The European Union’s Carbon Border Adjustment Mechanism: Challenges and Perspectives

Abstract

This report uses an economic lens to analyze the Carbon Border Adjustment Mechanism (CBAM) which is currently under discussion at the European Union (EU). The CBAM, which is set to replace free allowances for specific ETS sectors after a transition period, aims to address carbon leakage and preserve the competitiveness of industries participating in the EU ETS. Although the two policy instruments share the same goals, their economic impacts differ. On the one hand, free allowances level the playing field both within the EU and on international markets by reducing the cost of the EU ETS for firms. European firms have an incentive to reduce their carbon emissions even if they obtain a certain part of their allowances for free. On the other hand, the CBAM levels the playing field only within the EU unless it is complemented with export rebates (such as benchmark-free allowances on exported production). However, the CBAM incentivizes not only European firms but also foreign firms to reduce their carbon emissions when exporting to the EU. Furthermore, unlike free allowances, the CBAM is more consistent with the polluter-pays principle. The CBAM calls for product-based pricing of embedded carbon emissions equivalent to the manufacturing plant-based pricing of the EU ETS. The shift of the pricing base requires choices to be made on the economic sectors to target, the scope of emissions, the adjustments to be made for firmspecific carbon intensity and to country-specific carbon pricing. The pros and cons of those choices are discussed. The CBAM will generate substantial revenues which can be used to foster and smooth out decarbonization. The CBAM differs substantially from the Climate Club that has been proposed by the Nobel Prize winner, William Nordhaus, for extending carbon pricing worldwide. Yet, by allowing importers to pay only the carbon price difference between the CBAM jurisdiction and the manufacturing country, the CBAM also incentivizes countries to implement their own carbon price.

Reference

Stefan Ambec, “The European Union’s Carbon Border Adjustment Mechanism: Challenges and Perspectives”, TSE Working Paper, n. 22-1365, September 2022.