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Analysis | The EU Has Found a Way to Police Carbon Emissions Beyond Its Borders

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The European Union has a bold plan to make sure its own strengthened pollution standards aren’t undermined by trading partners with weaker ones. It’s introducing a levy known officially as the Carbon Border Adjustment Mechanism (CBAM) to combat so-called carbon leakage, which happens when companies shift production to places with laxer policies to reduce costs. The aim is to level the playing field and protect European manufacturers while prodding other regions to follow the EU’s lead on taxing emissions. The idea has triggered a hostile reaction from trading partners including Russia and China, and added to tensions over green subsidies with the US. 

1. How will the carbon levy work?

It will initially target steel, aluminum, cement, fertilizers, hydrogen and electricity, all carbon-intensive goods. The CBAM will start with a data-collection stage in October 2023, when importers will monitor and report the number of metric tons of carbon dioxide released from making the goods they bring in from abroad. After that, importers will need to buy a new type of pollution certificate to reflect that discharge in line with prices on the bloc’s Emissions Trading System, its cap-and-trade market for permits. The fee could be at least partially waived if a carbon levy has already been paid in the country where the goods were produced. That’s important, because it prevents the plan from being considered an illegal tariff under regulations drawn up by the World Trade Organization.

2. How strict are EU pollution caps? 

The 27-nation bloc, which sees itself as a pioneer on climate action, is tightening rules to meet a binding goal to be climate neutral by 2050 (meaning any greenhouse gas emissions are offset by removals). In July 2021, it rolled out the biggest overhaul to date of its 16-year-old emissions market: Permits will be harder to come by and the program will be extended to include shipping. The moves have helped send the price of permits on the ETS soaring more than 10 times in five years to reach a record of just shy of 100 euros ($106) per ton in 2022.

3. How serious is carbon leakage? 

Less than 4% of global emissions are currently subject to direct carbon pricing in line with 2030 goals laid out in the Paris Agreement, according to the World Bank, and environmentalists say most levies aren’t high enough to change the behavior of polluters. In the EU, the risk of carbon leakage became a hot topic after emissions prices soared. The issue will become more challenging as free permits that manufacturers now get from governments are phased out. 

4. What do critics say? 

Trading partners resent Europe’s efforts to force them to match the bloc’s climate ambitions. The EU’s pioneering plans on reducing carbon emissions can be used “almost as a trade weapon,” Belgian Prime Minister Alexander De Croo said during the COP26 climate conference in 2021. China, the world’s biggest emitter of greenhouse gases, has attacked the CBAM as a trade barrier, though it’s also planning to broaden its own emissions trading market. Russia, the second-biggest exporter of steel to the EU, has said the mechanism could drive up the price of key commodities such as rolled steel and aluminum, though its exports to the bloc have decline because of the war in Ukraine. The prospect of the CBAM has already pushed Turkey, the largest source of EU steel imports, to finally ratify the Paris Agreement. Perhaps most critically, America doesn’t have a carbon market and so would have to pay for carbon-intensive exports to the EU. The US government has been skeptical of the idea, while European nations led by France have criticized a cornerstone of Washington’s own green agenda — a package of subsidies for green investments that EU officials say could break WTO competition rules. 

5. Is the EU alone with a carbon border levy?

The US has kicked around its own version, potentially as part of a national carbon tax, which American businesses increasingly favor over new restrictions on emissions. So has Canada. Environmentalists and economists, including Nobel Prize winner William Nordhaus, have long advocated the approach because it allows countries to band together into a sort of “carbon club” to eliminate the problem of “free-riding” on the efforts of other nations. Germany has pitched its own idea for such a union alongside the Group of Seven. The EU’s plan is seen as a test of whether such a levy can be used to advance carbon pricing around the world. A local program is operating in California. 

6. Could it be derailed? 

In short, no. EU governments and the European Parliament have now signed off on the plan and it’s deemed to be in line with WTO rules. There are still technical challenges, including how to measure the amount of carbon embedded in a product and determining how to credit carbon fees paid in countries outside the bloc. The CBAM will end — or at least phase out — the free carbon allowances currently given to European industries seen as most likely to leave the bloc, potentially setting up a battle with its own steel and cement producers. The European Commission, the bloc’s executive body, will regularly review the mechanism and has the option of making tweaks if “an unforeseeable, exceptional and unprovoked event” harms its operation. 

More stories like this are available on bloomberg.com

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