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

Abstract

The EU and the UK both control domestic greenhouse gas emissions through cap-and-trade systems – their Emission Trading Systems. To reduce ‘carbon leakage’ they propose to charge imports for emissions at the same price as domestic producers through Carbon Border Adjustment Mechanisms, which take the domestic price and apply it to imports, without limits. We show that this approach could result in a technological improvement that reduces demand for domestic emissions, increasing global emissions. We propose alternatively that domestic producers and importers should bid in the same capped market for emissions permits. We show that such an arrangement avoids the possible perversity just noted and implies lower global emissions for any given technological improvement.

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. Both still have details to fill in, but the broad outlines are clear.

The CBAM’s purpose is to eliminate ‘carbon leakage’ whereby domestic production is displaced by production from jurisdictions that have weaker restrictions on emissions. For sales in the EU, it aims to charge the same rate for emissions embedded in imports as in domestic production. By doing so, the CBAM is also “expected to effectively support the reduction of greenhouse gas emissions in third countries”, contributing further to the EU's objective of reducing global warming.

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 intends to make 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. Both the EU and the UK are substantial ‘importers’ of emissions, so the treatment of imports is a substantive issue.

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 the absorption of goods 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 particular interest is if technical progress in the CBAM-country reduces the demand for emissions. Under current plans this would reduce the ETS permit price and hence the prices of CBAM permits and of imports and thus increase imports. The corresponding increase in production abroad would increase foreign emissions, possibly by more than the decline in emissions triggered by the original technical progress, in which case, despite emission-saving innovation, global emissions would increase.

Our paper provides a simple graphical demonstration of this danger. It then provides a more complete, albeit still simplified, general equilibrium model of the economy in which the perverse result just outlined can occur and provides simulations of the EU that suggest that it can occur with plausible ranges of parameters based on the iron and steel sector (the largest sector affected by CBAM). These simulations also show that, for any given improvement in emissions efficiency, our proposed combined market approach implies lower global emissions that does having separate ETS and CBAM markets. One aspect currently not fully specified is whether the CBAM should entail rebating ETS costs on exports. The EU says it will but has not said how and the UK has yet to decide. We model outcomes with and without such a rebate. 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.

Although the model and simulations should not be taken literally, this analysis suggests that for a relatively simple institutional change, the EU could place its emissions policy on a more secure footing and eliminate a possible perversity in its net zero policies.

The UK position, which still has details to settle, is discussed in an Appendix. The UK has agreed to combine its ETS with that of the EU, although, as yet, with no details, but currently does not appear to intend to combine its CBAM with the EU’s. We argue that the latter combination would also make very good policy sense.

Original WP015