Assessing Different European Carbon Border Adjustment Mechanism Implementations and Their Impact on Trade Partners

The European Union (EU) aims to reduce net greenhouse gas emissions by at least 55% by 2030, relative to 1990. The reach of this ambitious goal relies largely on the reform and extension of the EU Emissions Trading System (ETS). Under an ETS, a limited volume of emission permits is auctioned or freely allocated to emitters and then traded on a dedicated market. The resulting emission price penalizes carbon-intensive production and incentivizes the adoption of low-carbon technologies. However, higher costs for industries subject to an ETS may lead to a relocation of carbon-intensive industries to countries with less stringent climate policies. In order to minimize such “carbon leakage”, the EU ETS currently entails free allowances: a limited amount of emission permits allocated to sectors particularly exposed to carbon leakage (emission-intensive and trade-exposed sectors—EITE), to avoid competitiveness distortion for EU producers on both the domestic and export markets. However, free allowances are criticized for hindering the EU ETS by reducing the emission reduction ambition in EITE sectors and are incompatible with the EU target of net-zero emissions by 2050.

As part of the “Fit for 55” policy package, the EU will gradually replace the free allowances by a Carbon Border Adjustment Mechanism (CBAM). This CBAM will apply the price prevailing on emission allowances within the EU ETS to emissions released to produce commodities imported to the EU, unless a comparable emission price is already enforced in the exporting country. Export rebates are also currently discussed to refund allowance costs for products exported from the EU. While a CBAM without export rebates would level the playing field within the EU domestic market only, export rebates would ensure that the competitiveness of EU production on the world market can be maintained.

Beyond producers and consumers within the EU, such an EU CBAM will affect other economic actors along international supply chains. Numerical analyses have shown that, even though the EU CBAM could in principle motivate emissions reduction abroad, key EU trade partners could as well retaliate with trade sanctions. Understanding how the EU emission price is channeled to other countries is therefore crucial to increase acceptance of the CBAM by EU trade partners and to avoid repercussions on the global climate cooperation. Previous studies have analyzed the effect of an EU CBAM on the EU’s major trade partners, but little is known about the exposure of middle- and low-income countries as they are usually modeled at a low level of detail. Yet, research at the sub-regional level has shown that the distributional effects of an EU CBAM might exhibit a broad variation depending on local conditions.

We contribute to this literature by developing an analytical framework that allows numerically assessing the emission coverage of different EU CBAM implementations and their effects on the EU’s trade partners with a high spatial resolution. For that purpose, we use a throughflow-based accounting technique that allows us comprehensively tracking the CO₂ emissions caused by all the supply chains starting from, going through, and ending in the EU and apply it on highly-detailed economic network data from 2016. This approach enables estimating the pressure that an EU CBAM would impose on individual countries through direct and indirect trade dependencies, before any dynamic trade adjustments. Even though such trade adjustments might be changing the final effect of the CBAM, modelling them usually requires major assumptions on model parameters, a reduction of the regional resolution and a decrease in the tractability of the model. Here, by using simple assumptions, we complement such dynamic approaches by transparently estimating the drivers of these dynamic effects. Furthermore, we provide an assessment of the exposure of middle- and low-income countries to the EU CBAM that is missing in the current literature.

The structure of the paper is as follows. First, we assess the coverage of several implementations of an EU CBAM based on different assumptions of products and scopes coverage. Second, we use a hypothetical Comprehensive CBAM (CCBAM) that covers all emissions generated by producing imports to the EU as a benchmark for evaluating the multilateral effects of the EU CBAM: we explore conceptually through which channels carbon pricing within the EU affects its trade partners and empirically identify the countries that would likely be the most affected by an EU CCBAM. Third, we propose compensating schemes for an international recycling of the revenues of such an EU CCBAM to make it inclusive toward the most vulnerable countries. In the final section, we discuss the limitations of our approach, the robustness of our findings and their implications for policymaking.

Our results show that the coverage of the current EU CBAM proposal is relatively modest compared to the total emissions caused by all EU imports, and that this incomplete coverage might limit the efficiency of the EU CBAM. Even with conservative implementation options, we find that some low- and middle-income countries dependent on the EU for their exports would be disproportionally affected by the EU CBAM, as a large share of their domestic emissions would be covered by the EU emission price. Finally, the implementation of an inclusive international recycling of the EU CBAM fiscal revenue might increase the acceptability of the EU CBAM globally by mitigating its impacts on the most vulnerable countries, but its implementation will require balancing the conflicting interests of the EU trade partners.