Agreement on international climate tariffs seems beyond reach at the moment but could be the answer

Against the background of global warming and climate change, a reduction in emissions of CO2 and other greenhouse gases is essential. A classic economic policy instrument for this is higher taxes on CO2 emissions. If, however, not all countries increase the price of CO2, the economies that have a carbon tax will lose their international competitiveness. A fiscal border adjustment or climate tariff can counteract this risk.

Climate crisis due to market failure

Markets bring supply and demand together and – in the theoretical ideal case – ensure the optimal use of existing scarce resources. Functional markets require, among other things, prices that include all costs of economic activities. However, CO2 emissions cause additional costs to society that are not included in market prices. (Carbon dioxide emissions are representative of all climate-damaging greenhouse gases here.)

The main causes of CO2 emissions are the burning of fossil fuels (oil, coal, gas) and the destruction of forests. The price that consumers pay for products resulting from these activities is too low compared to the actual costs incurred. A low price usually leads to high demand. The result is a systematic overuse of natural resources. It leads to an increase in the carbon dioxide content of the atmosphere, which leads to global warming with considerable negative consequences.

Social cost of carbon dioxide

What is the price we would have to pay for the emission of one tonne of CO2 to cover all costs? The answer to this question depends on numerous influencing factors. A climate model must be used to calculate the impact of additional CO2 emissions on global warming and climate change.

  1. Then damages resulting from climate change have to be identified. One can think of an increase in weather extremes (heat waves­, droughts, storms, floods), a deterioration in health, and direct deaths. The economic consequences are, for example, crop losses due to water shortages, storms, and floods, as well as damage to property and infrastructure.
  2. Finally, this damage must be expressed in monetary units. If a house is destroyed by a hurricane, the repair costs can be calculated. But how should heat-related deaths, islands that have sunk due to rising sea levels or extinct animal and plant species be assessed in monetary terms? And what about losses that will come show up in 15 or 20 years?

Each of these three steps is associated with considerable uncertainties, making estimates of the additional costs of CO2 emissions vary widely:

  • Ricke, Drouet, Caldeira, and Tavoni calculate a median value one tonne of CO2 of around 400 US dollars for a globally applicable price – though carbon costs by country vary between 10 and 1,000 US dollars, per their calculations.
  • In a survey of economists and climate scientists in 2016, the average value of the social costs of a ton of CO2 was around 290 US dollars. The economists estimated these costs at an average of 173 US dollars lower than the climate scientists
  • The High-Level Commission on Carbon Prices published a report in May 2017  which stated: “… the explicit carbon-price level consistent with achieving the Paris temperature target is at least US$40–80/tCO2 by 2020 and US$50–100/tCO2 by 2030, provided a supportive policy environment is in place. “

Against the background of this uncertainty alone, it is understandable that an agreement on a global CO2 price is not realistic. For the foreseeable future, therefore, social costs will only be priced into the price of carbon only at the national level. This could result in considerable economic and ecological risks.

Loss of competitiveness and carbon leakage

If a country raises the price of greenhouse gas emissions on its own, this means higher production costs for domestic companies reducing the international competitiveness of these companies. Production and employment then decline, and citizens’ incomes fall.

At the same time, a carbon tax provides an incentive to outsource the production of energy-intensive products to countries where there is no or only a low CO2 price. This approach, carbon leakage, can lead to an actual increase in the global volume of greenhouse gas emissions ( If, for example, a German company relocates energy-intensive production steps to Australia and uses the original technology there, the emissions caused by transporting the goods from Australia to Germany are ]added to the emissions from production.

However, to maintain the international competitiveness of domestic companies and to avoid carbon leakage, the state can also introduce a so-called border tax adjustment.

Functioning of the border adjustment tax/climate duty

A border adjustment tax concept is based on the international regulations on value-added tax. This tax is levied in the country in which the purchase is made. If a German car company sells a car in the USA, the VAT is only incurred when the vehicle is purchased in the USA – and at the American VAT rate. Transferred to a German CO2 tax (or an EU-wide climate tariff), this means the following (see Fig. 2):

  • If a German company exports steel to the USA, no carbon tax is payable on the CO2 consumption associated with car production.
  • Products exported from the USA to Germany have a price advantage because American producers are not subject to a CO2 tax. To compensate for this, imports from the USA are subject to a CO2 tax in Germany. The amount of this compensation tax would have to be based on the amount of CO2 produced in the USA. If the German tax authorities do not know about this amount, they can work with the amount of CO2 that an average German company generates in the production of the product in question.

Effects of border adjustment taxes

Such a measure is designed to compensate for the price disadvantages of domestic companies. The international competitiveness of the companies is thus ensured – both on export markets abroad and at home. An increase in energy and resource consumption associated with carbon leakage can be avoided.

In the medium and long term, a higher price for non-renewable resources at home will create an incentive to push ahead with resource-saving technological progress and so increase resource productivity. For companies that succeed in doing so, this results in an improvement in their international competitiveness. They can, therefore, increase their production and employment.

Investments to adapt production facilities to changed technology result in increasing investment demand. The companies involved in adapting these plants also see an increase in production and employment.

Around the world, there is a growing incentive to use more low-carbon technologies. As a result, the products of foreign companies remain competitive in countries that levy a carbon tax.

However, this instrument is not entirely unproblematic. Generally, it should be compatible with the principles of the World Trade Organization (WTO), because domestic and foreign companies are treated equally – all companies must pay the CO2 tax. Nevertheless, some voices see a climate tariff as a discriminatory trade barrier. And so the implementation of this instrument has so far been prevented, partly because of its incompatibility with WTO rules.

And even if WTO compatibility exists, there is no guarantee that the trading partners concerned share this assessment. On the contrary, it is quite conceivable that important trading partners will classify this approach as an unjustified distortion of competition and therefore respond with punitive tariffs.

Nevertheless, higher prices for climate-damaging emissions are unavoidable to mitigate global warming and climate change. The demand of Nobel Prize winner William Nordhaus “nations must establish policies that raise the price of CO2, and other greenhouse-gas emissions” must, therefore, be endorsed.