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Towards a European carbon adjustment mechanism?

Mounia Mostefaoui

Author: Mounia Mostefaoui, PhD Student at Sorbonne Université
Topic: Climate change, borders, carbon tax, EU, Green New Deal
In this paper, we will discuss about the possibility of a carbon tax at the European frontiers. We will first deliver a brief overview of the definition and context of a European adjustment mechanism.  We will then summarize the outcomes of the recent European Impact Assessment, focusing on two main policy scenarios for the EU beyond the existing cap and trade system. [1]

1. Definition and context
On July 2019, the President of the European Commission, Ursula Von der Leyen, first mentioned that she would set a carbon tax at the frontier to avoid carbon leakages as part of her program for Europe. The European Green New Deal disclosed during COP25 in Madrid set the purpose of a carbon-neutrality for Europe in 2050. In order to reach this ambitious target, a common price for carbon would be necessary among other actions. 
The communication of the Commission regarding the European Green Deal included that a European carbon adjustment mechanism at the frontiers would be set for some sectors to balance discrepancies in the case that the levels of climate ambition worldwide stay constant or decrease while the EU raises its ambition. 
A new mechanism of “Carbon Border Adjustment” (CBA) would, therefore, have the purpose to avoid any risk of carbon leakage in the event of a lack of ambition from the international partners of the EU.
After a preliminary Inception Impact Assessment, the European Commission very recently asked for public feedback regarding its proposal for a directive on a CBA mechanism (between March and April 2020). On April 2020, the European Parliament published a series of four analysis notes that were produced as a result of this public consultation with inputs for the Commission regarding the operational implementation of a CBA with different policy scenarios that we are synthesizing in this paper.
On its consultation webpage, the European Commission indicates that the idea is to implement a legal bill to propose a CBA mechanism, which will take the form of a directive at the horizon of the second trimester of 2021.  
In its Inception Impact Assessment regarding this topic, the European Commission mentions that a CBA would be established on three main foundations:

