How might an EU Carbon Border Adjustment work?

​In this post we look at a simple EU Carbon Border Adjustment (CBA) design that would tax imports, before exploring some options for dealing with exports.
 
Import CBA design

Principles

1. Maintain the Phase IV free allocation methodology, where an installation in a sector on the Carbon Leakage List (that is not a new entrant and that makes a benchmarked product) is awarded allowances based on the following calculation: 
                                                                                       
                                                                                         Allocation = CLEF x PB x PT x CSCF
 
CLEF – Carbon Leakage Exposure Factor (currently 1 for sectors on the Carbon Leakage List)
PB – Product Benchmark used in the EU ETS for the product in question (CO2e/t)
PT – Product Tonnage (adjusted over time in Phase IV to take account of production changes)
CSCF – Cross Sectoral Correction Factor applied to entitlements that year (due to there not being sufficient allowances)

2. Levy a carbon tax on imports of the same energy-intensive products that have product benchmarks in the EU ETS
 
3. Use the EU ETS carbon price as the rate of the tax, taking the average price over a suitable time period
 
4. Charge the tax on an amount of emissions per tonne of imported product that is equivalent to the amount of emissions, on average, not covered by free allocation within the EU for a tonne of that product: 

                                                                         Chargeable Emissions = IT x [AEI – (CLEF x PB x CSCF)]
 
IT – Import Tonnage
AEI – Average Emissions Intensity for the product in question in the EU (CO2e/t)
CLEF – Carbon Leakage Exposure Factor (currently 1 for sectors on the Carbon Leakage List)
PB – Product Benchmark used in the EU ETS for the product in question (CO2e/t)
CSCF – Cross Sectoral Correction Factor applied to entitlements that year (due to there not being sufficient allowances)
 
5. Allow foreign producers to provide evidence that their emissions intensity is better than AEI, and/or that they are already subject to a carbon price in their jurisdiction for the emissions, so that their obligation can be reduced accordingly


Advantages

• The system can reasonably claim to expose foreign producers to the same carbon costs (and carbon price signal) as domestic producers in receipt of dynamic free allocation. The import tax is applied to the same basic products made by industries regulated under the EU ETS; the default charge is based on the average situation in the EU; and provision is made for individual foreign producers to have their obligation assessed more precisely in a manner equivalent to an individual EU ETS installation. This symmetry should level the playing field for EU producers selling in the EU market and help satisfy WTO rules concerning non-discrimination against foreign products.

 

• The system works in harmony with the agreed free allocation methodology that comes into force next year, mirroring free-allowance recipients’ exposure, avoiding double protection, and automatically providing for the import tax to increase as free allocation is phased out (by building in the CLEF and CSCF into the Chargeable Emissions calculation). As such, the design may be more amenable to ETS participants and could be phased in for different products with the agreement of industry associations.

 

• The system would minimise administrative burden. Unlike a CBA requiring importers of foreign products to surrender EUAs, the ETS cap would not need to be redefined to include consumption emissions. And by only taxing fundamental benchmarked materials, it would not be necessary to calculate the emissions intensity of complex and diverse products.

 

• The system also has environmental benefits beyond preventing domestic carbon leakage because it rewards foreign producers for reducing their emissions, and recognises if their jurisdiction uses carbon pricing, thereby extending the reach of the carbon price signal and encouraging international carbon pricing.

 
Issues

• The most serious limitation of the system is that it does not apply an adjustment to protect the competitiveness of exports, so cannot constitute an alternative to free allocation for exporters. We look at some options to address this blind spot in the section below.

• The system would not take account of indirect emission costs associated with the relevant imported products, but discriminating between products based on the electricity mix of the exporting nation and applying a tax that is not symmetrical to the EUA obligation faced by installations (which only covers direct emissions) could cause issues under WTO rules. It is probably more pragmatic, therefore, to retain indirect cost compensation for electro-intensive industries to deal with this threat of carbon leakage.

 

• Whether the system is compliant with WTO rules would also need to be examined carefully. The EU ETS is not a tax assessed on products, but a system with a fluctuating price that charges producers for emissions. Applying a border tax assessed on products, therefore, may prompt objections that foreign products are being treated differently to EU products. It may be that an EUA-based adjustment would fare better legally, in this respect, but it would come at the cost of having to redefine the ETS cap. Modulating obligations may also prompt the objection that like products (sometimes from different countries) are being treated differently. This could perhaps be seen off (or circumvented via exceptions in GATT Article XX) on the grounds that the default is to charge the same amount of tax on a given product, and deviations from this are calculated following a defined process that is open to all and which recognises non-arbitrary differences.

