The EU is accelerating its climate ambition over the coming decade to support its 2050 long-term strategy of reaching net-zero greenhouse gas (GHG) emissions. Key aspects of this acceleration include raising its emissions reduction target from 40 per cent to at least 55 per cent below 1990 levels by 2030 and implementing a sweeping set of policy changes – especially to its flagship emissions trading system (ETS) which puts a price on pollution by requiring companies to purchase allowances for their emissions.
The costs of the allowances have skyrocketed recently and now hovers around record levels of €50 per tonne of carbon dioxide equivalent or above. This is due – at least in part – to those participating in the market expecting a tighter supply of allowances as the EU increases its climate targets. Prices are expected to continue rising over the coming decade as the EU implements its ambitious climate agenda.
These concerns about rising allowance prices have motivated the most controversial aspect of the EU’s 2030 climate agenda – a charge on imported goods based on their carbon content. The carbon border adjustment mechanism (CBAM) would be the world’s first system of carbon tariffs, and aims to address the risk of ‘carbon leakage’, whereby EU firms either lose market share at home to more emissions-intensive competitors abroad, or have to shift production to places with little or no carbon pricing.
Carbon leakage undermines global climate efforts because it offloads emissions elsewhere with no net reduction overall. Although little evidence currently exists that it happens, there are good reasons why it has not measurably come to pass and why the decade ahead presents greater risks.
The EU – as with other places which price carbon emissions such as the UK – has protected certain domestic industries facing international competition by awarding them allowances for free to offset carbon costs. But this system of free allocation becomes limited as climate targets increase and the supply of allowances dwindles, and it also weakens incentives to reduce emissions domestically.
With the CBAM, the EU signals its transition away from free allocation in favour of a system of leakage protection that instead tries to create a level playing field between goods produced domestically and those from abroad – which could also better spur investment in climate mitigation. The European Commission recently released a proposal outlining how the CBAM will work, although changes are likely during the legal process which involves both the EU Parliament and Council.
The CBAM is expected to apply to a list of imported products from a narrow set of industrial sectors which are both emissions intensive and highly-traded, making them more vulnerable to the risk of carbon leakage – cement, iron and steel, aluminium, and fertilizers. Electricity is also included given the rising imports and interconnections with the EU’s more emissions-intensive neighbours, and more industrial sectors such as chemicals and refineries will likely be added later.
The aim is, starting in 2026, importers need to purchase special, non-tradable allowances, or CBAM certificates, each year based on the volume of goods they bring in and the independently-verified emissions content. CBAM certificates will closely mirror the prices of an allowance in the EU ETS, so that the charge importers face largely comes down to their overall volume of imports to the EU, the emissions intensity of the goods where they were produced, and the cost of an EU ETS allowance.
However, importers can reduce their CBAM obligations by using the carbon costs the goods face in the country of origin. Although the precise methodology is yet to be determined, it is likely to encompass only the actual costs from an ETS or carbon tax in the country of origin, which in practice means those incurred beyond any free allocation or exemptions rather than a reduction based on market price alone.
This is crucial for the CBAM to be effective and fair as it will avoid ‘double burdens’ and should incentivise carbon pricing as a clear path to reducing exposure to a carbon tariff. But it is also one of the most controversial aspects of the CBAM because many – especially in developing and emerging economies – see it as forcing climate policy choices onto other countries and undermining the Paris Agreement which relies on individual country commitments based on their own national circumstances. The only countries exempted from the CBAM will be those participating in the EU ETS but not as EU member states and those having linked their own ETS to the EU’s.
Therefore, a key consideration is which countries are the most exposed to the CBAM, which can be analysed by compiling total imports to the EU of the products identified in the five initial CBAM sectors, drawing on data from the United Nations (UN) Comtrade database and taking an annual average from 2015-2019.
Examining the collected trade flow data of the products in the CBAM proposal highlights a few key takeaways. Exports to the EU in CBAM sectors are concentrated among just a few big trading partners with the top two – the Russian Federation and China – accounting for more than one-quarter of trade. With the UK, Turkey, and Norway rounding out the top five, almost half of all exports to the EU in CBAM sectors are covered.
