The EU Carbon Border Adjustment Mechanism. What does it mean for the rest of the world?

The EU’s Carbon Border Adjustment Mechanism (CBAM), which takes effect on October 1, 2023, is a key element of the EU’s climate policy, designed to prevent carbon leakage. However, it also has wider implications for EU external trade with the rest of the world.

Balancing EU Climate and Trade Policy

The EU’s Carbon Border Adjustment Mechanism (CBAM) is a new tool to avoid carbon leakage. It aims to put a fair price on the carbon emitted during the production of carbon-intensive goods entering the EU to encourage cleaner industrial production in non-EU countries.

It will enter into force in its transitional phase on October 1, 2023. CBAM will initially apply to imports of certain goods and selected precursors whose production is carbon intensive and at the most significant risk of carbon leakage: cement, iron and steel, aluminium, fertilisers, electricity, and hydrogen. However, it will be gradually extended to more products.

The gradual introduction of CBAM is coordinated with the phase-out of the allocation of free allowances under the EU Emissions Trading System (ETS) to support the decarbonisation of EU industry.

CBAM is a key element of the EU’s Green Deal climate strategy. However, it also has wider implications for EU external trade. Imports from non-EU countries that produce emissions will be subject to a CO2 tax equal to the EU’s carbon price.

This will further increase the price of products that generate high emissions in the EU. Against this background, we discuss some of the implications and challenges of CBAM for EU trade, especially with its neighbourhood, the U.S. and China.

European carbon price affects all economies

Since 2005, many economic activities in the EU are subject to a greenhouse gas emissions trading scheme (EU-ETS). Under this scheme, buyers must purchase CO2 certificates in order to generate emissions – thus, these certificates are comparable to “emissions allowances”. The price for these certificates has risen noticeably in the last two years.

When carbon prices rise in the EU, this makes all goods that produce emissions more expensive. Hence, the demand for these products declines, and thus, real gross domestic product (GDP) declines as well.

In the summer of 2021, we published a study carried out by the Kiel Institute for the World Economy. The study simulated the consequences of increasing the carbon price of the EU by 50 US dollars. The resulting GDP losses are particularly large in the Eastern European EU countries (Latvia, Poland, Bulgaria). The reason is that these economies are more emission-intensive than in the rest of the EU.

GDP reductions are even higher in countries outside the EU that supply fossil energy to the EU (Azerbaijan, Kazakhstan, Norway and Russia, for example). They suffer from lower exports to the EU.

And there is another, more positive, consequence for countries outside the EU: Higher EU carbon prices reduce the international competitiveness of European companies. Hence, some countries outside the EU can increase their exports to countries that now still buy European products. Among others, some Asian economies achieve a slightly higher GDP, for example, Taiwan, Thailand, Cambodia and, to a very small extent, Japan and China.

GDP affects small, sectoral effects much larger

Looking at the entire economy, the impact of the European carbon price on GDP is relatively small in all countries. Even the biggest GDP losses are only 0.5 per cent.

The situation is different if we look at individual sectors. In the study on a higher EU carbon price mentioned earlier, for example, the result is that in some EU countries, there are production losses of 60 to even 100 per cent in the gas, coal and oil sectors. In the rest of the world, sectoral effects also turn out to be higher than GDP changes.

In addition to economic consequences, the European carbon price has an impact on greenhouse gas emissions – in the EU, but also in the rest of the world.

Carbon Leakage requires CBAM

If emission-producing activities become more expensive in the EU, the incentive to relocate these activities to countries that have no carbon price at all – or only a very low carbon price – increases. In the EU, this leads to lower emissions. However, emissions are increasing in the rest of the world. In the worst case, this carbon leakage can even be so large that global emissions increase on balance.

CBAM is the EU’s attempt to avoid carbon leakage. It means that goods produced outside the EU and sold in the EU will be subject to a carbon import tax. The sum to be paid is based on the amount of emissions related to the production of the imported product and the current carbon price in the EU.

During the transitional reporting-only period starting on October 1, 2023, affected companies will not yet have to pay any money. This initial phase is intended to facilitate a smooth rollout of CBAM and allow for an open dialogue between reporting companies and EU officials. However, once the permanent system takes effect on January 1, 2026, importers will have to start paying the carbon price for imports into the EU.

General consequence of CBAM

If products imported by the EU are also subject to a carbon price, there are more products worldwide whose prices will increase. Rising prices reduce the demand for consumer goods. And companies adjust to this lower demand.

Therefore, global GDP decreases more than it would in the case of a European carbon price without CBAM. This is good for the climate because, under given technological production conditions, there are fewer greenhouse gas emissions than without CBAM.

