66 Finance & economics The Economist July 17th 2021
At thecoalfaceofclimate policy
W
hen the European Union established its capandtrade
scheme for pricing carbon emissions in 2005 it faced a tricky
design problem. Making polluting firms buy permits puts them at
a disadvantage in global markets. Companies might respond to
the scheme by moving their dirty activities offshore, causing “car
bon leakage”. And if producers in places with lax environmental
standards outcompeted European firms, global emissions would
go up. The eusolved the problem by offering subsidies and free
pollution permits to some dirty industries exposed to trade.
Those handouts, however, have always had a target on their
back. On July 14th euofficials set out a plan to phase them out and
replace them with a “carbon borderadjustment mechanism”
(cbam). Between 2025 and 2035, producers of aluminium, cement,
fertilisers and steel will gradually lose their subsidies. But import
ers of these goods will have to buy a new category of pollution per
mit. How many they need will depend on the amount of carbon es
timated to have been emitted during the production of the goods.
The policy is in effect a tariff, intended to compensate for the fact
that foreign firms may face no carbon price, or one that is lower
than Europe’s.
The switch will please those who suspect that subsidies have
blunted the impact of carbon prices. In theory free permits do not
affect the incentive to reduce emissions, because at the margin the
financial reward for doing so is the same: firms that get greener
can sell their surplus entitlements. In practice the freebies have
sapped ambition. Michael Grubb of University College London
points out that companies know that if they sell their permits to
day, they might receive fewer handouts in future. Compared with
the industries that have received support, the power sector, which
has not, has decarbonised more quickly. Victoria Irving of Morgan
Stanley, a bank, says that some subsidised polluters have made
green investments, but “they have a long way to go”. Withdrawing
the subsidies without a new scheme would bring back the danger
of leakage.
Officials estimate that by 2030 the cbamand the suite of envi
ronmental policies announced alongside it will reduce emissions
in the affected sectors by 14%, compared with a scenario in which
nothing changes. However, imports would be 12% lower, becausetariffsdepresstrade. Though totemic, the scheme’s scope is rela
tively small. It would raise about €9bn in revenues in 2030 (al
though that figure may nearly double once the policy is fully
phased in). The carbon embodied in trade flows is typically less
than 10% of countries’ total emissions, according to the imf,and
the proposal covers only a handful of sectors. In 2019 the imports
in question were worth only €29bn ($33bn, or 1.5% of total trade in
goods for the bloc).
Tariffs do not have to be large, however, to provoke a response.
Perhaps it will be a good one: with the cbamin place, foreign coun
tries might as well price carbon at home and keep the revenue for
themselves (the euwill grant discounts for carbon taxes already
paid). As the scope of the cbamincreases, so will other govern
ments feel a greater pull towards pricing emissions. A more likely
consequence, however, is a brawl over whether the policy is pro
tectionist. Australia and India, both exporters to the eu, are alrea
dy grumbling that the tariff could be discriminatory and regres
sive. In March America warned the euthat border levies should be
a “last resort”. It has also said it is considering one of its own de
spite not pricing carbon itself, other than through an incomplete
patchwork of state schemes in which prices are too low.
There is also a danger of unintended consequences. Foreign
companies could redirect their greenest exports to Europe and
send their dirtiest output elsewhere, rather than cutting overall
emissions. This phenomenon, dubbed “resource shuffling”, has
troubled California, which has a cbamfor its electricity market—
the only existing comparable scheme. Firms could also adjust
their supply chains to exploit the limited scope of the policy. A car
maker that would have to buy permits to import steel may prefer
to buy a car chassis made with steel overseas, to which the cbam
would not apply.
The risk of such carbon leakage rises in tandem with the car
bon price. A study published in January by diwBerlin, a think
tank, found that a price of €75 per tonne would leave as much as
15% of the eu’s manufacturing vulnerable to being undercut in
this way. (European carbon prices are hovering between €5060
per tonne, and projected to increase.) Steel yourself
These problems, however, will be reduced to the extent that car
bon prices are adopted everywhere. The power of incentives
means carbonintensive production will always try to find its way
to where emissions are cheap, but that does not mean it is futile to
try to plug all the holes. The best argument for the cbamis that it is
a first step towards a world in which emissions cannot escape car
bon prices. Were they sufficiently widespread, the cbamwould be
rendered unnecessary.
Long before that happens, though, the eumust overcome op
position to the cbamat home. One problem is that trade will be ad
justed on the way in but not on the way out. Exporters, having lost
their subsidies, will still find themselves competing in markets
outside Europe’s borders against firms that can ignore the cost of
carbon. (Around 8% of the eu’s cement production, and 18% of
steel, is exported.) Already some lawmakers in the European Par
liament, which must approve the proposal, are calling for border
adjustment to exist alongside free permits, punishing foreigners
while continuing to shield those at home. Bowing to them would
turn a potentially usefulpolicyfor fighting climate change into
naked protectionism—andaninstructive example for other coun
tries into a cautionary tale.nFree exchange
Could the eu’s proposed carbon tariff on imports prove an example to others?