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ABSTRACT
As part of the European Green Deal, the EU is considering the introduction of a Border Carbon Adjustment (BCA) on imports as an alternative to free allocation of emission allowances to reduce the risk of carbon leakage under the EU’s Emissions Trading System (EU ETS). While a BCA for exports is not categorically excluded, it is less likely to be consistent with World Trade Organisation rules and therefore less likely to be proposed than an import-only BCA. In this paper, we show that replacing free allocation by an import-only BCA would weaken the competitiveness of EU producers in foreign markets. Free allocation also helps support the cost competitiveness of domestic products that are exported to non-EU markets. Therefore, a move to import-only BCAs does not necessarily make redundant the continued use of free allocation to help safeguard overall industrial competitiveness. While combining an import BCA with free allocation for exports can increase the risk of legal challenges, such risks may be reduced with an appropriate design. More broadly, policymakers need to navigate a complex trade-off between competitiveness support, a stronger carbon price signal, and extra fiscal revenue.
Key policy insights
A BCA on imports levels the playing field in domestic EU markets but does not provide competitiveness support to exports
Therefore, a move to an import-only BCAs does not obviate the need for free allocation to safeguard overall industrial competitiveness
While combining an import-only BCA with free allocation for exports increases the risk of legal challenges, such risks may be reduced with an appropriate design
Acknowledgements
We thank the audience of the Cambridge EPRG 2020 Spring Seminar for a useful discussion, and three referees and the Editor for their detailed feedback.
Disclosure statement
The views expressed in this article are those of the authors and do not necessarily represent those of any organization. Since the initial submission of the paper, Michael Mehling and Robert Ritz have become engaged as advisors to the European Commission on the design and impact of border carbon adjustments. No potential conflict of interest was reported by the authors.
Notes
1 See Neuhoff et al. (Citation2016) argue that an alternative policy based on instead levying a carbon price on the domestic consumption of carbon-intensive materials (rather than the current production-based approach of the EU ETS) is superior to current policy on free allocation as well as border carbon adjustments.
2 France had previously already proposed to introduce a BCA as part of a “fair ecological transition”. Outside Europe, BCAs have precedent at a sub-national level in California’s carbon trading system.
3 The EU is considering several design options, including a carbon tax on selected products (both on imports and domestic production), a new carbon customs duty or tax on imports, or the extension of the EU ETS to imports.
4 An export BCA incurs a two-fold risk of violating international trade law, as it may not benefit from the exemption of Article XX of the General Agreement on Tariffs and Trade which allows measures necessary to protect the environment or related to the conservation of exhaustible resources, and as it would be conditional on exportation, it could be, prima facie, classified as a prohibited subsidy under the Agreement on Subsidies and Countervailing Measures, see Holzer (Citation2014).
5 Most industries are likely to be able pass-through carbon costs to some extent creating a risk that free allocations leads to windfall gains; however, the tightening of rules in Phase IV of the EU ETS is likely to better target free allocations to those sectors where the capacity for cost pass-through is limited (Verde et al., Citation2019).
6 Neuhoff and Ritz (Citation2019) synthesize the theory and evidence on the pass-through of carbon costs to product prices by industrial sectors in light of their market structure, international trade exposure, and the design of free allocation.
7 See Denis-Ryan et al. (Citation2016) for a wider analysis of the challenges to deep decarbonization of carbon-intensive materials by national climate policy in the absence of a global carbon price.
8 Hecht and Peters (Citation2019) model a three-stage game involving carbon price competition in the first stage, the introduction of BAs in the second stage and oligopolistic competition between firms in the third stage
9 The “Porter Hypothesis” (Porter, Citation1991; Porter & van der Linde, Citation1995) holds that environmental regulation such as carbon pricing can be beneficial for long-run competitiveness by stimulating innovation and investment. See I4CE (Citation2015) for a recent analysis in the context of the EU ETS. In terms of our ABC framework, this adds another dimension to our long-run competitiveness Channel C—but does not alter the arguments we make about short-term cost competitiveness along Channels A and B.
10 The same is true for grandfathering that uses sector-performance standards, which seeks to facilitate movement to lower emissions forms of production but is still effectively a lump-sum transfer.
11 The EU ETS’s New Entrants Reserve also supports new entrants by providing benchmarked free allocations to new installations joining the EU ETS or for installations whose capacity has significantly increased since their free allocation was determined.
12 By diluting the carbon price, and hence near-term abatement incentives, free allocation may lead to “carbon lock-in” in industrial sectors that, over time, can increase the required volume of low-carbon investment—and thereby undermine longer-term industrial competitiveness.
13 This aligns with the likely focus of the EU’s proposed BCA: “Carbon leakage occurs when production is transferred from the EU to other countries with lower ambition for emission reduction, or when EU products are replaced by more carbon-intensive imports … a carbon border adjustment mechanism would ensure that the price of imports reflect more accurately their carbon content.” See EU Inception Impact Analysis, 2020, available at https://ec.europa.eu/info/law/better-regulation/have-your-say/initiatives/12228-Carbon-Border-Adjustment-Mechanism