CBAM: Climate Change Savior or Protectionist Ploy?

While the EU carbon price recently broke the symbolic threshold of 100 euros per ton, China’s carbon market has been hovering at around seven euros per ton. This huge discrepancy creates an advantage for non-EU exporters as they don’t need to bear the high price for carbon emissions. The price disparity pushes companies to move production to countries with lax climate policies and lower emission costs. Analysts have termed the phenomenon “carbon leakage,” and it rings alarm bells for European production. Currently, the EU tries to prevent leakage and solidify their emission reduction efforts by giving out free allowances to industries with high leakage risks.

Now, the EU is going to levy tariffs on imports from every country, spearheading a highly controversial climate action once again. After negotiations in December 2022, all parties in the EU decided to impose a Carbon Border Adjustment Mechanism (CBAM), which will initially apply to imports of certain goods and selected precursors whose production is carbon intensive. The first phase will address imports that have the most significant risk of carbon leakage: cement, iron, steel, aluminum, fertilizers, electricity, and hydrogen. EU importers must pay for emissions by buying CBAM certificates. The policy is set to take effect in 2026, with a transitional phase starting October 1, 2023.

During the 30th BASIC (Brazil, South Africa, India and China) Ministerial Meeting on Climate Change, ministers made a joint statement expressing grave concern about this unilateral border adjustment. They say CBAM will negatively impact the countries that don’t take sufficient steps to limit greenhouse gas emissions. The policy has thus attracted criticisms of protectionism and discrimination. It sounds like CBAM is helping the EU further procure benefits through trade protectionism and safeguarding domestic businesses, but is it really that simple?

Beyond troubling exporters to the EU, CBAM targets EU member emitters that are behaving irresponsibly as well. The new measurement does not mean the companies in EU will enjoy double protection. Rather, CBAM will gradually phase out free carbon allowances by the end of 2033, a strategically crucial part of this policy considering outsized free allowances have failed to unleash the emission reduction potential. The EU will collect the bulk of additional revenues obtained through CBAM via a more mobile EU-ETS (Emission Trade System) without free allowances holding it back. Effectively, the EU will no longer allow industries to take advantage of free allowances instead of investing in reduction measures. The EU should focus on CBAM’s substitutional effect for free allowances to counter the resistance in diplomatic negotiations. Viewed this way, CBAM is not protectionism but rather a meticulous yet ambitious policy that could potentially have huge benefits in mitigating climate change.

But what about the influence on global exporters? While CBAM has gained tremendous attention, providing an external monetary incentive to level the carbon price for emissions reduction, it is less powerful for global trade than it might appear. CBAM carries a far greater psychological impact on policymakers than an economic one. For example, for China, estimates based on the current proposal show that the affected proportion of EU exports will be less than 2%. Nevertheless, countries that are attempting to establish their own domestic carbon markets can feel the effect everywhere. It is sure to drive broader action, given the two signals sent by CBAM.

The first one is for investors. Climate policies are no longer domestic, as shareholders now must extend their considerations across the entire value chain. The three-year countdown demands swift responses from industry leaders to be better positioned for the adjustment. CBAM bypasses diplomatic hurdles and directs a clear signal to investors and the masses: low-carbon transformation is inevitable.

The other is for policymakers. The carbon price is vital. The trade sector will immediately feel the difference in the emission cost between the EU and domestic markets. The entry of various industries into the domestic emission trading system is far more effective than solely imposing stringent carbon emission restrictions on key industries. China, for instance, is establishing an emission accounting system and a standard for emission-intensive industrial enterprises to complete a general framework this year. CBAM would help speed up this process.

Globally, countries will potentially adopt border adjustment gradually. But the potential risk is that large trading partners, such as Russia and China, could introduce countermeasures and set up tariffs independently. With the widespread voices of doubt, the EU can take several actions to assist other countries to enhance their readiness for the forthcoming CBAM implementation. The EU should offer technical assistance to developing and least developed countries to help them prepare for the implementation of CBAM. The EU must publish detailed plans for implementing these actions. Legislative amendments should also be put in place to allow for swift responses to unforeseen circumstances and to limit any measures taken to a specific time frame. Additionally, the EU should continue to provide financial support through their budget to promote climate mitigation and adaptation in these countries, including decarbonization efforts in manufacturing, and help them adapt to new regulatory requirements. The comprehensive roll out plans must outline specific timelines, milestones, and measurable objectives to ensure transparency and accountability. Furthermore, to counter the resistance in diplomatic negotiations, the EU should concentrate on the substitutional effect of CBAM as a replacement for free allowances.

Admittedly, CBAM may not exert a huge influence on global trade in the short term, not as much as climate change itself. However, it serves as a powerful tool to effect financial incentives for climate action. With the earth warming at an unprecedented rate, CBAM brings the commensurate sense of urgency to the imminent existential threat that rapid climate change poses. If carried out properly, the global dialogue could strengthen bilateral economic relations and accelerate the global climate transition. But the balance is tricky and relies on fair design. While doubts may still exist, with CBAM on track, a price on carbon emissions will no longer require lengthy, tit-for-tat diplomatic negotiations.