Some thoughts on the CBAM debate

The European Union’s Carbon Border Adjustment Mechanism (CBAM) seeks to put a fair price on carbon emissions during the production of carbon-intensive goods entering the EU, to encourage green manufacturing in non-EU countries. 

By confirming that a price has been paid for the embedded carbon emissions generated in the production of certain goods imported into the EU, the CBAM will ensure the carbon price of imports is equivalent to the carbon price of domestic production, and that the EU's climate objectives are not undermined… CBAM will apply in its definitive regime from 2026, while the current transitional phase lasts between 2023 and 2026… On 1 October 2023, the CBAM entered into application in its transitional phase, with the first reporting period for importers ending 31 January 2024… The CBAM will initially apply to imports of certain goods and selected precursors whose production is carbon intensive and at most significant risk of carbon leakage: cement, iron and steel, aluminium, fertilisers, electricity and hydrogen. With this enlarged scope, CBAM will eventually – when fully phased in – capture more than 50% of the emissions in ETS covered sectors. The objective of the transitional period is to serve as a pilot and learning period for all stakeholders (importers, producers and authorities) and to collect useful information on embedded emissions to refine the methodology for the definitive period.

During this period, importers of goods in the scope of the new rules will only have to report greenhouse gas emissions (GHG) embedded in their imports (direct and indirect emissions), without the need to buy and surrender certificates… The Implementing Regulation on reporting requirements and methodology provides for some flexibility when it comes to the values used to calculate embedded emissions on imports during the transitional phase. Until the end of 2024, companies will have the choice of reporting in three ways: (a) full reporting according to the new methodology (EU method); (b) reporting based on an equivalent method (three options); and (c) reporting based on default reference values (only until July 2024). As of 1 January 2025, only the EU method will be accepted and estimates (including default values) can only be used for complex goods if these estimations represent less than 20% of the total embedded emissions… The Commission has also developed dedicated IT tools to help importers perform and report these calculations, as well as in-depth guidance, training materials and tutorials to support businesses in this transitional phase.

And the CBAM is only likely to expand downstream in the coming years.

CBAM is itself a spur to innovative production. In its current form, it will secure an EU market for low-carbon steel and aluminium, cement, fertiliser, hydrogen and electricity. The efforts EU companies are making in green steel, for example, could become competitive with domestic “dirty” steel given the EU’s high domestic carbon tax, but would be undercut by carbon-intensive imports in the absence of an emissions-linked border levy. But by creating a market for low-carbon products in these sectors, CBAM also undermines the market for EU products that use those materials as inputs, such as cars. While CBAM protects the level playing field for Europe’s green steel and aluminium producers, downstream manufacturers receive no such protection from imports made with carbon-intensive raw materials or power. What a downstream industry like carmaking should push for, therefore, is to widen the scope of CBAM to cars. This economic logic means CBAM is politically unsustainable in its current form. Once its effects are felt, politicians will face enormous and legitimate pressure to undo the competitive damage experienced by downstream manufacturers such as carmakers. At that point, expanding CBAM to more sectors will be a better policy than reversing it.

The CBAM has generated an intense debate. The Europeans see it as an instrument to expedite the green transition by providing its manufacturers the protection (and level playing field) to undertake innovative low-carbon production. Without such protection, its manufacturers would be uncompetitive against the lower-cost imports from developing countries. 

And there are only too many examples of how industry after industry in advanced countries has been laid low by cheap Chinese imports, riding on the back of lax environmental standards. It’s therefore fair to argue that the CBAM is another negative externality imposed on other developing countries due to China’s heavily subsidised and aggressive export policies. 

But the developing countries view this differently. They see CBAM as a form of protectionism, a non-tariff barrier to discriminate against imports and protect the domestic industry. And they are right in so far as it’s an explicit tax, but to level the playing field for the European manufacturers. And who can fault the European Union for encouraging green production technologies?

It’s well-known that the embedded carbon levels will be higher in the manufacturing imports from developing countries. After all, like low labour costs, less rigorous environmental standards are part and parcel of the competitiveness of developing countries. The CABM is now striking at the heart of this competitiveness. One bloc’s innovation policy becomes discriminatory to another. 

There are no easy ways to resolve this impasse. 

Collectively, the countries of the world are committed to certain shared goals - limiting carbon emissions and expediting green transition, poverty reduction, eradicating child labour and human rights violations, preventing money laundering, eliminating terrorism etc. It’s clear that none of these goals are achievable without global cooperation - all of them suffer from the problem of the tragedy of the commons. 

So how should the comity of nation states prioritise and co-ordinate on these areas of collective action failures? 

The foundational basis of the CBAM is to expedite the green transition. For sure, the EU has every right to define its policy priorities. However the EU’s CBAM policy conflicts with economic growth, productive job creation, and poverty reduction in developing countries. Does the global community want to collectively prioritise green transition over poverty reduction? The discourse must be framed to make the EU and other developed countries confront this dilemma. 

How do we ensure that this (green transition and poverty reduction) is not an either-or choice? Instead, how can it be made mutually inclusive?

One approach would be to work the CBAM policy to permit those kinds of manufacturing techniques that are labour-intensive. Manufacturing techniques in any industry with labour content and domestic value addition (in the exporting developing country) greater than a certain percentage can be permitted with a lower baseline of environmental regulation (or higher carbon emission). While measuring and documenting these are difficult, it’s no more than that required to measure and document embedded carbon in imports. 

Another approach would be to link the CBAM to an emission trading scheme. For example, the EU could allocate carbon credits to developing countries based on some reasonable measure of people living in poverty. Companies from those countries could in turn compete (based on some measure that achieves poverty reduction) to avail their respective country’s carbon credit allocations. This competition can be tailored to enhance firm competitiveness while also achieving poverty reduction. This could be linked to the EU’s commitment to support developing countries reduce their carbon emissions under various global agreements. 

In any case, from the perspective of developing countries, such bargaining with a proposal on the table may be a more effective response than outright rejection of the CBAM policy. The CBAM in some form or another is here to stay and we have to live with it.