Carbon leakage and import tariffs

intermediate

Putting a price on greenhouse gas emissions runs the risk of “carbon leakage”, which occurs when companies move production to markets with less onerous environmental regulations. Governments seek to avoid carbon leakage through free allocation, tax-free allowances, and exemptions. But such measures mean that companies are not as incentivized to cut their emissions, running counter to climate targets. As a result, some governments are considering whether to put a carbon price on imported goods.

#Carbon leakage

Climate policies like carbon pricing impose costs on companies with such programs in place. This increases the risk that domestic companies relocate to countries where they would face lower environmental costs. Such a move would shift those companies’ carbon emissions offshore, weakening the impact of the carbon price and reducing the original country’s economic competitiveness. Governments with a carbon price have sought to mitigate this risk in various ways. In some carbon markets, such as China’s emissions trading programs, participants receive a share of their emission allowances as free allocation, while some taxes, like those in Canada and South Africa, include exemptions or reduced tariffs for certain sectors.

In the EU Emissions Trading System, the European Commission has devised a list of sectors at significant risk of carbon leakage. The amount of free allocation for each participant is calculated based on production quantity and a benchmark value for that product in terms of emissions per metric ton. The EU has been steadily decreasing the volume of free allocation, and sectors less exposed to carbon leakage will see free allocation phased out after 2026, from a maximum of 30% to zero by 2030.

However, not only do these concessions mitigate potential carbon leakage, they also mean that some companies are not as incentivized to cut their emissions, thereby running counter to climate targets.

#Import tariffs

Governments around the world are starting to consider emissions linked to imported goods. Markets like the EU, Japan and US have much higher emissions embedded in imports than those produced domestically. This has raised the question of carbon import tariffs, and the EU has the most advanced scheme closest to implementation. Its Carbon Border Adjustment Mechanism (CBAM) was proposed in 2021 as part of the “Fit for 55” package, which is meant to enable the bloc to achieve its 2030 goal to reduce emissions by 55% below 1990 levels. The CBAM proposal must still be approved by the European Parliament and member states.

A policymaker mulling a carbon import tariff would need to consider:

• Which sectors would be involved
• When would the tariff begin
• When to phase out concessions such as free allocation
• How to take account of climate policies implemented by the exporting country.

In the case of the EU’s CBAM, the policy would require importers to buy certificates equivalent to the carbon price they would have paid if the good had been produced within the EU. If they can prove that they have already paid a carbon price during the manufacturing process, the corresponding amount will be deducted.

The European Commission has proposed that the policy would focus first on direct emissions during the production of cement, iron and steel, aluminum, fertilizers and electricity. EU lawmakers also want it to cover other types of chemicals, hydrogen and plastics. Phasing out free allocation of emission permits in the EU ETS will likely be needed to align with global trade rules. However, the speed of this reduction will probably be controversial and determine the upside impact on carbon prices.

The implementation of a carbon import tariff by one nation or trading bloc inevitably has significant global implications. So, unsurprisingly, the EU’s trading partners and fellow climate first movers are closely following the fate of what could become the world’s inaugural major CBAM. US lawmakers are mulling how to regulate the carbon content of imports. This comes amid the European Parliament wanting its CBAM to include sectors that are heavily traded with the US and China – a move that both countries would bristle at. The UK and Canada – both with robust carbon pricing and net-zero plans – are considering their own CBAMs, but they will likely hold off until the EU fully defines its scheme.