Carbon Border Adjustment Mechanisms: Accounting for our carbon footprint when exporting

Internationally, there is an increasing focus on sustainability and addressing carbon emissions across all sectors of industry. Therefore, it’s not surprising that attention is now turning to the role that international trade rules can play in addressing climate change.

The debate surrounding the potential introduction of a carbon border adjustment mechanism (CBAM) as an economic incentive to reduce carbon emissions has recently gained significant momentum in the European Union (EU).

If implemented, a CBAM would ensure that the carbon emissions of EU imports are charged at the same cost as their EU-produced equivalents. Like “Food Miles” in the mid-2000s, it is easy to see how the wide-spread roll-out of CBAMs could threaten New Zealand’s economic interests; as with so many things, the devil will be in the detail. In this article, we consider the merits of CBAMs, the prospects for their introduction, the risks and opportunities they present for New Zealand, and potential next steps.

What is the world doing about carbon emissions?

New Zealand, together with more than 110 other countries, has pledged carbon neutrality by 2050.

In a number of jurisdictions, including New Zealand, state-owned enterprises and superannuation funds are being asked to phase out fossil fuel investments and finance. Financial authorities, including central banks and financial regulators, are being asked to incorporate climate risk into their functions, and make climate-related financial disclosures mandatory.

Can trade rules address carbon emissions?

Accounting for the carbon emissions in exports is not a new concept. In the 2000s there were “food miles” campaigns to raise consumer awareness about the environmental impact associated with food production and trade, particularly the distances required to transport goods from their production location to their consumption location. New Zealand products were often targeted given the long-distances products travel to export markets such as Europe, North America and Japan.

A decade later, the merits of requiring exporters to pay a border tax or requiring importers to surrender carbon credits (for those in jurisdictions operating carbon emission trading schemes) began. These kinds of adjustments are referred to as CBAMs. Whereas food miles sought to account for the carbon emissions involved in the transport of goods, CBAMs seek to account for the carbon emissions embedded in the production of imported goods.

How does a CBAM work?

A CBAM would tax imported goods based on their carbon footprint with the aim of limiting “emissions leakage” and ensuring domestic industries that produce goods with a smaller carbon footprint can compete with imports that may be cheaper but have a larger carbon footprint. Emissions leakage occurs when manufacturers relocate to countries without, or with less stringent, carbon pricing regimes to produce their goods. This often results in no net decrease in global carbon emissions and an increase in the carbon emissions of the new host country. Goods imported from a country which applies a carbon price, like New Zealand, will usually receive a credit or an exemption.

Why does the EU want a CBAM?

Recently, the debate surrounding the use of CBAMs gained significant momentum with the European Parliament resolving to support the introduction of a CBAM as part of the European Green Deal.

At the heart of the proposal to introduce a CBAM is a desire by the EU to prevent carbon leakage in the event that international disagreement on climate action continues. Current measures largely focus on supporting domestic producers through partial exemptions to carbon prices under the EU’s emission trading system. But given the benchmark prices of EU carbon permits rose above 40 euros (NZD67) per tonne for the first time earlier this year (the highest price in the carbon market’s 16-year history), EU producers will be looking at their overseas competitors apprehensively. By comparison, the price of New Zealand’s carbon credits is approximately $37 per tonne (with a price ceiling of $50).

While a strategy of high carbon prices changes behaviours, such a strategy cannot be sustained without a CBAM. Policies that are seen to lock in high prices for carbon but ruin domestic industry with no global climate benefit will trigger political backlash and prevent the EU from implementing the full extent of the European Green Deal. It is therefore essential to make overseas producers face the same financial penalties for carbon emissions as domestic producers. Seen in this context, a CBAM is arguably required to safeguard the EU’s climate action ambitions and the objectives in the European Green Deal.

The other main reason for the EU to implement a CBAM is to incentivise other countries to introduce their own carbon pricing regimes, so that the CBAM does not apply between the EU and non- member countries. Some countries, like New Zealand, have already announced long-term carbon price paths to create transparent and predictable conditions for investment decisions.

Will a CBAM be easy to implement?

CBAMs are controversial given the possibility that they could be misused for protectionist purposes to shield domestic producers from overseas competition under the guise of climate action. Also, a CBAM has never actually been implemented so how it operates in practice is largely untested.

The EU’s trading partners will be carefully scrutinising the potential effects and implications of any CBAM.

The EU’s CBAM would also need to comply with the EU’s World Trade Organisation (WTO) commitments, including the obligation not to discriminate between like products imported from different countries and environmental objectives – which may need updating to reflect the challenges currently facing the international community.

There are a range of technical and practical challenges to be overcome if the EU’s CBAM is to be successful. The CBAM will need to define which products and sectors are covered, how to estimate the embodied emissions associated with imports, and what price level should be applied to those emissions. The design of the EU’s CBAM will also need to specify whether the measure applies only to imports, or whether exports are covered in the form of an equivalent rebate.

What do we think?

On the one hand, a CBAM would be economically efficient and intuitively fair: it would prevent carbon leakage by internalising the cost of carbon emissions to the EU’s trading partners, as well as to its own producers. Unfortunately, its economic and ethical attractiveness is in inverse proportion to the ease of designing a mechanism that could both achieve these desired ends and stay within international trade rules.

A well-designed CBAM would tax all imports at a rate that reflects the cost of producing like goods inside the EU. Further, the EU should allow importers to offset any penalties from the source country’s own carbon pricing scheme to prevent products from being ‘doubled taxed’. This approach should satisfy the WTO’s requirement to treat domestic and overseas producers equally and allow the tariff to automatically update when the price of carbon changes under the EU’s emission trading system, discouraging regulatory arbitrage.

Despite the best designed CBAM, in practice there is still the potential for it to become very complicated, contentious and political, especially if the CBAM is being applied to sophisticated manufactured items that comprise many components that have undergone many different production processes. Again, this challenge is not unsurmountable, if the EU rolls out its CBAM in stages, starting with limited coverage to the most carbon intensive sectors and goods.

Where to next?

At present, the European Commission is expected to present a legislative proposal for a CBAM in the second half of 2021 as well as a proposal on how to include the revenue generated to finance part of the EU budget. We will be watching these developments closely and reporting back on the potential impacts for New Zealand exporters.

Read Sustainable Impact - Issue one

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