Border carbon adjustments: a solution to carbon leakage?

May 14, 2018

Posted by: Frances Lawson

…we have to put in place a taxation at the border for those who decide not to make the same environmental choice” – President Emmanuel Macron, 22 March 2018

In 2005 the world watched with eager anticipation as the EU initiated the world’s largest carbon pricing scheme, describing it as “a cornerstone in the fight against climate change”. The logic was simple: in order to emit carbon, businesses (the sectors covered by the EU Emissions Trading System (EU ETS) are together responsible for almost half of the EU’s total carbon emissions) would be required to buy permits. Policymakers would limit their supply and market demand would determine their price. To avoid paying for them, businesses would be incentivised to research and adopt alternative practices that generate fewer emissions.

Over a decade later and the flames of hope reduced to mere embers of what could have been. The carbon price meandered around the €5 mark until recently and has only recently started to climb towards ~€10 in anticipation of recently agreed strengthening measures. To put this into perspective, last year’s report by the High Level Commission on Carbon Prices – supported by the World Bank and the International Monetary Fund (IMF) and co-authored by Nobel Prize-winning economist Joseph Stiglitz – suggests a carbon price of $40 to $80 (~€32 – €65) is needed by 2020 to prevent a 2C rise in global temperatures.

Policymakers are well aware of mechanisms to increase prices. For example, the supply of allowances could be reduced further or, as President Macron has suggested, an EU-wide a minimum or ‘floor’ could be imposed, so that the carbon price never drops too low.

Why aren’t such measures implemented? One key reason is that if the carbon price is too high, in order to remain competitive the production of goods could shift to jurisdictions where it is lower or non-existent (so-called ‘carbon leakage’). This would undermine the environmental aims behind carbon pricing, while also adversely affecting the economy. While there is little evidence that carbon leakage has occurred so far, it remains a concern for industries and policymakers, and as carbon prices rise the risk will increase.

President Macron offers a solution to this problem through his proposal for an EU border carbon adjustment mechanism (BCA). Imported goods would be taxed to ensure they face a comparable carbon price to those produced in the EU. As the carbon price rises, so would the border tax, thereby reducing the incentive to shift production overseas in search of a lower carbon price.

The idea isn’t new. In recent years they have been proposed by senior Republicans in the United States (including two former-US Treasury Secretaries), the Chairman of steel giant ArcellorMittal, Lakshmi Mittal, and legislation has been proposed (but ultimately rejected) in respect of the EU ETS and California ETS. However, while promising on the surface, there are a number of complicating issues, not least their legality.

Are BCAs legal?

The most relevant and difficult legal question facing BCAs is whether or not they are compatible with World Trade Organisation (WTO) rules that constrain the ability of states to implement measures that restrict trade. A number of recent reports focus on precisely this issue (see here, here and here). Of particular relevance is Article III (2) of the General Agreement on Tariffs and Trade 1994 (“GATT”), which provides:

The products of the territory of any contracting party imported into the territory of any other contracting party shall not be subject, directly or indirectly, to internal taxes or other internal charges of any kind in excess of those applied, directly or indirectly, to like domestic products.

In other words, imported goods can be taxed but only to the extent that ‘like’ domestic products face the same charge. The 1970 GATT Working Party on Border Tax Adjustments set out a non-exhaustive list of factors to consider for determining “likeness”, which includes “the product’s end uses in a given market; consumers’ tastes and habits, which change from country to country; [and] the product’s properties, nature and quality” (at 18). This list focusses on the end product’s characteristics. However, for BCAs to work, it must be possible to levy different charges on otherwise similar products on account of the emissions generated during their respective production processes. Some WTO dispute reports suggest that products can be differentiated on the grounds of how they are produced. For example, in US — Tuna II (Mexico) tuna imports into the US could be differentiated by the way in which they were caught). However, this was because of the effect it had on consumer preferences; consumers are currently not responsive to the carbon emissions used to produce goods.

Does this mean that BCAs are doomed from the start? Not necessarily. Jennifer Hillman, former member of the WTO Appellate Body, points out that BCAs could be viewed as placing the same charge on similar products. While different producers may pay different total amounts, the BCA could impose on them the same price per tonne of carbon emitted during production. Further, she argues that BCAs would not be infringing upon the overriding objective of Article III, which is to prevent measures that protect domestic products.

Even if BCAs are not construed in this favourable way, it may be possible to rely upon Article XX which provides for circumstances in which trade-restricting measures are permissible. Most relevant are Article XX(b), which provides for measures “necessary to protect human, animal or plant life or health”, and XX(g), which provides for measures relating to the “conservation of exhaustible natural resources if such measures are made effective in conjunction with restrictions on domestic production or consumption”. To satisfy these provisions, evidence would be needed to show that BCAs are not merely disguised restrictions on trade but are in fact necessary to mitigate against the adverse impacts of climate change (Article XX (b)) or to reduce fossil fuel use (Article XX (g)). Moreover, they would need to be necessary in the absence of adequate alternatives (see United States—Measures Affecting the Cross-Border Supply of Gambling and Betting Services). There are other ways of mitigating against carbon leakage, for example the EU ETS currently allocates some permits for free to particularly vulnerable industries. BCAs would need to be demonstrably more effective than other means of tackling carbon leakage so as to satisfy the Article XX criteria.

Concluding Remarks

Ultimately, it is unclear whether WTO rules permit BCAs. A recent report by NGO Climate Strategies concludes that “it is clear that the WTO legality of BCAs
will ultimately depend on their design” (at p.38). This seems right, and we await the details behind President Macron’s proposals. However, WTO rules are not the only obstacle in the path of BCAs. First, they fly in the face of the dominant neoliberal narrative of free trade and low taxes, which could make it more difficult for the idea to gain political traction. Second, many conceptions of BCAs only offer a partial solution to the risk of carbon leakage. They tax imports so that in the domestic market goods are not differentiated by the carbon pricing regime governing their production. However, this differentiation would prevail in export markets (to remedy this, some BCA models include a mechanism to subsidise domestic goods that are exported so that they remain competitive). Third, it is not clear how the level of the BCA charge would be set. The EU ETS price fluctuates; there is no fixed reference point that can be used.

Nevertheless, BCAs may be the best way of ensuring that the carbon price can rise as high as it needs to be in order for there to be a real impact on emissions, while mitigating against economic and carbon leakage risks. Other mechanisms that tackle carbon leakage risks have the unfortunate consequence of dampening the incentive to decarbonise. For example, the current practice of issuing free allocation of permits to vulnerable industries means that those industries have fewer permits to buy and are therefore less incentivised to decarbonise. Although BCAs have been advocated by climate change academics for some years, it is only recently that they have found much in the way of political support. Given the seeming remoteness of meeting the 2 degree target, BCAs are certainly worthy of further exploration. In that sense, President Macron’s comments are a promising indication of political support for this important initiative.

This article has been co-authored by Vedantha Kumar.