Many of the countries most exposed to the CBAM are also the closest to the EU geographically. Four of the five highest exporters in CBAM sectors – Russia, the UK, Norway, and Turkey – are directly on the EU borders as are six of the top ten. Some of those countries have carbon price levels either at the EU ETS level or close to it, and two of that top ten – Norway and Switzerland – would actually be exempted entirely from the CBAM because of their participation in (Norway) or linkage to (Switzerland since 2020) the EU ETS. A third, the UK, launched its own ETS in 2021 following Brexit, with prices in the opening months roughly comparable with those in the EU (chart).
While the top traders are typically middle- or higher-income countries, some lower-income and least developed countries are also heavily exposed to the CBAM based on their trade in particular sectors. Mozambique is a top exporter of aluminium to the EU, sending more than half its aluminium products covered by the CBAM to the bloc, which comprises seven per cent of its GDP according to the European Commission. For these countries, their vulnerability to the CBAM is especially significant given their greater dependence on these exports as an engine of their economies, and their more limited ability to shoulder compliance costs such as emissions monitoring.
The top exporters of CBAM-covered products to the EU which would not be exempted are Russia, China, the UK, and Turkey. A deeper look at each country’s profile shows which sectors are most exposed to the EU CBAM and how domestic carbon pricing schemes – or the lack of them – affect these countries’ payments at the EU border.
Each country’s emissions intensity in the CBAM sectors is a significant factor in their vulnerability but as high-quality, comparable data is challenging to obtain – especially at the product level – making direct comparisons should be avoided. The EU aims to address this challenge in part via a three-year transition period from 2023-25 during which importers are required to report the emissions of their products.
Russia exports 7.6 per cent of its CBAM-covered products to the EU. It is the top exporter in the iron and steel and fertiliser sectors and the second highest in aluminium with significant exposure in the electricity sector as well. Although these sectors comprise a relatively small share of the country’s overall exports, several high-ranking Russian officials have expressed concern about the CBAM’s economic impacts and frame it as a unilateral trade restriction.
But other leading officials have responded to the EU CBAM by calling for Russia’s first domestic carbon pricing scheme to mitigate impacts of the mechanism on the Russian economy. This proposal came to fruition in early 2021 when Russia approved a pilot ETS in Sakhalin – a region abundant in fossil fuels – with hopes to begin trading in July 2022.
Russia intends to model its new domestic system closely on the EU ETS to ensure its recognition by the EU, and is also expanding efforts to monitor emissions nationwide with a proposed climate bill planned to enter into force in 2022 which will require companies emitting above a certain threshold of greenhouse gases to report their emissions output.
China faces the greatest exposure to the EU CBAM in its iron and steel sector where it is the second-highest exporter for 2015-19 as well as the aluminium sector – but the impact of the mechanism on China’s economy may be partially alleviated by domestic carbon pricing instruments.
China has eight regional ETS pilots, most launched between 2013-14, covering almost all iron and steel and aluminium enterprises in those jurisdictions. In 2021, China’s national ETS began operation, regulating more than 2,200 power companies and covering around 40 per cent of China’s carbon emissions in its initial phase. The national ETS is also likely to expand to include iron and steel and aluminium during China’s 14th Five-Year-Plan (2021-25), increasing the number of installations facing a carbon price.
Although advancing rapidly in carbon pricing, China’s prices remain significantly lower than the EU ETS. Average 2020 allowance prices in China’s regional ETSs ranged from $3.28 to $12.62, in contrast to average EU secondary spot prices of $28.28 – and this price differential has widened as EU ETS allowance prices soared in 2021.
Such differentials call into question how much China’s carbon pricing instruments will shield it from the EU CBAM, but China only exports 1.6 per cent of its CBAM-covered goods to the EU so even relatively high EU border payments may not have a significant impact on the Chinese economy in the early phases.