• A final technical issue with the system is that it does not treat foreign producers identically to domestic producers in the rare instance that they emit less than the EU allocation per tonne of product. That is, a domestic producer that emits less per tonne of product than their allocation is able to sell allowances to generate revenue, but a foreign producer emitting the same amount would not receive any revenue under the system—they would just avoid having to pay the tax. One possible solution would be to pay foreign producers (or to give them EUAs from under the existing cap) thereby preserving symmetry and ensuring the carbon price signal is sent out fully beyond EU borders. This seems unlikely to be politically popular, however, and the legal implications under WTO rules would need to be examined.

 
Export options
 
Reimbursement

One option to protect the competitiveness of exporters is to reimburse them up to benchmark level for emissions per tonne of exported product not covered by free allocation (again building in consideration of the CLEF and CSCF, so as to adjust automatically to any reduction in free allocation over time). That is,
 
                                                                Reimbursable Emissions = ET x [PB – (CLEF x PB x CSCF)]
 
ET – Export Tonnage
PB – Product Benchmark used in the EU ETS for the product in question (CO2e/t)
CLEF – Carbon Leakage Exposure Factor (currently 1 for sectors on the Carbon Leakage List)
CSCF – Cross Sectoral Correction Factor applied to entitlements that year (due to there not being sufficient allowances)
 
And emissions would be reimbursed at the rate of the EU ETS carbon price (averaged over a suitable time period).
 
Notwithstanding the fact that the carbon price used in the reimbursement may differ from the actual price paid for EUAs surrendered in relation to the production of the products, we can note that the net situation after surrender and reimbursement would be that an exporter pays (or receives) a percentage of the carbon price on every tonne exported, depending on their emissions intensity (where an installation meeting benchmark pays/receives 0%).

This would expose exporters fully to the carbon price signal with respect to emissions intensity performance while reducing their carbon costs. It would also abate (or even reverse) the carbon price signal with respect to production decisions, thereby protecting against carbon leakage.

There may be political obstacles to funding an export rebate, although we should bear in mind that the money could come from auction revenues, which the exporters would themselves have contributed to when buying allowances to meet their compliance obligations.
 
There may also be legal objections to subsidising exported production under the system when an installation outperforms its benchmark. But this feature could be removed by not allowing Reimbursable Emissions to exceed actual emissions at the end of the compliance year. This would come at the cost of not exposing exporters fully to the carbon price signal with respect to emissions intensity, however. Alternatively, the benchmark could be set slightly beyond best practice at the time, but this would come at the cost of weaker carbon leakage protection.
 
Perhaps the most fundamental issue, though, is whether the system would cause market distortions at home by treating ETS installations differently depending on whether they sell their product in the EU or abroad.
 
Take two identical installations making a product in the EU, for instance. Installation A—which sells its product in the EU—would have to buy EUAs to meet its compliance requirements not covered by free allocation. Installation B—which sells its product abroad—would have to do the same but would also receive a rebate as outlined above.
 
We can see that selling a product in the EU would only be as profitable as exporting it under this system if the product could be sold for a premium in the EU (due to the import tax). And the premium would have to be equivalent to the export rebate per tonne of product. That is,
 
                                                                     EU premium per tonne = CP x [PB – (CLEF x PB x CSCF)]
 
CP – Carbon Price
PB – Product Benchmark used in the EU ETS for the product in question (CO2e/t)
CLEF – Carbon Leakage Exposure Factor (currently 1 for sectors on the Carbon Leakage List)
CSCF – Cross Sectoral Correction Factor applied to entitlements that year (due to there not being sufficient allowances)
 
For this to hold there would have to be very substantial pass-through of the import tax into ETS product prices. Whether world supply curves can be assumed to be so elastic across all the relevant markets in the EU would need to be examined.
 
