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Demystifying carbon border adjustment for Europe’s green deal

From carbon leakage to “green protectionism”, the European Green Deal envisioned by the incoming Commission has many critics. But some adjustments to the deal could make domestic manufacturers more carbon efficient while simultaneously encouraging foreign producers to become more environmentally friendly.

By: Date: October 31, 2019 Topic: Energy & Climate

European Commission President-Elect Ursula von der Leyen has made a strong plea to accelerate Europe’s transition to a “green” economy with the goal of achieving ambitious targets of reduction of greenhouse gas (GHG) emissions by 2030 and a reduction to zero net emissions by 2050. A central element in achieving this transition is to put a significant price on all GHG emissions that will incentive producers and consumers to switch to less green-house gas-intensive alternatives. But if domestic producers were taxed heavily on their emissions, they would be put at a disadvantage to foreign producers. The president-elect, in line with a group of more than 3000 distinguished American economists, has therefore proposed to introduce border carbon adjustment. But this proposal has been heavily criticised from various angles. In this blog post, I first discuss the problem before exploring the three main criticisms. Finally, I sketch a way forward.

Toying with the problem

Taxing domestic producers on their GHG emissions  without taxing foreign producers would disadvantage domestic production. The incentive for consumers would be to continue buying the same products but shift to suppliers from abroad instead of switching to more efficient domestic producers.

Imagine a plastic toy. Suppose there are two toy producers in the EU. One (A) uses an efficient production process and therefore only emits 1kg of CO2 while the other (B) needs 2kg to produce the same toy. There is also a third producer (C) in a country outside of the EU that provides the same toy with 3kg of CO2. Finally, there is an efficient foreign producer (D) that also needs only 1kg. Suppose the price of the four toys is equivalent to 10 euros. Consumers will be indifferent to the four toys based on the price and will choose the toy that they like most for its colour or other characteristics.

Now suppose the EU introduces a tax of 1 euro per kg of CO2, but only on the domestic producers (this would be a very high price but for sake of simplicity, I use that. The described logic fully applies also at lower prices, for example at 100 euro per ton, i.e. 1/10th of the price used here). The result would be the following prices documented in the Table below showing that the foreign producers C&D would gain a significant advantage relative to the two domestic producers. Domestic producer A would gain a price advantage relative to domestic producer B and consumers would be incentivised to shift to A. However, only consumers that have a strong preference for domestic production would continue sticking to A while all others would shift to C&D. Depending on the respective elasticities, the domestic CO2 tax might achieve very little in terms of consumption of CO2 but it would destroy the domestic industry.

The obvious solution to this problem is to introduce a tax that would also apply to the foreign producer. The result is given in the last row and illustrates the power of border carbon adjustment. Dirty producers, domestic or foreign, would be penalised. Producers B and C would have to quickly render their production more efficient or risk losing their EU market share. Meanwhile, producers A and D would both gain market share.

The table nicely illustrates why on first principle grounds, the introduction of a CO2 tax is a powerful instrument to change production patterns. It also shows why first principles require some form of border carbon adjustment if the tax is supposed to be effective in changing the consumption of CO2 and not just in shifting production abroad. Obviously, moving production abroad would not only be bad for domestic industries but also be bad for the climate in that the relevant global greenhouse gas emissions would barely change with the introduction of the EU tax. In contrast, a tax combined with some form of border adjustment would not only reduce domestic CO2 consumption in the EU but also prevent carbon leakage. It would also provide a strong incentive —due to the big size of the EU market to foreign producers —to innovate and update their production processes. Over time, these efficiencies would also reduce CO2 consumption in third countries, in which there is no tax on CO2. Finally, the Border Carbon Adjustment (BCA) would also relieve the domestic producers of the tax when they export abroad. The BCA would provide a tax rebate for those exported goods so that in the foreign market, the domestic producers would not be put at a disadvantage.

The strength of the described effects, i.e. the amount of carbon leakage, obviously depends on the price of carbon, the amount of carbon content in the respective products and the elasticities of demand to price changes. All three are a matter of empirical research. For some products, the respective numbers may be such that border carbon adjustment is irrelevant. But those products would likely also be the products for which the carbon content is rather low, thereby making them less of a problem for climate policy. Or put differently, to the extent that the carbon price will matter in decarbonising, it will also matter in putting a wedge between domestic and foreign producers in the absence of BCA.

Three criticisms of border carbon adjustment

There are three fundamental critiques of border carbon adjustment:

The first criticism is that emerging economies would be put at a disadvantage and will therefore oppose the EU’s BCA. This argument is undoubtedly wrong in theory but may be right in practice. The table above illustrates that the argument is wrong in theory. Foreign producer D is not put at a disadvantage to domestic producer A. The relative price of their products does not change as a result of the introduction of the BCA. On the contrary, only introducing a domestic tax would have been putting the emerging market producer at an unfair advantage relative to the domestic producer. In practice, however, the argument may still be right, in that emerging market industrial processes might be less efficient than domestic ones.  On a practical level, this will lead to opposition from emerging markets to the EU introducing such a measure. But as argued above, the point of introducing the BCA is also to provide incentives to producers elsewhere to make their production more efficient.

