With the European Green Deal, the European Union (EU) has committed to being climate neutral by 2050. The recent “Fit for 55 package” is a first step towards this goal and specifies how the EU wants to reduce greenhouse gases by 55 percent from 1990 levels by 2030. Carbon pricing will play an important role.

The plan is to tighten the targets for the EU emissions trading system (EU-ETS) covering the energy sector and energy-intensive industries and introducing a second trading scheme for transport and buildings.

With these steps and the already high EU-ETS carbon price of 50€/tCO2 or more, the question of how to avoid carbon leakage, from the relocation of energy-intensive industries and its emissions abroad, and how to shield EU industry from the adverse competitiveness effects on becomes more pressing.

It has been long known that the best way to do that would be an international carbon price – if not globally, then at least in a club with major trading partners, in particular the USA and China. Our recent study by the Kiel Institute undertaken for the Bertelsmann Foundation stressed this.

Climate policy in a larger set of countries would, of course, benefit the global environment the most. If only the EU implemented a carbon price of 50$/tCO2 on all its carbon emissions, this would reduce global emissions by merely 2.5 percent compared to 38. 6 percent for a global carbon price. A club of only the EU, the USA, and China would result in 20% reductions.

While unilateral EU actions would assume that around 15 percent of the reduced emissions are just shifted abroad, a joint carbon price with the EU, the USA, and China reduces this leakage rate to less than 4 percent.

Unfortunately, such a climate club is not easy to put together. In China, national emissions trading has at least started this year. But, the Chinese trading system is still immature, covers only the electricity sector, and its carbon price is very low. It is not likely that the system will become comparable to the EU-ETS before 2030.

In the US, national carbon pricing is not even on the agenda. The planned technological and investment support cannot avoid carbon leakage as there are no absolute emission limits, and competitiveness and leakage effects are not prevented.

So far, the EU has addressed the leakage effects of its unilateral climate policy through the free allocation of emissions allowances. This is not efficient, though, and increasingly less possible with decreasing emission allowance budgets.

An instrument that has received a lot of attention and that the EU commission actually plans to implement is border carbon adjustment (BCA). This levies a carbon price on the carbon content of imported goods and, in its “full” version, also refunds the carbon costs of exporters. Together these will level the playing field in international trade.

Theoretically, a full BCA has the potential to reduce carbon leakage significantly. In our study, for a 50$tCO2 price in the EU only, BCA reduces leakage to around a third with a leakage rate of 9.5 percent. Yet, it does not reduce leakage to zero and leads to only a very few additional global emission reductions. Furthermore, this theoretically elegant and effective instrument to reduce carbon leakage entails many problems and risks in practice.

The recording of emissions along value chains is difficult and associated with costs. A trade-law compliant design is only possible if the reimbursement of costs from EU exporters is waived. Regardless, introducing a border adjustment is likely to evoke reluctance from important trading partners such as China and the USA. Finally, the share of additionally captured emissions is less than 1% of global emissions, and the necessary simplified calculations based on benchmarks reduce incentives for climate protection abroad.

With these drawbacks, it would be better to limit BCA and only implement it as part of a climate club. If in such a climate club – say with the USA, Great Britain and China to start – countries agree on a minimum level of climate protection in the form of CO2 prices or equivalent regulation, dispense with border adjustment measures between these countries while implementing harmonized border adjustments vis-à-vis third countries it could encourage other countries to join the club.

However, the EU is determined to implement BCA independent of any club. The plans are already too far advanced to refrain from doing so without a general loss of credibility in climate policy. If one accepts that the EU will introduce BCA as a given, one can at least acknowledge that the sketched design is pragmatic and largely in line with scientific recommendations.

The plans at last open the door to climate clubs and provide for CO2 prices to be credited abroad and for bilateral agreements to be concluded that exempt countries from border adjustment. This creates initial incentives to introduce CO2 pricing comparable to the EU.  Finally, it is, in the end, an empirical question of whether the theoretical advantages of BCA or the likely practical problems dominate so that at least one will be able to learn from the EU experiment.

Altogether, the discussion about carbon leakage due to unilateral European climate policy must gain momentum. For acceptance and the effectiveness of higher CO2 prices in Europe, it is necessary that emissions are not simply shifted to other countries and that CO2-intensive goods are not just increasingly imported.

Yet, border adjustment is not the silver bullet, and it is not unlikely that it will entail higher costs than benefits even though the EU commission does many things right in its envisioned design. The goal must be to apply this bureaucratic and error-prone instrument to the lowest possible import volumes and make it a building block, not a stumbling block, to effective global climate protection.

Bertelsmann Stiftung (Hrsg.) Hendrik Mahlkow, Joschka Wanner, Gabriel Felbermayr, Sonja Peterson. EU-Klimapolitik, Klimaclubs und CO2-Grenzausgleich. https://www.bertelsmann-stiftung.de/de/publikationen/publikation/did/eu-klimapolitik-klimaclubs-und-co2-grenzausgleich