Carbon Taxes in the Global Market: Changes on the Way?

After an unpredictable legislative journey, the European Union has entered the final stage of negotiations on the world’s first carbon border adjustment mechanism (CBAM). It would appear that some in the United States Congress are paying attention.

On June 8^th, the European Parliament rejected a proposal to reform the EU’s Emissions Trading System (ETS) which sets the EU’s domestic carbon price and postponed a vote on the complementary CBAM designed to stop carbon leakage. By June 22^nd, however, both parts of the broader “Fit for 55” climate package passed with large majorities.

Given the Council of the EU agreed on a CBAM general approach in March, leaders from both the Parliament and Council will now negotiate a compromise text. The EU’s goal is to have a final text voted on and passed by both institutions before the end of the year in order to implement the initial reporting phase of CBAM in 2023.

For now, it is unclear how the final text will look, but there are a few important aspects to consider.

First, the original European Commission proposal did not include export rebates for EU industry, making CBAM simply a border tariff. The Council’s general approach did not make a judgment on the rebates, while the Parliament’s version adds export rebates for sectors dependent on exports.

The Commission is tasked with assessing the World Trade Organization (WTO) compatibility of such rebates. The outcome is important for EU-U.S. relations because if the WTO or the U.S. feel CBAM is a protectionist measure, it could cause the U.S. to retaliate with tariffs of its own on EU goods.

Second, the Parliament’s version expands the sectors covered by CBAM vis-a-vis the Commission’s proposal and includes a timeline to add other sectors in the future. If adopted, the expanded scope could significantly impact producers in third countries that do not have a carbon tax, such as producers in the United States that export to the EU.  

Finally, the Commission stated producers who pay a carbon tax in their home jurisdiction equivalent to EU standards would be exempt from paying the CBAM cost. So far, the EU has not laid out a process for determining if another jurisdiction’s carbon taxing regime is equivalent to the EU’s. Therefore, even if the U.S. were to implement a carbon tax, it is unclear if the EU would accept the tax as equivalent and eliminate the application of CBAM to U.S. imports.

While the EU negotiates its own law to prevent carbon leakage, it may have succeeded in another, potentially equally important objective abroad. The Council’s approach to CBAM emphasized “encouraging partner countries to establish carbon pricing policies to fight climate change.” In other words, by merely proposing CBAM as a price on U.S. imports, the EU tried to force U.S. policymakers to the climate negotiating table. Signs indicate the approach is starting to work.

U.S. Senator Sheldon Whitehouse (D-RI) introduced a bill in early June called the “Clean Competition Act,” aimed at taxing the carbon content of imports into the United States. Unlike several other proposals in the U.S., Whitehouse’s bill would actually constitute a partial border adjustment, rather than just a border tariff—an important distinction. While it is an improvement to include a partial border adjustment, the proposal still falls short in several other ways.

Generally, two variables determine the carbon tax base. The first is how imports and exports are taxed, and the second is what share of domestic carbon emissions is taxed.

On paper, one can imagine a carbon tax solely on the carbon output of domestic production. That seems simple. But in effect, doing so would create a tax bias against domestic manufacturing, as domestically produced goods of all kinds would face taxes, while imports would face no taxes.

Such a policy design would be vulnerable to carbon leakage, as illustrated in Table 1, whereby companies subject to taxes or regulations designed to reduce carbon emissions move operations offshore, where they will not be subject to the same policies, thus not ultimately reducing (and possibly even raising) carbon emissions. Current EU policy under the ETS, for example, is vulnerable to leakage.

Ideally, a carbon tax would tax domestic carbon consumption, or the carbon emissions involved the production of goods consumed in the taxing jurisdiction. To tax domestic consumption, a carbon tax would include a carbon border adjustment, taxing the carbon content of imports and exempting the carbon contents of exports as illustrated in Table 2. Sen Whitehouse’s proposal follows such design, but it is uncertain whether it would be accepted under the WTO or if export rebates would be considered an illegal subsidy.

Several proposals today are described as “border adjustments”; however, most are not true border adjustments. A border adjustment makes the tax code neutral between goods produced domestically and goods produced abroad. A tax on the carbon content of imports without a domestic carbon price is not neutral and is not a border adjustment—it is a tariff (see Table 3). It is likely a carbon tariff policy would run afoul of WTO discrimination rules in the absence of a domestic carbon tax.

Lastly, one can imagine a domestic carbon price that also features a tax on imports but does not feature a corresponding exemption for exports, as illustrated in Table 4. The tax would fall on exports, creating a penalty for domestic exporters and making them less competitive in other jurisdictions that may lack carbon prices.

The last policy option also results in a border tariff and describes the Commission’s original EU CBAM proposal (without export rebates). Given that CBAM is based on the EU’s domestic carbon price (weekly ETS average price) and is designed to be a climate measure more than a revenue mechanism, it is possible it could satisfy WTO rules; however, it is disputed and could be considered discriminatory against imports.

In terms of the share of domestic carbon emissions being taxed, best practices suggest the base should be broad, covering as large a portion of carbon emissions that is administratively feasible. Relatedly, the simplest way to administer a carbon tax on the broadest set of emissions possible is to administer the tax upstream, when fossil fuels are produced and refined.

In contrast with best practices, however, both CBAM and the Whitehouse bill only focus on specific carbon-intensive industries. The decision, while suboptimal, reflects the trade-offs in designing a border adjustment mechanism. While it might be easier to tax domestic carbon emissions upstream, it is difficult to do the same for imports. Instead, the proposals would approximate the carbon content by taxing energy-intensive domestic producers and importers. Such an arrangement is not ideal, although it is designed to maintain some level of parity between taxation of domestic producers.

To make CBAM a true adjustment mechanism, the EU should include export rebates for European producers selling goods outside of the EU. It is unclear if rebates satisfy WTO rules, but the EU has made clear it wants to comply with the WTO.

For the Whitehouse bill in the U.S., in addition to the less-than-ideal focus on specific carbon-intensive industries rather than carbon emissions as a whole, the bill’s border adjustment is not fully balanced. As the Niskanen Center’s Shuting Pomerleau noted in her analysis of the bill, exporters of domestic finished goods may not be eligible for the border adjustment rebate, even though they would pay the domestic tax.

As policymakers on both sides of the Atlantic debate the way forward on carbon border adjustment mechanisms, it is important to keep principles of good tax policy in mind. A broad-based domestic carbon tax that truly rebates the domestic price for exports will allow governments to raise stable revenue, limit carbon leakage abroad, incentivize greenhouse gas emission reductions at home, and potentially avoid a harmful trade war over climate tax measures.