Climate Protection and Industry Support – Why the EU’s CBAM is not Sufficient

The negotiations at this year’s UN Climate Change Conference (COP27) showed that the EU must lead the way in climate protection and cannot rely on other countries to follow at the same pace. But globally differing climate policy efforts increase the risk that companies will relocate their CO2-intensive activities from the EU to third countries with less stringent climate policies.

To protect against this so-called carbon leakage, the EU plans to introduce a Carbon Border Adjustment Mechanism (CBAM). The mechanism requires importers from outside the EU to pay the same CO₂ price on the emissions generated during the production process as EU producers. But CBAM is controversial in terms of climate and trade policy and is not sufficient to support the industry given the challenges ahead.

Carbon leakage works via different channels

In general, carbon leakage refers to the shift of CO₂ emissions to third countries with less strict climate policies. Ambitious national climate policy measures result in higher CO₂ costs for domestic companies compared to their foreign competitors. There are several channels for carbon leakage:

• Price channel: When CO₂ emissions are more expensive in one country, the domestic demand for fossil fuels falls. This puts downward pressure on world market prices for fossil energy and creates incentives in countries with less stringent climate policies to increase demand for fossil fuels. As a result, the CO₂ emissions in these countries increase.
• Output channel: Higher national CO₂ prices in one country imply rising production costs for domestic firms. Foreign competitors, however, are not subject to these additional costs and therefore gain international competitiveness. Consequently, the production of emission-intensive goods abroad increases while it decreases domestically. With this, foreign CO₂ emissions also increase.
• Investment channel: The level of the domestic CO₂ price also affects companies’ investment decisions. If climate policies in third countries are advantageous from a company’s point of view, the firm may decrease its domestic investment, increase foreign direct investment, or even relocate entire production facilities abroad. This again leads to an increase in CO₂ emissions abroad.

In the EU, domestic industrial production is already generally less emission-intensive than in competing third countries. If European production is now replaced by more CO₂-intensive foreign production, overall global CO₂ emissions will increase.

Free allocation of emission allowances protects EU industry from carbon leakage

Under the EU Emissions Trading Scheme (EU ETS), the free allocation of emission allowances is intended to reduce the risk of emissions and production being shifted abroad. To date, most allowances in the EU ETS have been allocated free of charge. Since 2013, the number of free allowances has been decreasing but companies in CO₂-intensive sectors with high trading intensity still generously receive free allowances.

With its more ambitious climate targets, the EU can no longer maintain the system of free allocation. The free allocation of allowances weakens the CO₂ price signal and the incentives for low-carbon and energy-efficient production.

The CBAM is supposed to combine climate and industry protection

But unilaterally higher CO₂ prices in the EU ETS can increase the likelihood and extent of carbon leakage. To prevent this, the CBAM is intended to offset cost differences between EU products that fall under the EU ETS CO₂ price and goods from third countries which are subject to lower or no CO₂ prices.

Under the CBAM, importers are required to buy CBAM certificates to ensure that the imported goods are subject to the same CO₂ price as European products. The goal is to:

• Achieve the full climate protecting effect of the CO₂ price by eliminating the free allocation.
• Provide incentives for climate-friendly production abroad by applying the CO₂ price to imports.
• Protect EU industry from foreign competition by aligning the CO₂ price level between domestic and imported products.

The treatment of exports remains the big controversy

If and how exports of European producers to the rest of the world can be taken into account in the CBAM is a highly controversial political and legal issue. In an ideal border tax adjustment, the domestic CO₂ tax is added to imports and rebated for exports.

Currently, the EU Commission proposes a CBAM without cost refunds for exports. Accordingly, EU exporters would remain at a disadvantage in international competition or even face a double cost burden if they are to pay the EU ETS CO₂ price on their production and the CBAM price on imported inputs.

Export rebates are the political and legal pitfall of the CBAM

Thus, industry players are strongly demanding a regulation including rebates or refunds for exports under CBAM to protect the EU industry. Non-EU countries are an important market for European companies in the emission-intensive steel, aluminum and fertilizer sectors: in 2019, nearly 30 percent of all aluminum exports and one-fifth of all steel and fertilizer exports were shipped to countries outside the EU.

However, export rebates are hardly enforceable internationally. They threaten trade conflicts with potentially large economic damage. After all, it is very likely that export rebates will be considered a discriminatory and thus prohibited subsidy under WTO law since they favor exports relative to (domestic or foreign) goods for the EU domestic market.

Subsidies and international cooperation are needed

As an incomplete mechanism with enormous international conflict potential, the CBAM can by no means be a silver bullet for the multiple challenges the EU industry faces. Rather, it can protect the EU’s domestic markets from cheap, emission-intensive imports.

But to further protect EU industry and to accelerate emission reductions in the industrial sector, subsidies should complement CO₂ price and CBAM. Financial support for decarbonization, for research and development, and as insurance against innovation risks are key instruments for reducing companies’ cost burden of rising CO₂ prices.

Additionally, subsidies can protect EU companies against strong international competition, secure transformation risks, and establish competitiveness between (still) expensive climate-friendly domestic technologies and the (often at present) cheaper conventional production at home and abroad.

However, subsidies also come with challenges in implementation. On the one hand extensive subsidies are, at least in the short run, a significant burden on the state budget and politically controversial. On the other hand, they can trigger international trade conflicts as trade partners might see themselves at a disadvantage due to heavy subsidization of European firms.

Finally, international cooperation on climate and trade policy issues remains important – regardless of differing climate policy approaches and ambitions. Against this background, the concrete design of the CBAM should be carefully considered by the EU, as trade conflicts with important global partners might also undermine common climate policy interests.

Sara Holzmann

Sara Holzmann is Project Manager in the Sustainable Social Market Economy program at the Bertelsmann Stiftung. She works on issues of environmental economics and climate policy in the context of the transition to a climate-neutral society and economy.

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