A Carbon Border Adjustment for the UK?

Carbon leakages occur when a country imposes a decarbonisation policy (e.g. a fee for emissions) and industry relocates its production to a cheaper location that imposes no such policy. As well as its possible effect on jobs in the first location, this could be disastrous for global climate action, because it will result in more greenhouse gas emissions in less-regulated countries.

The UK Government recently held a consultation on how to address carbon leakage.  In our response, based on our detailed consideration of border measures for carbon policy prepared for the Climate Change Committee, we argue that as carbon leakage is inextricably linked to a continuing demand for high-carbon products, the 'full' solution to leakage lies in all countries having decarbonisation policies.

However, since coordinated multilateral action will inevitably be slow and patchy, the UK must consider unilateral action as well. This cannot just comprise relaxing the policy, such as continued allocation of free Emissions Trading Scheme (ETS) allowances because that just impedes the UK’s progress towards decarbonisation. In this blog, we briefly present some of our responses on one approach to unilateral action – a Carbon Border Adjustment. 1

A Border Carbon Adjustment involves extending domestic carbon pricing by introducing carbon-related charges on imported products, equivalent to those domestic producers pay. That is, it levels the playing field in the domestic market. Border carbon adjustments might also induce or stimulate action abroad. The EU will shortly introduce the Carbon Border Adjustment Mechanism (CBAM), and a large part of the consultation concerned whether and how the UK should follow suit.

To manage adjustment costs and trade frictions, the easiest solution for the UK is to mirror the EU’s approach as closely as possible in terms of sectoral coverage, emissions scope and methods for calculating emissions. Linking EU-UK ETS schemes will absolve UK firms from EU CBAM charges and administrative requirements and is therefore also highly desirable. Our further advice on UK CBAM design follows from this high-level recommendation.

CBAMs should apply only to sectors that are subject to the UK ETS because the justification of a border intervention is that imports should pay the same 'price'/'fee'/'cost' for emissions as do domestic producers. Without the ETS there is no clearly identifiable fee for 'adjustment', just a tax on imports, which is contrary to our international commitments to the World Trade Organization and free trade agreement partners. The ideal is that CBAMs apply wherever there is an ETS, but practically their scope depends on the 'trilemma' of trading off environmental ambition, equity/non-discrimination and technical feasibility. If these change over time, so will the ideal coverage.

If the UK insists on a different process from the EU’s CBAM - or even just different documents or different verification procedures - it increases the chances that exporters will not bother to supply the (smaller) UK market and focus instead just on the EU. Moreover, unless the UK aligns its ETS entirely with the EU’s, UK exporters to the EU will have to do additional paperwork and potentially pay the EU CBAM. Thus, alignment of processes with EU ones is essential. To be efficient, the UK should also seek joint enforcement - whatever is good enough for the EU is good enough for the UK and vice versa.

There are major challenges around the monitoring, reporting and verification of emissions for use in the calculation of the CBAM-charge including defining legal responsibility for meeting requirements, enforcement, scope, data and pricing, which we explore below.

Importers of products covered by a CBAM should be responsible for meeting all CBAM requirements. Asking exporters to do this and enforce this at the border is hugely complex for a border check and would involve huge numbers of exporters around the world having to buy UK carbon permits. The result would very likely be that some exporters would just not bother and the number of suppliers to the UK would fall. Thus, asking importers to organise this seems the most viable option. However, it is not without risk: in asking importers to manage the CBAM, one needs to accept that some current importers may also choose not to, and thus the business of importing would become more concentrated and less competitive. In addition, exporters will still have to provide the necessary information, potentially further crimping export supplies.

Policies need to be effectively and even-handedly enforced. There will always be cases where data are not available and yet the UK wishes/needs to import. Thus, there has to be a 'no documentation' option – a default CBAM charge, in principle varying by product and its country of origin. This is likely to be necessary for many developing countries, at least for a period, but it would also help to ensure that the CBAM does not unduly impinge on small firms or small transactions. One possibility is to have a threshold for trade (say, an annual limit at firm/product level) that requires light documentation for information purposes alone, and if it is regularly exceeded, full data to be provided.

A CBAM should apply to direct emissions in the production process (called ‘scope 1’ in the regulations) and indirect emissions embodied in electricity used in production (scope 2). Ideally, we would also include scope 3 emissions – those embedded in other inputs to a good (e.g. in raw materials and parts). Such indirect emissions are hard to measure and this rapidly becomes impossible for complex goods, but if they are not included it is too easy to evade the CBAM by restructuring to move 'dirty' processes just upstream from the regulated product. [For example, if aluminium faces an emissions charge – either via the ETS at home or the CBAM for imports – but cars do not, there is an incentive to move assembling cars outside the UK, where aluminium is charge-free.]  However, there is a trade-off between covering embedded carbon and the effort of doing so, which must be made pragmatically.

Using the same methodologies for assessing direct and (eventually) indirect emissions developed through EU CBAM will make compliance more feasible for firms also exporting to the UK. The EU CBAM requirement to report on emissions will commence in October 2023 and so by the time the UK takes action, measurement will be established practice that firms can replicate for UK-bound products (though they could still face different UK and EU ETS prices.)