The second criticism is that BCA would not be compatible with the WTO and be a form of green protectionism. This criticism is discussed in some detail by my colleagues Horn and Sapir. In my view, there are two main replies to this critique. The first is that WTO compatibility depends on the precise design of BCA. A well designed BCA can be made WTO compatible. The second and more fundamental reply is that even if BCA was not WTO compatible, it may still be the right political choice to introduce BCA. The EU is a strong advocate of the global multilateral and rules-based trading system. However, it is a political choice whether it is more important to support the WTO or to achieve ambitious reductions in GHG emissions. If there were to be a trade-off between the two and the global multilateral rules-based system were incompatible with achieving the necessary reductions in GHG emissions, couldn’t and shouldn’t even the EU’s choice be to pursue the latter? Of course, the ideal solution would be to make the BCA WTO compatible, which is possible asargued by Jennifer Hillman, a former WTO appellate body judge.

The third, and perhaps most pertinent criticism of BCA is that it is practically unfeasible. The core of that practical argument is that it is relatively easy to measure the emissions domestically while it is difficult or even impossible to measure them in third countries. Domestically, the factory would be fully taxed based on the amount of all CO2 emitted, which is relatively easy to measure as one can measure the input into the production of cement, chemicals, electricity etc…  Should one ask foreign producers to report on their emissions? Who would verify those reports? How deep into the value chain is one looking? Where did a car producer buy its steel? From which power plant did the electricity for a ton of steel come from? Could one find an international treaty framework establishing standards of measurement? Should there be a form of carbon rating measuring and confirm the CO2 content of all products in the world? So how could one tax the foreign producer according to its true emissions?

A related criticism is that there might be retaliation from our trade partners, including from the US and China, even if the measure is WTO compliant and even if objectively there will be no discrimination of foreign producers. Trade partners may still see a BCA as an “extraterritorial overreach”. The corresponding negotiations could be lengthy and complicated and a big worry is that a lot of time and political capital will have to be spent with possibly little effective result in the end. So politically, the question is whether the EU is ready to have very tough negotiations.

Towards a practical solution?

A practical way to design BCA could be a form of a GHG value-added tax. In other words, for every product sold in the EU, a tax would be levied depending on the amount of GHG that was needed to produce that product (I do not discuss here the issue that tax authority in EU is decentralised and the complex interactions between a GHG tax and the emission trading system). The fundamental question is how one would establish the GHG content of the product. Since there are millions of different products, this is a significant challenge. It would essentially require every producer to not only establish a price for every product sold but to record the CO2 content of its production. The pretty detailed description that every product already contains would also have to be complemented with a clear number of the amount of GHG that was emitted in producing that product. It would be on that number that the tax is applied.

Domestically, such a system appears burdensome but not overly burdensome. Our toy producers A and B would have to record all emissions during the year needed to produce the toys and would have to divide it by the number of toys produced. The public authorities that already do occasional quality checks on the products would also randomly check compliance with the overall emission reporting. If the numbers reported significantly diverge from the amount of CO2 emitted, the producer would be liable to pay a fine. In fact, the EU could use standardised norms such as ISO 14067 that have been created to measure the carbon footprint of products (see details)

Such a system would be burdensome, subject to fraud and less efficient than taxing production directly. However, it would make it possible to address the problem of carbon leakage. Foreign producers could automatically be treated like the least efficient domestic producer unless they prove to be better. In our example, the domestic authorities would, by default, tax toy C and toy D as if they were produced by producer B, i.e. with 2kg of CO2. This tax would be grossly unfair on producer D and be overly generous to producer C. Such a BCA would amount to protectionism of domestic industry and unduly penalise producer D while subsidising producer C.

One would, therefore, have to establish a way for the foreign producers to report their carbon content in the same way as domestic producers. The efficient foreign producer D would have a strong incentive to do so. They will be ready to collaborate with domestic authorities (just as foreign producers are willing to collaborate with domestic authorities in proving that their toy is safe to use etc). One could imagine that such a strong price mechanism would then give rise to private agencies (carbon rating agencies) that monitor compliance and accuracy of reporting. In fact, there are already numerous consultancies that provide such services. One often mentioned criticism is that that would be unfair to small and medium-sized companies relative to big companies. To address this criticism, one could even agree that the EU would pay the price of certification.

Concluding remarks

The purpose of this post was to demystify the debate on BCA, debunk some false beliefs and trigger debate on the way forward. The practical problem of solving BCA is substantial and likely to keep the Commission and the EU busy for some time to come. It is an important empirical question, how important carbon leakage is in practice, but for the EU with its strong reliance on industrial production and exports, carbon leakage is likely to be of relevance. If a carbon tax is supposed to change behaviour, then it is likely that leakage will also be a problem – but more empirical research here would be welcome. BCA therefore rightly figures prominently in the Commission’s agenda

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