In this post, we dive into carbon border adjustment mechanisms, the objectives, how it works, the benefits, CBAM and the global trade landscape, the challenges.
Definition
A Carbon Border Adjustment Mechanism (CBAM) is a carbon tariff imposed on imports to ensure that goods from countries with less stringent climate policies face a carbon price similar to domestic production, preventing carbon leakage. The European Union (EU) is implementing the first CBAM on carbon-intensive products like steel, cement, and fertilizers, with reporting requirements starting in October 2023 and full implementation in 2026.
Objectives of Carbon Border Adjustment Mechanisms:
Prevent carbon leakage: CBAMs are designed to stop companies from moving their production to countries with weaker climate policies to avoid carbon costs.
Level the playing field: By applying the same carbon price to both domestic and imported goods, CBAMs ensure that European companies, which are subject to the EU’s carbon price, are not at a competitive disadvantage compared to foreign producers.
Incentivize global emissions reduction: By putting a price on embedded carbon in imported products, CBAMs encourage non-EU countries and their industries to reduce their greenhouse gas emissions.
Support domestic climate goals: CBAMs help ensure that the EU’s own climate policies remain effective by extending the carbon price to imports, which supports the Union’s overall decarbonization efforts.
Promote fair trade: By promoting sustainable trade, CBAMs aim to encourage the importation of products that meet higher climate standards and support a more equitable transition to a green economy.
How Carbon Border Adjustment Mechanisms Works:
Importers pay a carbon fee: EU importers must purchase certificates to cover the carbon emissions embedded in the production of imported goods, such as cement, iron, steel, aluminum, fertilizers, electricity, and hydrogen.
Equivalent carbon pricing: The fee is calculated to match the carbon price that EU domestic producers pay under the EU’s Emissions Trading System (ETS). This creates a level playing field between EU-made and imported goods.
Discourages carbon leakage: The mechanism prevents companies from moving production to countries with lower climate standards to avoid carbon costs.
Adjusts for carbon pricing in the country of origin: If a carbon price is already paid in the country where the goods are produced, the amount paid can be deducted from the CBAM obligation, preventing the same emissions from being taxed twice.
Incentivizes global decarbonization: By adding a cost to carbon-intensive imports, the CBAM encourages producers in other countries to invest in cleaner production methods.
Phased implementation: The mechanism is being phased in gradually, starting with reporting requirements and moving to full implementation with certificate purchases.
The Benefits of Carbon Border Adjustment Mechanisms:
Prevents Carbon Leakage: This is the primary benefit. Carbon leakage occurs when a country with strict climate policies sees carbon-intensive production move to countries with less stringent regulations, simply shifting emissions rather than reducing them globally. CBAMs level the playing field by imposing a price on the carbon embedded in imported goods, ensuring that emissions reductions in the implementing country are not offset by increases elsewhere.
Safeguards Domestic Competitiveness: By ensuring imported goods face comparable carbon costs to domestically produced ones, CBAMs protect local industries from being disadvantaged by higher operating costs associated with stringent climate policies. This helps prevent job losses and industrial decline in the regulating country’s carbon-intensive sectors (e.g., iron and steel, cement, aluminum).
Incentivizes Global Climate Action: CBAMs create a powerful economic incentive for other countries to adopt their own effective carbon pricing mechanisms or cleaner production technologies. Non-regulating countries wishing to export to the CBAM-implementing jurisdiction would face a border tax; by implementing their own domestic carbon price, they can collect the revenue themselves rather than having it paid at the border.
Drives Innovation: The mechanism encourages both domestic and international producers to invest in cleaner technologies and low-carbon production methods to reduce their carbon liability and gain a competitive edge.
Generates Revenue: The revenue collected from the sale of CBAM certificates can be used to fund further climate change adaptation and mitigation projects, both domestically and potentially in developing countries to help them transition to greener economies.
Supports Overall Climate Goals: By effectively addressing carbon leakage and promoting cleaner production, CBAMs ensure that domestic climate policies, such as the EU’s Emissions Trading System (EU ETS), achieve greater global emissions reductions than they would in isolation.
CBAM and the Global Trade Landscape:
Leveling the playing field: CBAM aims to create a fair competitive environment for EU businesses by applying the same carbon costs to imported goods as those faced by domestic producers under the EU’s Emissions Trading System (ETS).
Encouraging decarbonization: It incentivizes non-EU countries to implement stronger climate policies and invest in clean technologies to avoid paying the carbon price on their exports to the EU.
Preventing carbon leakage: The mechanism is designed to stop companies from moving production to countries with less stringent climate policies to avoid carbon costs, which would lead to higher global emissions.
Shifting trade patterns: CBAM could lead to trade shifts, favoring countries with lower-carbon intensive production processes. This could negatively impact the exports of developing countries, although revenue from CBAM could potentially be used to help these nations transition to cleaner technologies.
Covered sectors: Initially, CBAM applies to imports of carbon-intensive goods such as iron and steel, cement, aluminum, fertilizers, electricity, and hydrogen. The scope may be expanded in the future.
October 1, 2023: The transitional phase of CBAM began, with reporting requirements starting in January 2024.
January 1, 2026: The financial component of CBAM is set to be fully implemented, requiring the purchase of CBAM certificates.
The Challenges of Carbon Border Adjustment Mechanisms:
Administrative and technical challenges
High administrative burden: Compliance costs can be disproportionately high, especially for small businesses due to low thresholds and unclear reporting instructions.
Complexity of monitoring: Differences in carbon pricing systems and the diversity of calculation and reporting methods create complexity in monitoring, accounting for, and tracing emissions
Limited language options: The platform for reporting can pose a challenge due to limited language options.
Trade and economic challenges
Potential for discrimination: Some trade partners argue CBAMs are discriminatory, favoring countries that use carbon pricing over other decarbonization policies, says the Centre for European Reform.
Disadvantage for developing countries: Developing nations that rely on exporting energy-intensive products may face lower competitiveness in the European market and could lose out on investment if manufacturing moves to the EU to avoid taxes.
Increased costs for downstream sectors: EU industries that use products covered by the CBAM will face higher input costs, potentially impacting their competitiveness.
Risk of carbon leakage: While designed to prevent carbon leakage (where emission-intensive activities move to countries with less stringent policies), a poorly designed mechanism could shift production to other countries without strong climate policies, a concern highlighted by the Toulouse School of Economics.
Lack of capacity: Countries that lack the capacity for monitoring, reporting, and verifying emissions face significant difficulties in implementing a CBAM system.
Global coordination: The effectiveness of carbon pricing is undermined by a lack of global coordination. Implementing a CBAM is a step to address this but requires international cooperation to be fully successful, says the Toulouse School of Economics.
Need for a global climate policy: Some argue that the real challenge is the lack of a comprehensive global climate policy framework, which makes implementing mechanisms like CBAM a more complex issue.
Conclusion
A Carbon Border Adjustment Mechanism (CBAM) is a trade policy tool that places a fee on imported goods based on the greenhouse gas (GHG) emissions generated during their production. The primary goal is to prevent “carbon leakage,” where businesses relocate carbon-intensive production to countries with less stringent climate policies to avoid costs, and to encourage cleaner industrial production globally.