The emissions price applied by a CBAM should track the prevailing UK ETS price throughout the year, as a price fixed for a full year in advance for the sake of certainty would be too crude and allow the CBAM price of emissions to diverge too far from the domestic price. The EU scheme whereby they use a weekly average and require importers to hold, at the end of a quarter, permits for 80% of their imports up to the end of that quarter is a reasonable compromise. One further option, which we are exploring, is why not require importers to purchase permits in the same market as domestic producers buy their ETS permits. That would provide the closest alignment between foreign and domestic suppliers to the UK market.

The EU CBAM reduces its CBAM charge on an import to the extent that the producers have paid for emissions already at home. Apart from the practical calculation details, Lydgate et al (pp64-66) note that reducing the CBAM fee according to amounts already paid could, perversely, run into difficulties with the World Trade Organization’s (WTO) non-discrimination (Most Favoured Nation) requirement because it will result in the UK charging different border fees on like goods from different countries. This would be more of a problem if the UK sought to defend the CBAM as a genuine border tax adjustment rather than as a General Exception (GATT Article XX).

Some countries, notably the US, argue that the implicit cost of meeting performance standards should be taken into account as it is equivalent to a carbon price. The heterogeneity of approaches makes it difficult to calculate with any precision what prices producers are paying. There is no way of calculating foreign (or even domestic) compliance costs with reasonable accuracy; the UK will need to decide what factors can be taken into account when calculating the carbon price already paid by imports and do so in a way that best resembles the domestic ETS price. This will require discussion with trade partners as well as careful attention to how the EU is handling this issue in its CBAM.

To maximise simplicity and ease of implementation, one might consider transaction thresholds below in which CBAM would not be applied - and would not require paperwork. While this clearly opens up a little room for tax evasion by subdividing transactions, for large emissions-intensive products included in the CBAM this seems unlikely to be a major problem. One would clearly need to keep records of such transactions and supplement a transaction threshold with an annual threshold. The attraction of the thresholds is that it allows new, occasional, and opportunistic exporting (importing) and thus allows scope for experimentation in trade, whereby small trades test the water in a market before a firm builds up a major operation.

A major policy issue is how to handle exports within an ETS/CBAM system, and it is one the EU has not yet decided on. As well as the UK domestic market, carbon leakage from UK regulations can occur abroad if the ETS makes UK goods uncompetitive so that purchasers substitute cheaper but ‘dirtier’ sources.

The clean solution is to rebate any ETS cost on exports, just as VAT expenditures are rebated (zero-rated). This is in the spirit of a border tax adjustment (to which the CBAM is broadly equivalent). However, if the CBAM is to be justified in the WTO as an environmental case of General Exceptions (Article XX), rebating ETS on exports looks perverse - it says we charge for emissions for goods consumed at home but not for the same goods consumed abroad. Even without WTO constraints this hardly looks like good environmental policy.

Rebates also raise the following issue. A substantial share of UK exports in the sectors likely to be included in the CBAM are to the EU. The EU will apply full CBAM charges from 2026. It has stated that it is willing to forgo all CBAM-related administration as well as charges for exports from countries that align with its ETS (which the UK did until April 2023 and still does in most details). If the UK aligned its ETS to the EU’s, this would obviously not include rebating export costs on exports to EU countries (or those aligned with them). Whether exports elsewhere receive rebates would depend on the EU decision which is not yet clear.

The rebate issue also ties up with the question of how to deal with countries who seek to apply a CBAM or equivalent to UK exports. The rebate makes their doing so more or less inevitable, but if UK exports have to pay the ETS in the UK, other countries would probably apply lower or no further charges, in exactly the way in which the EU CBAM will be reduced in line with emissions charges already paid in the country of origin.

Another issue for UK carbon leakage policy is to consider the impact of its policy development on Northern Ireland. Electricity generators in Northern Ireland fall within the scope of the EU ETS, while other ETS-included sectors fall under the scope of the UK ETS. Linking ETS schemes with the EU would resolve this complication neatly by removing CBAM requirements from Northern Ireland. The EU CBAM legislation specifies that countries with linked ETS schemes can avoid the imposition of CBAM charges and the administrative requirements of reporting embedded emissions. Linking schemes would benefit all UK trade in EU CBAM-covered sectors. In summary, linkage with the EU ETS and a mirroring UK CBAM would address both of these problems at once.

The UK has not, in recent years, sufficiently regarded the complexity of introducing major policy changes for either the private or the public sector. This has caused major uncertainty in the private sector because precise policy and implementation details have not been provided in good time, there have been last-minute postponements and changes in details etc. This delays adjustment, suppresses investment in trade and production, and can eventually lead to firms giving up serving the UK market. A CBAM is exceptionally complex for both private and public parties and the proposed UK timetable – introduction by 2026 - is not realistic. The government needs to allow more time to ensure that consultation and political debate settles on the details credibly and then allows firms several years to get information systems in place and the public sector to devise really effective ways of administering the CBAM. The only credible way of achieving implementation in 2026 would be to align with the EU and borrow, or better join, their systems.