How to price CBAM permits: Combining the markets for ETS and CBAM carbon permits

Abstract

The EU and the UK both control domestic greenhouse gas emissions through cap-and-trade systems – their Emission Trading Systems. For charging imports a corresponding emission price, they propose Carbon Border Adjustment Mechanisms that take the domestic price and apply it to an unlimited volume of imports. This approach sets the carbon price based solely on the domestic side of the market, leaving the total emissions driven by EU or UK consumption indeterminate. In particular, a technological change reducing the demand for domestic emissions would lower the carbon price, increase imports, and possibly increase global emissions. This paper offers graphical and analytical expositions of this problem and through simulations shows that this perverse effect is likely. It also assesses the practical challenges of combining the ETS and CBAM markets as perfectly manageable.

Non-Technical Summary

The European Union (EU) is in the process of introducing a Carbon Border Adjustment Mechanism (CBAM); the United Kingdom Government has announced its intention to do so from 2027 and is consulting on the details. Both still have details to fill in, but the broad outlines are reasonably clear.

The objectives of the CBAM are threefold. First, the EU (UK) charges EU firms for the greenhouse gases (shorthand – carbon) they emit through its Emissions Trading System (ETS), and the CBAM is designed to charge similarly for the carbon embodied in imports. It thus aims to ensure that, for the products included in the CBAM’s remit, every unit of consumption pays the same cost of emissions regardless of origin. Second, by levelling the playing field in the domestic market between local and imported goods it aims to prevent carbon leakage. Third, it hopes to incentivise exporters abroad to reduce their emissions.

The ETS, in both the EU and the UK, are cap-and-trade systems. The authorities declare a total acceptable emissions level for their domestic producers and issue the corresponding number of emission permits. Abstracting from a lot of details, in the EU the authorities will take the average price of ETS permits in the previous week and issue any number of CBAM permits for imports at that price. In the UK, the Government is considering making the CBAM akin to an indirect tax as imports enter the country, with the price determined by the price of domestic permits over the preceding quarter.

In both cases, importers and domestic producers would face approximately the same emissions price and hence the same incentive to abate emissions; this, in turn, ensures that abatement is achieved in the least-cost manner. However, in both cases, the price of emissions (permits) is determined not by EU or UK demand for the goods causing emissions but only by the demand for such goods that is met by domestic producers. Thus, the trade-off between emissions and other goods is in effect determined by only half the actors in the market: it is as if the price of milk was determined by purchases only by people who are lactose-intolerant who then impose this price on everybody else.

This paper explores the implications of this prima facie perverse way of proceeding. It is more than a mere academic curiosity. The Government estimates that over half of the emissions embodied in England’s consumption of goods come from imports.

We propose to combine the markets for ETS and CBAM permits so that the price is determined by everyone buying and selling emissions-intensive goods in the EU (UK). This will allow government to determine the amount of emissions created by consumption in their jurisdictions rather than just by production, which seems more in consonance with achieving net-zero objectives. With full information, a government could set the number of permits for domestic production in their currently chosen approach such that it replicates the result of our proposal. But full information is impossible; moreover, circumstances constantly change, and the two approaches react differently as they do so.

One case of interest is if technical progress in the EU/UK- i.e. in the CBAM country - reduces the demand for emissions. Under current plans this would reduce the ETS permit price and hence the price of CBAM permits. This, in turn, would reduce the price of imports and the resulting increase in the volume of imports (i.e. production abroad) could increase foreign emissions by more than the decline in emissions triggered by the original technical progress. That is, despite emission-saving innovation, global emissions could increase!

Our paper provides a simple graphical demonstration of this danger. It then provides a more complete, albeit still simplified, model of the economy and shows that with separate ETS and CBAM permit markets it is quite possible that the result outlined above occurs. Next, we simulate the model and show that with plausible ranges of parameters, partly based on the iron and steel sector (the largest sector affected by CBAM), the outcome is perverse more often than not. Finally, we discuss some of the practical challenges of combining the ETS and CBAM markets, all of which seem small relative to those of establishing the two markets in the first place.

Our analysis suggests that for a relatively simple institutional change, the EU could place carbon pricing on a much more secure footing and eliminate a possible perversity in its net zero policies. The UK is still debating the form of its CBAM, and we would urge it to consider a combined market from the start. At the same time, we recognise that the benefits of aligning with the EU may well outweigh those of a combined market implemented by the UK alone, even if this entailed separate markets. Ideally, there would be one market combining the EU and the UK and covering both the ETS and the CBAM.

Read Working Paper 015