Of course, CBAM also has economic consequences for countries outside the EU. The economic impact of a higher carbon price combined with CBAM affects non-EU economies differently.

Impact of CBAM on China’s economy

China has criticised the planned introduction of CBAM, although Chinese companies are only marginally affected by the initial transition period.  Chinese officials are framing the measure as unfair to Global South countries with lower historical emissions or as a protectionist measure.

What effects on EU foreign trade with China can be expected? Due to the carbon price for products imported by the EU, China is likely to reduce its exports of emission-intensive products to Europe.

But there is also one positive effect for China: Higher EU carbon prices reduce the international competitiveness of European companies. Hence, China will be able to increase its exports to some countries that now still buy European products.

Even in the case of an EU carbon price plus CBAM, GDP of China will not decline. This is probably due to the fact that lower Chinese exports to the EU are compensated by higher exports to third countries.

Impact of CBAM on the U.S. economy

There are concerns in the U.S. that CBAM will be an unfair burden on U.S. companies, especially since the U.S. does not have a carbon-pricing system.

In principle, the effects of a European carbon price with CBAM on U.S. GDP are hardly noticeable for the U.S., according to the study published in 2021. The simulations calculate a loss of 0.016 per cent.

Even for particularly emissions-intensive products such as coal, oil and gas, production in the US declines by only one to three per cent. The reason for this is in our opinion that transport costs for these products are relatively high. Hence, the EU tends to import these products from countries closer to the EU.

Basically, the more distant a country is from the EU, the smaller the negative economic effects of higher greenhouse gas prices in the EU, including with CBAM. Conversely, this means that the European neighbour countries suffer the most from both climate protection instruments of the EU.

Impact of CBAM on EU neighbour countries

The European neighbour countries are closely linked economically with the EU. Declining export opportunities for their companies, therefore, hit these economies disproportionately hard.

In general, the European neighbour countries that still produce with climate-damaging technologies suffer the most from CBAM. The quantity of goods that these countries can sell to the EU declines. The net revenue per product unit declines, too, because part of the carbon taxes has to be covered by the companies.

And these countries have an additional disadvantage. EU countries receive revenues from the carbon price and from CBAM. They can redistribute these revenues back to consumers and companies, thus increasing consumer demand and investment demand within the EU.

The non-EU countries have no revenues from CBAM. Hence, they also lack the financial resources to compensate for shrinking exports to the EU by strengthening domestic demand.

Implications for EU Economic Policy

Higher carbon prices in the EU and its foreign trade flanked by CBAM have partly negative economic effects on countries outside the EU. Negative economic effects are likely to meet with resistance abroad. Two aspects, in particular, should be taken into account.

The EU claims that CBAM is compatible with WTO rules. In principle, it can be assumed that a carbon tax on imported products is compatible with the rules of international trade. Article XX of the “General Agreement on Tariffs and Trade” allows such measures, inter alia, if it is „necessary to protect human, animal or plant life or health“.

Nevertheless, it cannot be ruled out that individual countries in the rest of the world will not share this view and file a complaint with the WTO. The EU should prepare itself for this. And in the event of a conflict, it should speak with one voice and not allow itself to be divided.

Second, it is precisely the negative economic effects on the European neighbour countries that are problematic. Especially in times of increasing geopolitical tensions, it would be wise to bind these states more closely to the EU. Economic disadvantages resulting from the necessary EU climate protection policy are counterproductive.

Therefore, it would make sense for the EU to use at least parts of its CBAM revenues as transfers to these countries. If these funds are linked to the expectation that they will be used for the ecological transformation of the EU’s neighbouring countries, this will not only help the climate. The companies in these countries can then produce with fewer emissions. And that makes it easier for them to sell their products in the EU despite CBAM.

Independently of this, the EU should try to promote the establishment of a climate club. In this club, several countries agree on a common carbon price that is as high as possible. As an incentive to participate in this club, its members can freely exchange goods among themselves.

In other words, they form a free trade zone. Countries that do not join the club can only trade with its members if they pay a tariff. The EU is already such a climate club, which could be expanded.

About the author

Thieß Petersen is Senior Advisor at the Bertelsmann Stiftung, specializing in macro-economic studies and economics. His focus lies on the causes and effects of financial and economic crises as well as the chances and risks of globalization. Among others, he has recently worked on the effects of carbon pricing and the benefits of a potential global climate club.

Peter Walkenhorst is Senior Project Manager in Bertelsmann Stiftung’s Europe’s Future Program, where he works on transatlantic relations and European-Chinese relations. Previously, he was a member of the foundation’s Germany and Asia Program, responsible for projects on the systemic conflict with China and social cohesion in Asia. 

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