Working Paper

Designing Effective Carbon Border Adjustment with Minimal Information Requirements. Theory and Empirics.

Campolmi, A; Fadinger, H; Forlati, C; Stillger, S; Wagner, U (2024) Designing Effective Carbon Border Adjustment with Minimal Information Requirements. Theory and Empirics. Centre for Inclusive Trade Policy Working Paper 012

Published 4 April 2024

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CITP Working Paper 012

Abstract

High carbon prices in the EU might drive emission-intensive industrial processes towards countries with relatively lower carbon prices. To prevent such carbon leakage, the EU’s Carbon Border Adjustment Mechanism (CBAM) taxes emissions embedded in imports for the difference between carbon prices in the EU and the origin country. Because embedded emissions are very difficult to measure, CBAM applies to only five industries and accepts benchmarks instead of actual embedded emissions. These simplifications make CBAM tractable but compromise its effect on carbon leakage. We propose an alternative policy that requires no knowledge of embedded emissions and can be applied to all tradable sectors: the Leakage Border Adjustment Mechanism (LBAM). LBAM implements import tariffs (and, possibly, export subsidies) that sterilize the changes in imports (and exports) induced by a higher EU carbon price. LBAM requires information only about domestic output-to-emissions elasticities as well as elasticities of import demand and export supply, which we estimate using publicly available data. We calibrate a granular structural trade model with 57 countries and 131 sectors to quantify the welfare and emission impacts of LBAM. We find that LBAM improves over CBAM in terms of global emissions and EU welfare. We assess how ‘climate clubs’ of countries that adopt common carbon prices and border adjustments mechanisms perform on these outcomes.

Non-Technical Summary

While global climate policy coordination remains slow, some countries significantly tax carbon or subsidise low-carbon technology unilaterally to reduce their own contribution to global emissions. However, such unilateral policies only reduce global emissions if they prevent carbon leakage - the displacement of emissions to other countries. International trade is an important channel for carbon leakage because levying a carbon tax unilaterally lowers a country’s comparative advantage in the production of carbon-intensive goods. Border carbon adjustments on imports and exports address leakage but have not been implemented until recently, when the EU launched its Carbon Border Adjustment Mechanism (CBAM).

The CBAM taxes imports based on their embodied emissions to preserve EU competitiveness given unmatched carbon pricing abroad. In this way, CBAM discourages the replacement of EU production with imports with high carbon content (import leakage) while also correcting for the absence of a foreign carbon tax.

Implementing the CBAM is challenging as it requires carbon content data for exports, which is exceedingly difficult to obtain. Therefore, the EU will charge CBAM tariffs in only a handful of energy-intensive sectors. However, incomplete coverage provides incentives for offshoring the production of unregulated final products that contain CBAM-regulated intermediates. Such simplifications aside, the reporting requirement creates a distortive non-tariff barrier to trade by shifting the burden of collecting data on carbon content from the EU authorities to foreign firms. Since those firms have obvious incentives to under-report, the EU plans to engage in extensive monitoring and verification. The bureaucracy required for it significantly increases CBAM’s costs. For example, multi-plant firms might reshuffle emissions without truly cutting them by shipping output from their cleanest plants to the EU and output from the most polluting plants to the rest of the world.

This paper develops an alternative policy instrument that prevents leakage without requiring carbon content data of foreign production. The basic idea is to implement product-specific import tariffs (and export subsidies) that exactly offset the changes in EU imports (and exports) that would otherwise result from an increase in the carbon prices between the EU and its trading partners. We call this the Leakage Border Adjustment Mechanism (LBAM). Using a structural model of international trade in differentiated products with many sectors and countries we simulate what would happen to imports and exports in response to rising EU carbon prices and then compute LBAM tariffs and export subsidies that undo those changes.

Given the model, the information requirements for this calculation boil down to (i) how domestic production costs change with the carbon price and (ii) how those cost changes affect substitution between domestic and foreign products among domestic consumers. These requirements can be easily met using readily available data and well-established econometric methods. Thanks to overcoming information constraints, the LBAM can be applied to all tradable sectors. This is a key advantage because it avoids distortions between sectors and tariff evasion. Moreover, the LBAM imposes no reporting burden on foreign firms and no monitoring burden on EU authorities.

In our analysis, we regard the EU as the domestic economy that unilaterally implements a carbon price and a border adjustment mechanism. Using the model, we quantify the impacts on EU welfare and global emissions of the increase in the EU’s carbon price from 15 dollars in 2018 to 105 dollars in 2023. In the absence of border adjustments, this carbon price increase reduces global emissions by 0.97%. Carbon leakage is manifest in the sizable displacement of EU manufacturing production by dirty EU imports and by dirty third-country exports to the rest of the world. We analyse how different border adjustments affect welfare and emissions, relative to this reference case.

The current EU proposal which limits CBAM tariffs to very few sectors improves only marginally upon the reference case. In contrast, an LBAM with import and export leakage border adjustment implies 50% additional global emission reductions compared to the reference case. When limiting the LBAM to import tariffs only, it still reduces emissions by 15% more than in the reference case.

We extend our analysis to the scenario where the EU coordinates its carbon pricing and border adjustments with the UK, Canada and the US. When Canada and the UK have a common carbon price with the EU, the LBAM increases the effectiveness of the club in reducing global emissions by around 60%. compared to a club without border adjustment. If the US joins too, global emission reductions are magnified by a factor of six without border adjustment and by a factor of seven with the LBAM. This justifies the introduction of an LBAM even when more countries join the climate club. Finally, when the US joins the club, EU welfare increases, while this is neither if the EU pursues policies unilaterally nor for the smaller carbon club.

Author Profiles

headshot Chiara Forlati

Chiara Forlati

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Ulrich J Wagner

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Sabine Stillger

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Harald Fadinger

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headshot Alessia Campolmi

Alessia Campolmi

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