What are carbon border adjustments?

Carbon border adjustments are known by many different names, including border carbon adjustments or border tax adjustments, but they all aim to achieve the same objectives: Address differences in the domestic climate policies, and the resulting emissions intensity of production, between trading partners. By accounting for these differences in climate ambition and emissions from the production of goods, carbon border adjustments are designed to protect industrial competitiveness and avoid shifting production — and emissions — to countries with dirtier processes or weaker environmental standards, which is known as carbon leakage.

Carbon leakage entails a geographic shift of production between countries without any net benefit to global greenhouse gas emissions, either through shifts in investment patterns, loss of market share for domestic industries to more emissions-intensive trading partners, or changes in energy markets that result in greater global emissions. While no significant carbon leakage has occurred to date, it remains a concern of policymakers for some emissions-intensive industries in countries with ambitious climate policies.

Carbon border adjustments apply fees on imported goods based on their emissions content and can also include rebates or exemptions from domestic policies for domestic producers that export their goods to markets abroad, especially to countries with laxer climate policies. As carbon border adjustments have typically been discussed, the price an importer would pay would be aligned with the domestic carbon price, but recent discussions in the United States envision an implicit carbon price based on a range of regulatory and other policies.

Some observers have raised concerns that carbon border adjustments could amount to disguised protectionism, and they involve unsettled issues of trade policy that, if not carefully designed, could provoke disputes in the World Trade Organization (WTO). Carbon border adjustments are also sometimes criticized as incompatible with the (UNFCCC), particularly Article 3.5, which forbids measures that constitute “arbitrary or unjustifiable discrimination” or serve as a “disguised restriction on international trade”. International observers have also expressed concerns that border adjustments can stifle multilateral climate efforts through the UNFCCC. No jurisdiction has yet put in place a carbon border adjustment, but interest is growing among policymakers. The EU is seriously considering a proposed CBAM, Canada has issued a request for information on such an approach, the United Kingdom’s parliament has initiated an inquiry, and California applies a mechanism resembling a border adjustment on imported electricity under its cap-and-trade program.

EU’s proposed carbon border adjustment mechanism

In July 2021, the European Commission released a package of proposals to help the EU achieve its updated climate targets of reducing net greenhouse gas emissions 55 percent below 1990 levels by 2030 and becoming carbon neutral by 2050. The proposals include establishing a CBAM that would put a carbon price on imports of covered goods to ensure that ambitious climate action in Europe does not lead to carbon leakage. It also aims to encourage industry outside the EU to take steps in the same direction to reduce emissions. Revenues from the CBAM would go towards the EU’s general budget.

Under the proposal, the CBAM would be introduced in a transitional period from 2023 to 2025. During this period, a reporting system would apply to importers of covered goods to facilitate a smooth rollout of the program, gather data, and to facilitate dialogue with non-EU countries. Starting in 2026, the CBAM would become fully operational, and importers would start paying a financial adjustment. As the CBAM phases in, the free allowances under the EU ETS for sectors covered by the CBAM would be phased out. The goal is to transition from a system of free allowances to the CBAM to ensure no discrimination between domestic and imported goods or between imported goods from different countries. The fee that importers face would be reduced to reflect the value of free allowances until the phaseout is completed.

The CBAM would initially cover goods from sectors at high risk of carbon leakage: cement, iron and steel, aluminum, and fertilizers. The proposal would also cover electricity generation, given increasing interconnectivity with the EU’s more emissions-intensive neighbors, such Ukraine, Turkey, and countries in North Africa and the Balkans. Before the end of the transitional period, the CBAM could be extended to cover other goods.

Under the program, importers would be required to purchase certificates equal to the total embedded emissions of the covered good each year. The price of the CBAM certificate would be based on the weekly average auction price of EU ETS allowances. If a non-EU producer can show that they already paid a price for carbon emitted during production of the imported good, then that price could be deducted for the importer.

Importers would calculate the embedded emissions of their goods according to established EU methodologies and would need to independently verify their calculations. Embedded emissions (expressed in metric tons of carbon dioxide equivalent) are the direct emissions released during the production of goods. The method for calculating embedded emissions will vary by the type and complexity of good. If the actual direct emissions data is not available, then importers will be allowed to use default values for determining embedded emissions in the good. Where feasible, default values for goods will be set at the average emission intensity of each exporting country and for each covered good except for electricity. Actual emissions data could only be used under narrow circumstances for electricity because of technical and market challenges.

The default value for electricity will be based on the best available data determining the average emissions factor in metric tons of carbon dioxide per megawatt-hour of price-setting sources in the non-EU country, group of non-EU countries, or region within a non-EU country. By the end of 2025, the European Commission will evaluate the CBAM system and determine whether to include calculations of indirect emissions from purchased electricity and heat. Indirect emissions from transportation are not expected to be considered for coverage during this review, which likely reflects the administrative complexity they would introduce and concerns about WTO compatibility, since the EU ETS does not cover transportation.

Certain non-EU countries who participate in the EU ETS or have an emissions trading program linked with the EU ETS will be excluded from the CBAM system. In addition, the EU can negotiate agreements with other countries that could be considered an alternative to application of the CBAM.

