Will the CBAM fill the UK’s fiscal gap?

Behavioural responses

One expressed objective of the EU CBAM is to encourage decarbonisation elsewhere in the world. We do not know how much will occur as firms seek to avoid CBAM charges, but we do know that any that does occur will reduce charges per unit of imports.

Moreover, even if the CBAM induces no changes in emissions, exporting countries could capture the emissions fees for themselves by raising their rates or introducing their own charges for emissions. In addition to the cases noted above, various countries have legally confirmed and will soon launch their own carbon pricing measures, e.g., like Brazil, Colombia and Nigeria. It seems reasonable to expect that, even if for no other reason than capturing revenue, partner countries will increasingly levy their own emissions charges and raise them towards EU levels.

Some governments (notably, it seems, the USA’s) are allergic to any carbon pricing, so one might think that revenue losses due to their introducing carbon charges would be limited. But exactly those countries – again notably the USA – will very probably push for exemption from the CBAM on the grounds that their own regulatory policies curtail emissions and impose similar costs on producers as the CBAM. It is a very complex issue to calculate the equivalence between regulations and an explicit charge, especially since efforts to reduce emissions ought to reap their own reward in terms of reducing the CBAM charges due. However, on purely political grounds, there seems to be some probability that such claims for equivalence will prevail. When we come to consider the UK, a much smaller economy than the EU and politically closer to the USA, the granting of equivalence seems rather plausible.

A further ‘danger’ to the revenue stream is so-called carbon shuffling, whereby producers devote their ‘cleanest’ plants or production lines to serving the EU, so that what goes to the EU is materially less emissions-intensive than the producer’s average. This is bad for emissions abatement, and also for revenue.

The CBAM is going to raise the prices of the products it regulates in the EU because it will raise import prices, and the corresponding phasing out of free allowances in the ETS will raise domestic costs. Economists are fairly used to (I refrain from saying are good at) predicting changes in trade patterns as a result of price and cost changes. But there are at least two major complications to consider.

First, the ETS is levied on a firm/plant basis. If these firms produce many products, how the free allowances are allocated over products is unknown, and, in particular, we do not know how they will be allocated as the supply of free allocations gradually dries up when the CBAM replaces them. Thus, predicting price and output changes is very uncertain.

Second, the EU has not yet decided whether it will rebate ETS charges on EU exports. If it does not, EU exports will lose competitiveness around the world as free allowances are phased out and this is bound to feedback into domestic sales and activities and thus onto imports. While this will not reduce the revenue raised on the back of imports per se, it will reduce the revenues raised from the ETS, offsetting CBAM collections, and one could argue that they ought to be set against the CBAM. The question of export rebates is very fraught: failing to levy charges on emissions in EU exports seems inimical to EU climate ambitions, while levying them has potentially serious consequences for competitiveness.

What about the UK?

Finally, how can we move from predictions for the EU to predicting the revenue that the UK CBAM might generate? We know next to nothing about the UK CBAM beyond its coverage, which includes all the sectors in the EU CBAM except electricity and with glass and ceramics added. The government’s brief statement seems to suggest that it will be modelled pretty closely on the EU’s CBAM, so we will assume here it is a direct copy.

In April 2023, weak macroeconomic prospects, especially in manufacturing, led the UK ETS carbon price to start to fall below the EU’s, see Figure 1. In mid-year, the UK Government made a surprise issue of additional permits and promised issues over the period to 2027, and subsequently, it’s declining enthusiasm for active climate policy became evident. As a result, the gap between the UK and EU prices remained large over 2023. By the end of the year, it was about £27/tonne - £33/tonne compared with £60/tonne in the EU. Although the gap may be contracting in 2024, it is still around £20/ton according to the latest data. The UK Government talks a good long-term game on emissions abatement, but overall, we believe it reasonable to assume that the UK will persistently price emissions at or below the EU level. This means that, even if EU suppliers to the UK have to provide all the CBAM paperwork, they will pay nothing additional for emissions.

Table 1 presents data on UK and EU imports of the EU’s six CBAM products – definitions are in the notes to the table. Assuming that neither the UK nor the EU charges CBAMs on each other’s exports (as S&P explicitly assume for the EU), the table shows imports from other countries in value and in quantity terms. (We present quantity data because energy costs seem likely to be related to gross weight.) The value of UK imports never exceeds 10% of that of the EU in value terms or 7% in quantity terms. This implies that if the UK’s CBAM were a mere scaled replica of the EU’s, revenues would be less than 10% of the EU’s.

Table 1: Imports other than from UK or EU+, 2022

Sources: HMRC and Eurostat;
Notes: EU+ is countries applying the EU’s CBAM (EU, Norway, Iceland, Lichtenstein and Switzerland).
Products defined as in the EU CBAM (EUR-Lex - Ares(2023)4079551 - EN - EUR-Lex (europa.eu)).
EU+ data converted to sterling at 2022 average exchange rate of 1.173.
* Quantity units are kilograms
** Quantity units are terawatt hours

Electricity is not part of the UK CBAM, but since no UK imports come from outside the EU+ countries, that is not significant. In addition, the UK includes glass and ceramics, but as yet with no precise definitions. To approximate what this might add, we look at UK imports from outside the EU+ countries in HS chapters 69 and 70 (ceramic products and glass and glassware respectively): this is about £1.77 billion in 2022. Containing several highly processed products, these chapters almost certainly exceed the coverage of the CBAM and so exaggerate the base on which CBAM revenues could be raised. We do not know the energy intensity of such imports, but overall, this addition seems unlikely to add much more revenue.

Based on the European Commission estimate that the EU CBAM could generate around €2 billion revenue in 2028, the number for the UK would probably not exceed £0.17 billion.4 Even compared with customs revenue of £5.5 billion in 2022-23, this is small, and compared with the government’s current overall financial gap for 2022-23 of £131 billion it is vanishingly so. Revenues will undoubtedly increase in later years, but as we have suggested above, the WoodMac and S&P estimates of €9 billion and €80 billion for the EU in later years seem over-optimistic in terms of how rapidly the CBAM will extend to other products, how much carbon shuffling is likely to occur and the extent to which other countries will forego the revenue available if they introduce their own charges.

Conclusion

To conclude, estimates of the EU’s revenues from its CBAM vary substantially with forecasters’ assumptions about the details of the CBAM, the carbon price, the energy intensity of imports and the reactions of trade to the new charges. The UK’s CBAM is even less well defined, but by comparing the amounts of trade on which UK and EU CBAM charges will be levied, it seems unlikely that the UK will raise more than 10 percent of the EU’s revenues.

These estimates are hugely uncertain, but it is certain that the UK CBAM as currently conceived will not fill much of the UK’s fiscal gap over the next decade. However, that is not the point of the CBAM; it is there to aid decarbonisation; and, if the UK could bring itself to align its ETS and CBAM with the EU’s, to avoid UK exporters from having to do the paperwork and pay the cost of the EU’s CBAM. A CBAM that completely succeeded in inducing other countries to decarbonise – or merely co-existed with their autonomous decarbonisation - would raise nothing!