         1) a legal tool, 
         2) a methodology for the carbon footprint and pricing of imported goods,
         3) and the possibility to restrain the CBA mechanism to selected industries only.
2. The problem of a common price and of “common but differentiated responsibilities”
Efficiently tackling climate change worldwide presupposes the existence of a common price for carbon at the global scale. However, setting-up this ideal common price for carbon faces many obstacles: 
·      The most developed countries have a history of hundreds of years of carbon emissions accumulated overtime for their industrial development. This historical responsibility would imply a bigger effort coming from them, while on the contrary developing countries, that emitted less carbon over time, also argue that they have to ramp up their technical and economic development to efficiently limit their emissions.
·      This refers to the principle of “common but differentiated responsibilities” of the United Nations Framework on Climate Change Convention (UNFCCC).
 The differentiated method also has its inconvenients:
          -       European emissions reductions are too small for a significant impact at the global scale, especially in case the biggest emitters (like China, India, Brazil, the United States) do not reciprocate the reduction efforts. This is called the “free-riding” phenomenon, referring to the paradoxical individual advantage of a single player to simply benefit from the efforts made by the group while not making the effort itself. This situation would retroactively increase the burden for the European Union to reduce global emissions, and negatively affect the European competitiveness in the main emitting sectors and associated markets, so negative economic impacts could be the result of a differentiated approach. 
         -       So, fixing the global issue of climate change requires not only actions from the EU, but also requires the absence of inaction from the rest of the world to avoid a unilateral vain commitment.
3. Presentation of the problem of carbon direct and indirect leakages 
The direct leakage problem is associated with the fact that some European sectors move their activities in places with less taxes, lower employment and/ or production costs. In such a situation, the importation of goods produced in delocalized places outside the EU replaces the internal European production in accounting. However, the emissions worldwide actually remain the same or even increase as this case usually generates additional emissions costs associated with the transportation to EU of goods produced elsewhere.        
The indirect leakage problem refers to the situation of countries reducing their demand in energy from fossil origin and therefore decreasing its price: this induced price reduction paradoxically leads to an incentive for more emissions coming from fossil energy in the countries which aren’t regulated. Globally, this may have the unwanted effect of actually increasing the greenhouse gases (GHG) emissions.
4. Present policy in the European Union
Today, the situation of  the EU is the following:
-       It regulates emissions through the Emission Trading Scheme (ETS) concerning the heat and power generation and the energy-intensive manufacturing sector. The ETS is a cap and trade system, meaning that a limit is set for the amount of some GHG emissions. This cap is decreased with time in order to reduce the total emissions. Under this limit, companies can buy or get emission allowances enabling them to trade those allowances. Capped international credits coming from emission-saving activities may also be bought by companies. The ETS system is valid over all the European Union, plus Iceland, Liechtenstein and Norway. It sets a limit for some GHG for around 11,000 industrial plants and power stations, as well as airline companies delivering flights between the countries for which the ETS operates.
-       Initially, free allowances were given for big industrial emitters to decrease the economic burden of the ETS policy.
-       National members of the EU have their own local carbon tax system essentially for the services sector.
-       Currently, no policy exists regarding the border.
-       The reduction of present emissions is less expensive than the reduction of future ones, which means that a “rational” economic agent on a purely accounting basis has incentives for preferring a high present price of carbon for reaching emission reductions as soon as possible. This preference is actually however conflicting with the question of competitiveness and acceptability regarding the ETS without adjustment of the carbon price at the border, as individual economic agents who are already financially pressurized or even precarious on the short-term prefer to discount the present hoping for a wealthier future, sometimes without even caring for a higher price to pay as the present offer.
The main challenge of an innovative European policy including a carbon tax at the border will be a significant reduction of European emissions with measurable effect, solving the problem of leakage and creating incentives for the non-EU nations to avoid the free-riding phenomenon.
 5. Presentation of two main policy scenarios
            5.1. The scenario of a policy within the EU
                        5.1.1. A carbon taxation based on consumption
A first option would be to consider instruments within the EU border only given the several unknowns regarding a possible international legal regime for carbon taxation. A European consumption-based carbon tax would be applicable for every good regardless of its source. The money collected from this tax would be given back to encourage cleaner production sectors. The main point to address in this scenario would be the acceptability of this tax by the market. The exact redistribution of the collected tax isn’t defined yet and this would be also a key point for a better acceptability by the market to understand how the money is used. The “yellow jacket” protests in France were an example of the damage that a rejection from the market can cause under certain conditions, including a too heavy economic burden on the poorest consumers.
                        5.1.2. A consumption-based tax and free allowances
 This scenario combines the idea of a carbon-based taxation based on consumption as described above, plus the attribution of free allowances, as described by Dixit (1985) [2]. Such a scenario is like a tariff added when the good is imported. The advantage of this option is that it avoids the preference for imported goods that would be less expensive otherwise. However, this scenario doesn’t solve the issue of indirect leakage described above.
            5. 2.  The scenario of a policy at the border
                        5.2.1. A carbon price on imports or Carbon Border Adjustment (CBA)
 The principle of a policy at the border instrument consists of the setting of a carbon price for EU imports, meaning that importers would either have to pay a tax for importing goods within the EU or to buy ETS allowances. In any case, what they would pay for is usually referred to as a Carbon Border Adjustment.
The CBA addresses the problem of competitiveness as well as the one of direct leakage, but does not completely solve those issues: the basic price to be paid by importers through a tax or ETS allowances is negotiated. Common sense tells us that the price to be paid should be proportional to the carbon footprint of the imports. But in reality, things are more complex than that as the actual carbon footprint is not easy to assess precisely, especially where several components are involved. As for direct leakage, in the case that importers buy allowances, the ETS prices are then affected, also impacting the costs for national producers.
                        5.2.2. A “complete” Carbon Border Adjustment mechanism (CBA + tariff at the border)
The CBA mechanism described above can also be associated with a tariff at the border in a similar way as for value added tax in order to represent what economists call the “complete CBA mechanism” [3] using both a carbon pricing on imports and a tariff at the European frontiers. Using a cap and trade mechanism combined with free allowances in lieu of a CBA for the purpose of decreasing the pressure on European producers has actually been in vain so far as the free allowances actually play the role of a tacit subsidy to production [4].
                        5.2.3. A compensating tariff
Another option available would be to set a tax compensating the differences in the carbon price applied in the country of origins of the exports and the price applied in the EU.  For Bohringer, such a system includes the same limitations as the CBA. [5].
                        5.2.4. A common import tax
Finally, a fourth policy scenario involves the creation of a uniformly applied tariff for imports coming from countries not using legally binding carbon policies against potential free riders. To put incentives on other countries for reducing their emissions, the European Union may add another import tax of a few percentages only that could be uniform concerning any good coming from a country with low or no carbon tax policy as suggested by Nordhaus [6].
 We discussed the possibility of a carbon tax at the European frontiers. We provided a global picture of the context of a European adjustment mechanism. Based on the recent Inception Impact Assessment, we also highlighted two main types of policy scenarios for the EU beyond the existing cap and trade system. The implementation of those technical instruments is critical for the success of the European targets regarding the respect of the Paris Agreement and are definitely not only a matter of economic or policy considerations, but also of preservation of life on Earth.
[2] Avinash Dixit, 1985, Tax policy in open economies, Chapter 06 in Handbook of Public Economics,  vol. 1, pp 313-374  
[3] Felder & Rutherford, 1993, Unilateral CO2 Reductions and Carbon Leakage: The Consequences of International Trade in Oil and Basic Materials
[4] James Markusen, 1975, International externalities and optimal tax structures. ... Journal of International Economics, vol. 5, issue 1, 15-29. 
[5] Böhringer, C., Carbone, J. C. and Rutherford, T. F. 2016, 'The Strategic Value ... Environmental Agreements', Environmental and Resource Economics, 65 
[6]  William Nordhaus, 2015, « Climate clubs: Overcoming free-riding in international climate policy », American Economic Review, 105(4), 1339-70. 
Article written by Mounia Mostefaoui