Turkey is also developing its own carbon border tax, while Australia and Canada are reportedly considering similar measures.

Meanwhile, in the US Senate, proposals for CBAM-type frameworks could be part of a move in the right direction. Without setting a national carbon price domestically, however, such a system would be discriminatory.

American companies will argue that they already pay a high implicit price for carbon due to lower average GHG emissions. US steel companies, for example, primarily use electric arc furnaces, which emit far less carbon dioxide than the blast furnaces used in many other exporting countries like China, Russia, Ukraine, South Korea, India and Canada. Nevertheless, without putting an explicit national price on carbon, America’s CBAM is unlikely to be consistent with international trade rules.

The proliferation of carbon taxes could have profound implications for emerging and developing economies. While countries like China, India, and South Africa have challenged the CBAM, the EU’s new regime may prompt them to develop their own carbon-pricing mechanisms to mitigate the impact on their exports and GDP.

To be sure, carbon border taxes may serve as mere excuses for protecting domestic industries from imports. But if implemented effectively, countries facing CBAM charges might eventually, albeit reluctantly, respond by adopting robust carbon-pricing regimes. This could be the best chance the world has to facilitate the necessary technological, production, and consumption changes needed to avert catastrophic climate change.

I am grateful to Kimberly Clausing, Robert Stavins, and Catherine Wolfram for helpful comments.

Jeffrey Frankel, professor of Capital Formation and Growth at Harvard University, served as a member of president Bill Clinton’s Council of Economic Advisers. He is a research associate at the US National Bureau of Economic Research. Copyright: Project Syndicate, 2024. www.projectsyndicate.org