Alternatively, reimbursements might be 'reverse engineered' to reflect the EU market premium for the product in question due to the import adjustment:
 
                                                                  Reimbursable Emissions = ET x PTF x [AEI – (CLEF x PB x CSCF)]
 
 
ET – Export Tonnage
PTF – Pass Through Factor (i.e. the percentage of the import tax passed on into the EU price per tonne of product)
AEI – Average Emissions Intensity for the product in question in the EU (CO2e/t)
CLEF – Carbon Leakage Exposure Factor (currently 1 for sectors on the Carbon Leakage List)
PB – Product Benchmark used in the EU ETS for the product in question (CO2e/t)
CSCF – Cross Sectoral Correction Factor applied to entitlements that year (due to there not being sufficient allowances)
 
How PTF would be determined, and whether modulating reimbursements according to PTF would be consistent with assessments of carbon leakage risk, would need further consideration (as would the implications of retaliatory tariffs from major economies).

Exemption

As an alternative to reimbursement, emissions associated with exported production could be exempted from the obligation to surrender EUAs up to benchmark level per tonne not covered by allocation. Exporters could be rewarded with EUAs from a pot under the cap if their compliance emissions were lower than their exemptible emissions due to outperforming the benchmark.
 
                                                                        Exemptible Emissions = ET x [PB – (CLEF x PB x CSCF)]
 
ET – Export Tonnage
PB – Product Benchmark used in the EU ETS for the product in question (CO2e/t)
CLEF – Carbon Leakage Exposure Factor (currently 1 for sectors on the Carbon Leakage List)
CSCF – Cross Sectoral Correction Factor applied to entitlements that year (due to there not being sufficient allowances)
 
Like the reimbursement system, this would expose exporters fully to the carbon price signal with respect to emissions intensity but reduce their carbon costs. It would also abate (or reverse) the carbon price signal with respect to production decisions, thereby providing carbon leakage protection.
 
The same issues may present themselves in terms of forgoing ETS revenues and subsidising exports, but perhaps less directly by virtue of the adjustment not being administered in money. Similarly, the provision of subsidy could be avoided by not allowing Exemptible Emissions to exceed compliance emissions or by setting a more stringent benchmark.
 
Likewise, the same market distortion issues would need consideration, with the possibility of defining Exemptible Emissions to reflect pass-through of the import tax into ETS product prices.
 
In terms of how exemption differs from reimbursement, it has the disadvantage of requiring the ETS cap to be redefined (due to the exclusion of some territorial emissions) and would potentially cause a greater divergence in the cash flow situation of installations selling in the EU and those exporting. But it has the advantage of not having to provide a reimbursement based on a carbon price that may differ from the one paid to meet compliance.

Free allocation
 
Rather than providing an export adjustment, free allocation could be retained for exports (subject to review in relation to international carbon pricing) while phasing it out for other production. Allocations in this instance would be calculated using exported production levels rather than total production levels. 

Providing dynamic allocation would expose exporters to the carbon price signal with respect to emissions intensity, while reducing their carbon costs and abating (or reversing) the carbon price signal with respect to production (thereby providing carbon leakage protection). This would broadly raise the same issues as an exemption, but would not require a redefinition of the ETS cap.

Providing non-dynamic allocation, on the other hand, might help mitigate risks of market distortion, because domestic producers would not be rewarded with free allowances if they were to switch from selling in the EU to exporting. But it would come at the cost of creating windfall profits for contracting exporters and could not really claim to provide carbon leakage protection, insofar as it would not abate the carbon price signal with respect to production decisions.
 
Conclusions
 
A basic CBA for imports is relatively straightforward to design and could theoretically replace free allocation as a means of establishing a level playing field for EU producers selling in the EU. This transition could even be automated through inclusion of the CLEF and CSCF in the calculation of Chargeable Emissions.
 
This would not provide an alternative to free allocation for exporters, however, so an export adjustment would also have to be offered (or free allocation retained for exporters) if the system was to replace the current one.
 
A tandem system of this sort would face myriad political and legal obstacles and have complex implications for the domestic market, creating different conditions for installations selling in the EU and those exporting. Whether the benefits over the current system warrant dealing with the challenges would have to be carefully considered.
 
An import-only adjustment administered as a complement to the free allocation system, could strengthen carbon leakage protection at home and encourage emissions reduction abroad. It might also promote international carbon pricing, whether implemented or just threatened. But if such a scheme is introduced with the ultimate intention of replacing free allocation, it could be a wolf in sheep’s clothing for exporting installations.

For further information, please contact damien.green@perspectiveclimate.com