The UK exports only 2.9 per cent of its CBAM-covered products to the EU with the iron and steel sector facing the greatest exposure as it exports an average of $3.9 billion to the EU annually. The UK is also a top exporter of fertilizers and aluminium to the EU.
However, the UK’s own ETS which replaced the UK’s participation in the EU ETS significantly softens the blow of the CBAM to the UK economy. Unlike China, the system’s price levels are high enough to blunt the CBAM but there remain numerous uncertainties going forward.
The UK ETS’s current design largely mirrors the EU ETS and has so far delivered carbon prices comparable to the EU with UK allowance clearing prices during the first two auctions only slightly exceeding the EU. The UK has also advanced far in decarbonizing its power sector in part through a minimum price since 2013 – coinciding with a period of low carbon prices in the EU ETS – that is now set at USD $25.16. This is significant in reducing CBAM exposure for UK electricity exports, and for indirect emissions from industrial materials stemming from their electricity consumption, although the CBAM may not cover indirect emissions initially.
As the UK ETS is not directly linked to the EU ETS, it cannot be exempted from the CBAM and so avoiding vulnerability depends on maintaining similar price levels and market design. For instance, the UK has its own system of free allocation and, if this system is maintained as the EU transitions away from free allocation, UK industries will increasingly face greater exposure to the CBAM since their actual carbon costs will begin to diverge significantly from EU competitors. Given its close trading ties with the EU, the UK will continue to be among the most exposed trading partners as the CBAM expands to new sectors – exports to the EU account for almost half the value of the UK’s total goods exports.
Relative to other major exporters to the EU, the UK retains a significant competitive advantage owing to its advanced carbon pricing instruments, and both the EU and the UK have expressed interest in exploring linking their markets which would then exempt the UK from the CBAM. The UK has also expressed interest in a CBAM of its own since it faces similar challenges to the EU with industrial competitiveness in the face of significant carbon prices.
Although Turkey does not currently have any domestic carbon pricing schemes in place, since 2012 it has been exploring the possibility to help achieve mitigation targets. With the legal and institutional framework for an ETS already in place, Turkey is a candidate to accede to the EU and is working to fulfil relevant environmental obligations. But with its lack of a domestic carbon price, the EU CBAM looms large.
Cement is generally a less traded industrial material owing to its high weight-to-value ratio, but Turkey is by far the largest exporter of it to the EU, accounting for almost 30 per cent of CBAM-covered products in the sector. Turkey is also a major iron and steel exporter to the EU.
Turkey’s exports of CBAM-covered products to the EU account for 6.2 per cent of its overall exports to the bloc, but this share is likely to increase significantly with the addition of more sectors. Both the Turkish public and private sectors are working closely with the European Bank for Reconstruction and Development to develop a domestic carbon market to shield it from the EU’s upcoming border measures.
The analysis shows initial impacts of the CBAM are likely to be concentrated among a relatively small number of major trading partners, many just outside EU borders. Even for these countries, the CBAM share of trade in the covered sectors is small, especially compared to their overall exports to the EU and the rest of the world.
This will certainly increase as the CBAM adds new sectors, but whether the CBAM ever reaches the point where it extends to complex manufactured goods such as machinery or a wide array of consumer products remains a distant, and perhaps unlikely, prospect. Concerns about carbon leakage dissipate with each step along the product value chain beyond the basic industrial materials, and carbon pricing is already developing worldwide – especially among the EU’s neighbours – albeit more slowly than is optimal for the EU or global climate efforts.
Some advances in carbon pricing among EU trading partners may spring directly, or at least in part, from the CBAM, and its effectiveness will be judged by many on this controversial aspect – even though the instrument is aimed at supporting the EU’s climate efforts rather than to be a weapon for imposing policies on trading partners.
The EU’s CBAM may also galvanize discussion on the relationship between climate and trade policy, both between individual countries and multilateral bodies such as G20 and the World Trade Organization (WTO). And these are discussions the world needs to have as countries forge their own paths to climate neutrality, as the policies they will rely on to get there must ensure ambitions are recognized and increasingly aligned in a common effort to address this century’s most pressing challenge.