At first glance, a Carbon Border Adjustment Mechanism (CBAM^[1]) would appear to be a welcoming tool. It is designed to ensure that countries and regions that are curbing their greenhouse gas emissions are not penalised by the transfer of industrial production to other locations. However, amidst the current Covid-19 pandemic, there are some indications suggesting that a CBAM could be treated as a good opportunity for the introduction of protectionist measures or be perceived by trading partners as such. It is not surprising that a recently published study^[2] has shown that the EU can expect especially strong resistance to the introduction of a EU CBAM from important trading partners such as China, India and Japan. At the same time, many countries are currently in the process of setting up emissions pricing systems. This also includes countries such as the United States where carbon border adjustment is being discussed. As a consequence, the introduction of various  emissions pricing systems with their own individual border adjustment mechanisms seems likely to happen in the near future.  Since these pricing systems are subject to local constraints and given the complexity of such systems, there is little chance of finding an agreement on a global emissions trading system that all countries and regions could adhere to, at least not in a medium-term perspective.

Therefore, it seems appropriate to raise the concern that differently designed CBAMs might lead to severe distortions in the international trading system and could jeopardise economic recovery after the pandemic. At the same time, this would also hamper efforts to mitigate climate change. Free trade increasingly involves trade in climate protection technologies, which should, in the interests of climate protection, be traded as cheaply and with as few barriers as possible. The ideal solution would be the adoption of a global pollution rights trading system as outlined and envisaged under the Kyoto Protocol. Climate Diplomacy should continue to pursue this goal. However, in the medium term, different systems are likely to  co-exist as necessary intermediate steps. To alleviate the negative impact of such fragmentation, regional CO2 trading systems should be designed to make it as easy as possible to combine them with other systems. In the following paragraph, the EU-CBAM will be used to demonstrate what a possible solution could look like.

 

Possible implementation of a CBAM that takes into account global trade relationships

The EU is discussing various options for the design of a CBAM, all of which have their own strengths and weaknesses. However, if one wishes to establish a system that can be easily combined with others, the best solution would be to adopt one based on tradable pollution permits:

Initially, a CBAM based on permit trading would not be radically different from the introduction of a simple CO2 tariff. Since the cap for the EU Emissions trading system (EU-ETS) has already been decided for the next decade and is currently being applied, it would not be possible to add additional permits for imports in the short term. Therefore, a parallel system should be set up. This system would require importers to purchase permits at the EU's external border based on the quantity of GHG-emissions released by the production of the goods that they are importing.

This would entail a certain – but one excessive - administrative cost. The existing EU customs nomenclature would, for each good, indicate the quantity of GHG-emissions released on average during its production^[3]. When importing such goods, importers would have to purchase permits corresponding to the declared quantities of GHG on top of paying import duties. The price of these permits should correspond to the average burden on EU industries, so that the WTO’s non-discrimination principle does not get violated. If an importer can prove that the product has already been burdened by similar measures in its country of origin, and that - through the use of more efficient technology - it has produced fewer GHG-emissions than assumed in the customs nomenclature (or that it has otherwise offset the GHG-emissions it had produced), it would have to purchase fewer permits or none at all.

As a second step, this could be extended to create a trading system analogous to the EU-ETS. The number of available permits would be capped and reduced each year in line with the GHG-emission reduction targets, which are yet to be established. Since the quantity of permits would thus be limited, they could no longer simply be purchased at the border at the time of import. Instead, they would be auctioned or allocated^[4]. This means that importers who did not have any permits would have to purchase them via a trading system. This ”cap and trade“ of available permits would create ever higher entry barriers into the EU market for producers whose country of origin is involved in little climate change mitigation in the production processes. As a rule, these countries will eventually tend to be the poorest ones.

Finally, as a third step, the EU ETS and the imports trading system won’t be merged before 2030. For instance, German industrial companies that had surplus CO2 permits due to gains in efficiency could then sell them to importers^[5].

 

Strategies for including other regions

In the aforementioned scenario, there would then be three types of permits: EU-issued permits (EU ETS), permits from other regions’ trading schemes, and permits that show GHG-emissions have been offset or that they lie below the declared quantity in the customs nomenclature. It would therefore be necessary from the outset to establish rules for recognising and establishing the equivalency of non-EU permits to EU permits.