The commission’s proposal is currently being reviewed by the European Parliament, which, along with the Council of the EU, negotiates final legislative packages. The final legislation could therefore change from the commission’s initial proposal, including changes to the sectors covered under the CBAM and other key facets of its design.

U.S. interest in border adjustments and tariffs

U.S. discussions around border adjustments have focused on domestic efforts. In July 2021, Senate Democrats announced that their $3.5 trillion in Fiscal Year 2022 budget reconciliation instructions would include a carbon border adjustment. The instructions were made public on the same day the EU released its CBAM proposal. Democrats called the timing coincidental but argued the United States and EU must work together to put pressure on China and other heavy polluting countries to reduce emissions.

Following the release of the budget reconciliation instructions, Sen. Chris Coons (D-Del.) and Rep. Scott Peters (D-Calif.) introduced the Fair, Affordable, Innovative, and Resilient (FAIR) Transition and Competition Act (S. 2378 and H.R. 4534, 117th Congress) that would establish a border carbon adjustment. Their proposal would levy a fee on imported goods, initially covering a set of energy-intensive, trade-exposed industrial goods (e.g., iron, steel, aluminum, cement) and fossil fuels (e.g., natural gas, petroleum, and coal) to protect U.S. companies and reduce global emissions.

The fee would be based on the domestic environmental cost incurred in the production of the good or fuel. Federal agencies would determine the domestic environmental cost based on the average cost incurred by domestic companies in each covered sector to comply with any federal, state, regional, or local law, regulation, policy, or program that is designed to reduce emissions. The proposed border adjustment exempts least developed countries and does not exempt countries that impose a border adjustment on U.S. exports.

In August 2021, as part of a reconciliation package, Senate Democrats issued a budget resolution that included a “Carbon Polluter Import Fee.” For Senate Democrats, the inclusion of a carbon import fee was politically tied to the fate of including a carbon tax in budget reconciliation. With the prospects of including a carbon tax in budget reconciliation diminished, some Democrats and aligned groups have suggested that the Biden administration already has the executive authority to implement a form of carbon border adjustments (i.e., carbon import tariff).

Advocates of this approach argue that President Biden could implement a tariff based on carbon emissions under Section 232 of the Trade Act of 1962, which allows the president to restrict imports of goods critical to national security. For instance, President Donald Trump used Sec. 232 to place tariffs on steel and aluminum and to create negotiating leverage for other goods. Recent Sec. 232 tariff agreements provide an indication of how the Biden administration is looking to advance carbon-based trade policies to encourage domestic manufacture of clean steel and aluminum while at the same time aligning global trade with climate goals.

In October 2021, the United States and the EU reached an agreement to lift tariffs on each other’s steel and aluminum exports. The United States will lift tariffs on a certain amount of EU-produced metals imported into the United States, and the EU will pause its retaliatory tariffs. The United States and the EU plan to replace these tariffs with the first carbon-based sectoral arrangement on steel and aluminum trade by 2024. Details have yet to be worked out, but the expectation is that both jurisdictions would align efforts to place import tariffs based on emissions criteria (e.g., emission intensity of products). It is unclear at this stage what implications an U.S.-EU sectoral arrangement would have for U.S. steel and aluminum exports to the EU that are covered under the CBAM. The arrangement would be open to any country interested in joining that meets criteria for restoring market orientation and reducing trade in high-emissions steel and aluminum products.

Following the EU agreement, in February 2022, the United States and Japan reached an agreement to allow historically-based, sustainable volumes of steel imports from Japan. Both countries also agreed to enter discussions on global steel and aluminum arrangements to address both market overcapacity as well as the carbon intensity of the steel and aluminum industries. The agreement includes conferring on methodologies for calculating steel and aluminum carbon intensity and sharing emissions data.

In the U.S. context, a key design issue concerns whether and how a border adjustment could be implemented in the absence of a federal price on carbon. The Biden administration has acknowledged the difficulty in calculating the environmental cost without an explicit carbon price. However, Biden economic and climate advisors have argued that the technical challenge of basing a border adjustment on an implicit carbon price is not insurmountable, encouraging further research on methodologies, and that the implicit price created through the U.S. policy mix can be harmonized with explicit carbon prices abroad.

A related issue is whether a border adjustment could be implemented without any additional federal policies at all. Some observers argue that a carbon tariff could be based purely on differences in emission intensity. However, some policymakers and analysts raise concerns that such an approach, in the absence of regulatory policies to justify it, would be seen as protectionist and as an arbitrary and impermissible violation of the core WTO principles of nondiscrimination and national treatment.

There is also growing interest among Republicans in a border adjustment. In December 2021, Senator Cramer of North Dakota wrote an op-ed with former national security advisor H.R. McMaster arguing that a transatlantic climate and trade initiative would reduce emissions, increase energy security, and reduce Russia’s power to use energy to coerce Europe. The initiative could include a joint trade mechanism between the United States and EU that would levy a common carbon fee on imported goods. Cramer and McMaster argue that a carbon border fee would be far more damaging to the Russian economy than sanctions since the lifecycle greenhouse gas emissions of Russia’s fossil fuel exports to Europe are about 40 percent higher per unit of energy than U.S. shipments of liquefied natural gas. Cramer does not support linking a border adjustment to an explicit domestic carbon price.