Why we shouldn’t hang all our hopes on the CBAM

A web of complexity underneath a straightforward logic

There are good reasons that the CBAM is sucking up the oxygen in a room. Levelling climate costs at the border appears a straightforward and effective way to prevent carbon-intensive goods from flooding European markets. However, the CBAM’s simple appeal belies a complex series of trade-offs between its ability to combat the leakage of emissions and jobs across borders, international and domestic implementation politics, and red lines across different sectors and trading partners.

The CBAM would effectively apply EU carbon pricing policies on some goods imported from other countries. Those most likely to be targeted are highly emissions-intensive and globally traded industrial commodities like cement, steel, aluminium, and chemical products. Unsurprisingly, influential trading partners like China are arguing that the CBAM undermines the Paris Agreement, which relies on individual commitments based on national circumstances, and potentially also World Trade Organization (WTO) rules to ensure equal treatment for products no matter their country of origin.

What is not in dispute is that the decade ahead presents far more significant risks of carbon leakage, where EU companies increasingly compete with companies in other countries that face lower costs on their emissions (and sometimes none at all). The price of emissions certificates in the EU Emissions Trading System (EU ETS) has soared beyond €50 per tonne and is likely to continue climbing. Few countries among the EU’s trading partners have comparable carbon pricing.

A better way to address differences in climate ambition abroad than free emission certificates at home?

Since the launch of the EU ETS in 2005, Europe has mitigated the risks of carbon leakage by awarding free emission certificates to domestic industries with high carbon costs and strong international competition. However, giving away emissions certificates for free – typically referred to as “free allocation” – is not a viable long-term decarbonisation strategy and faces limits as the cap on overall emissions declines.

The CBAM was originally envisioned as an alternative to free allocation that would instead make foreign industries face similar costs to those inside Europe. That way, EU producers can more easily invest in costly new technologies and reflect the cost of those investments in their prices without the risk of losing market share. But designing a CBAM that closely approximates the costs that EU firms face is extremely challenging without making the policy too complex to implement, violating WTO rules, or triggering retaliation from trade partners. The fundamental questions that emerge are:

Will the CBAM allow Europe to decarbonise while maintaining a competitive industrial base?

If not, what else needs to happen? And, crucially, does the intense focus on a CBAM come at the cost of other policy imperatives and opportunities for international cooperation?

Navigating trade-offs means a weaker final product

The EU is clearly trying to strike a balance with a CBAM that levels the playing field and is politically acceptable and WTO-compatible. Much of the final proposal will be debated intensely and altered before it is passed into law, but some issues deserve particular attention. First, the EU will likely need to extend free allocation on top of the CBAM in some form to ensure buy-in from domestic sectors that are concerned the final CBAM will not be sufficient to level costs at the border, especially for the EU’s exports. But in doing so, the proposal will almost certainly face greater scrutiny from the WTO and other trade partners.

Second, the EU will likely face strong resistance from trade partners if it assumes a relatively high carbon content of imports, which the leaked proposal does by setting default values based on the EU’s worst-performing facilities. The leaked proposal also assigns revenue from the CBAM to the EU’s general budget instead of returning at least a portion of proceeds to trading partners, which could further raise tensions.

But perhaps the prickliest design choice to navigate is how to credit foreign exporters for the carbon costs they face in their country of origin.

Explicit carbon pricing is not a perfect proxy for a country’s climate ambition, with some governments preferring more direct approaches including standards and regulations.

However, explicit carbon pricing is the simplest and clearest measure of carbon costs and is the approach followed by the European Commission in the leaked proposal. This will be a difficult pill to swallow for countries, like the US, that do not adopt carbon pricing but are making ambitious climate commitments. For those jurisdictions imposing a carbon-pricing mechanism, the EU will likely want to ensure that these new systems represent real emission costs. Either way, the European Commission seems to be leaving some wriggle room with a clause that allows them to enter “sectoral agreements” with trading partners to take account of their carbon-pricing mechanisms.

These challenges illuminate that the final CBAM design will be the result of delicate trade-offs and may not be the saviour of European industry, and certainly not at the outset covering a relatively narrow set of sectors. Regardless of the ultimate CBAM design, the coming decade will also require an intensive focus on bringing innovative low-carbon production technologies online and creating markets where companies that use industrial goods choose low-carbon alternatives.

Industrial decarbonisation is a bigger challenge than what the CBAM can deliver

Almost half of the emission reductions we need by 2050 come from technologies that are still in the early stages of development. That requires a laser focus on developing innovative technologies over the next decade. As industrial decarbonisation technologies approach market readiness, many require carbon prices of €70 to €170 or higher per tonne to be commercially viable, which will require additional investment from the EU and member states to help companies shoulder the costs, as they’ve already done with feed-in tariffs for renewable energy.

It is not enough to simply produce low-carbon goods – there also needs to be market demand

As with innovation, a carbon price plays a role, but there is also a need for governments to do more this decade, including using their purchaising power by setting emissions standards in their procurement decisions; developing a system of labelling so companies know the emissions content of the materials they use; and setting product standards that limit the carbon intensity of goods sold.

That the CBAM will not solve the industrial decarbonisation challenge on its own is not a reason to scrap it altogether, but we also need to be realistic about its potential. We must take a comprehensive approach to achieve what the CBAM alone cannot, and we need to start now.

This article was published in an abbreviated version on 13th of July 2021 in Background Tagesspiegel Energie und Klima (in German).