Initially, this could be achieved through bilateral agreements and through the recognition of standards by certification companies (for the purposes of the last two types of permits mentioned). However, the EU should establish an independent "clearing house" as soon as possible  alongside other interested parties and task it with recognizing and establishing equivalency between the various pollution permits. Ideally, such a clearing house would be part of the WTO or of a UN organisation. Alternatively, a private body operating in the stock exchange and financial system environment could be a viable option. A major advantage of having such a clearing house located within the WTO would be that it would possess a high degree of credibility. This is necessary to demonstrate that the respective carbon border adjustments work to ensure equal treatment around cost burdens for climate change mitigation rather than enforcing hidden protectionism.

At its core, the clearing house’s assignment would be to assess the costs that a company in a specific region would have to bear as a result of GHG-emissions. Since not all regional pricing systems directly set a price per ton of CO2 (China, for example, measures CO2 intensity) and many regions have other measures in addition to CO2 pricing that effectively reduce emissions, it would be necessary to develop categories for converting CO2 prices per region. In the end, there would be an exchange rate system for pollution permits from different systems. Since permits from (previously voluntary) offset mechanisms will, in light of the "CO2 neutrality" target, become far more significant in the future, they should be included in this system as soon as possible. After all, if the EU really wants to be carbon neutral by 2050, the number of permits issued needs to be reduced dramatically. Nonetheless, emissions will continue to be generated simply through operational processes, for instance in the chemical industry. The easiest way to bring such products to the market would be to show that their emissions have been offset.

One problem in this system would be the treatment of the so-called Least Developed Countries (LDCs). As described above, a CBAM could disadvantage these countries the most, since LDCs have the fewest resources to switch to low carbon production systems^[6]. Since these countries are also the least responsible for global climate change, there is consensus not to further burden them financially in the same way as industrialised countries. Nevertheless, there are good reasons not to exclude LDCs and middle-income countries from a CBAM. On the one hand, this would be contrarious to  the WTO's most-favoured-nation clause. On the other hand, it would incentivise investments in GHG intensive technologies precisely in those countries. Therefore, in order to prevent CO2-intensive production being diverted to LDCs, no exceptions should be allowed. However, the EU should increase its financial and technological support for these countries in the use of low-carbon technologies and thus compensate the poorest countries for losses they may face because of the EU-CBAM.

 

Conclusion

Such a system of establishing appropriate conversion factors between different carbon pricing  systems may be a realistic, if only second-best, way of reconciling an open world trading system with the requirements of climate change mitigation on the basis of the Paris Agreement. Unfortunately, there is little prospect for the establishment of a functioning global trade in pollution rights in the medium term. This solution would allow each country to decide for itself whether and, if so, how it wants to price GHG-emissions. Parallel to the introduction of the CBAM, the EU should seek to work together with like-minded partners on the mutual recognition of permits. At the same time, it needs to define rules for the CBAM within the WTO framework so that this mechanism cannot be used to hide protectionism. The G20 would be the ideal framework to start off with, ideally before the EU CBAM is implemented.

 

NOTES

[1] For details of the advantages and disadvantages of a CBAM and a weighing of the various theoretical possibilities for its concrete implementation see: Cernicky/ Hartlieb: Carbon border adjustment mechanism: Tax or tariff for the climate? Konrad Adenauer Foundation, 2020

[2] Perception of the Planned EU Carbon Border Adjustment Mechanism in Asia Pacific – An Expert Survey. Regional Project Energy Security and Climate Change Asia-Pacific, Konrad Adenauer Foundation. 

[3] It would be important to use a transparent and verifiable system to determine these values as individual products could otherwise easily be protected against foreign competition if excessively high values were used.

[4] Determining the functioning of an allocation system (to countries/companies, etc.) would be a complex process.

[5] As a consequence of the integration of imported GHG-emissions,, the total quantity of GHG-emissions in the EU system would be mathematically higher than before. This might lead to the need to redefine the EU-reduction-targets.

[6] Whether this is really a problem would be a topic to be examined in another paper. Since less developed countries are generally less industrialized and export fewer processed products, the costs of adapting to a GHG-free economic system should not be any higher than the costs that they would anyway incur in establishing a competitive economic system; this would at least hold true in the case of countries that are not dependent on exports of raw materials.