Graphite and diamonds: take just one element - carbon - and assemble it differently, and you get a strikingly different result. The same could be said of carbon pricing. While the concept is widely accepted as a key part of the net zero push, how these carbon pricing initiatives are assembled can lead to very different administrative and financial outcomes.  

Earlier this year, the European Commission proposed the world's first carbon tariffs on imported goods that are not subject to equivalent carbon prices: the Carbon Border Adjustment Mechanism (EU CBAM). You would be forgiven for thinking this can't possibly be the first; as Angus pointed out almost a year ago, there are 64 carbon pricing initiatives implemented globally. So what's really changing?

Isn’t there already a carbon tax?

One of those existing carbon pricing initiatives is the EU Emissions Trading System (ETS). The ETS was introduced in 2005, and works on a market-based "cap-and-trade" principle: a cap is set on the number of “units” of gas emissions permitted across the EU. For each unit that an affected company emits, it must surrender a permit.

The European Commission issues some permits for free. If that allowance is not sufficient to cover a company’s emissions, it must purchase more permits, either from the European Commission or from companies that have permits to spare. Those companies that can reduce their emissions at lower cost than the permit price are thereby incentivised to reduce emissions and sell permits.

That incentive diminishes over time as more companies reduce emissions, leading to more permits on the market, and a drop in permit prices. To counteract that trend, the EU reduces the number of permits available in the market, driving prices back up by increasing scarcity.

NIMBY: cross-border competition and carbon leakage 

While carbon pricing is certainly gaining traction, implementation is far from global, covering only around 21.5% of global greenhouse gas emissions. Carbon prices also vary significantly between jurisdictions.

These differences in carbon price, and lack of cross-jurisdictional policy coordination, can lead to ‘carbon leakage’ across geographical borders, whereby one country’s carbon pricing initiative reduces emissions in that country while simultaneously increasing emissions elsewhere, with a net neutral or even net negative outcome on global emissions.

In practice, this occurs when overseas competitors are able to outcompete domestic companies, or where it is cheaper for domestic companies to restructure their operations (either by importing more carbon-intensive goods at lower cost or relocating production processes to other countries in which climate policies are more lax) than to buy permits or invest in clean technologies.

The European Commission has sought to minimise these unwanted economic incentives and counter any disadvantage to EU producers by issuing free ETS allowances. However, while some industries - like the power sector - have halved their emissions since the ETS launched, in the manufacturing industry - which initially received 80% of its allowances for free - emissions have largely flat-lined.

How does the EU CBAM address this?

Under the “Fit for 55” proposal - aimed at reducing the bloc’s emissions by 55% from 1990 levels by 2030 - the European Commission would gradually withdraw free allowances for aluminium, cement, fertiliser and steel producers at a rate of 10% each year from 2026 onward (with all free allocations phased out by 2035).

Instead of free allocations, the Commission proposes to phase in an import tariff calculated on the basis of each product’s carbon content. Importers would be required to apply for authorisation to import in-scope goods, declare the total goods imported and the total embedded emissions, and surrender sufficient pre-purchased CBAM certificates to cover those emissions. Importantly, the proposal would not allow participants to trade CBAM certificates, unlike EU ETS allowances.

How is the UK responding?

The EU ETS applied to the UK until the end of the Brexit transitional period, with the UK initiating its own ETS on 1 January 2021.

In late September, the House of Commons Environmental Audit Committee (the EAC) launched an inquiry into the role that CBAMs could play in meeting the UK's environmental objectives and preventing carbon leakage, following recommendations it made back in February. The UK’s Climate Change Committee has also recommended introducing a CBAM to leverage trade arrangements to incentivise other jurisdictions to decarbonise,  particularly in the context of trade in agricultural and industrial products.  However, the Board of Trade called on the UK government to challenge so-called "green protectionism", stopping notably short of recommending a CBAM.

While the EAC feels the UK Government "appears to be in listening mode", the Government has not yet suggested what action it may take. Internally, policies to address carbon leakage are notionally led by HMT, although other agencies such as BEIS, FCDO, DIT, and DEFRA have interests that may diverge significantly from each other.

So what's the problem?

Clearly, reducing emissions and incentivising progress towards net zero is A Good Thing. Why, then, have CBAM proposals been so controversial?

The answer, as always, is that these things are complicated as well as highly politically and philosophically charged. At the same time as Green EU politicians criticise the proposals for being too slow and too narrow, a group of Republican senators has written to President Biden to express "serious concerns" that the US "should not allow the EU to define a climate and trade standard it has not helped shape". They point to predictions that "non-OECD economies will account for more than 100 per cent of global GHG emissions growth between now and 2050".

On the other hand, critics (including Brazil, South Africa, India, and China) argue that this imbalance means the EU CBAM may simply penalise developing countries that don't yet have the technological capacity to cut emissions - in contravention of the principle of “common but differentiated responsibilities and respective capabilities” enshrined in international climate law.  

Both domestic carbon pricing and border tariffs may also result in a consumer gap, with potentially regressive social effects: if producers in “carbon-lax” jurisdictions are at a competitive advantage, products produced in more sustainable ways will need to demand a higher price point. On the other hand, if the EU CBAM results in a market-wide price increase in carbon-intensive products, the risk is that these become a luxury available only to better-off end consumers.

CBAM critics may also have a real ability to throw a spanner in the works. While the Commission has said that the proposals are designed to comply with WTO non-discrimination rules, if challenges were brought, the EU would likely need to rely on environmental exceptions under the General Agreement on Tariffs and Trade. This is a high threshold to meet - and if not, it's back to diplomacy.

Even if the proposal is approved and implemented without resistance or retaliation, it remains to be seen how the EU CBAM would interact with policies elsewhere. In the US, Democrats have hinted at a "polluter import fee", while a few carbon pricing policies have started to appear at the state level. The Canadian government also intends to launch a consultation on border carbon adjustments. It also seems likely that the EU’s largest trading partners—like Russia, Turkey and China—may at least consider doing the same. However, tax commissioner Paolo Gentiloni has suggested that only a "very limited number" of countries will have a system similar enough to the EU's to qualify for an exemption - and Director-General for Taxation and Customs Union Gerassimos Thomas told the European Parliament's Environment Committee that such exemptions are not legally permissible.

Nor is the scope of the EU CBAM itself entirely clear. Even before the initial proposal has been fully sketched out, there are already hints that the regime might expand to cover additional sectors, such as refineries, polymer manufacture and vehicle manufacture, or indirect emissions from electricity generation, heating and cooling. 

A silver lining?

As always, this type of patchwork regime will inevitably create distinct administrative and compliance costs for importers, not only in carbon-auditing their supply chains and implementing monitoring and reporting systems, but also in terms of understanding exactly how the various regimes interact.

Even then, companies will face the ongoing cost of keeping up-to-date on legal and policy developments across their global footprint. As policies are implemented and their impact studied, and as research and thinking on climate change progresses, carbon pricing initiatives are bound to be tweaked, updated and outright replaced. To stretch the analogy, more carbon allotropes are waiting to be discovered.