Designing an effective border carbon adjustment mechanism

Goran Dominioni, Dan Esty 22 April 2022

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In adopting the 2015 Paris Agreement, global leaders embraced a bottom-up approach to climate change action, whereby countries choose their contribution (‘nationally determined contribution’) to control the build-up of greenhouse gases (GHGs) in the atmosphere. Thus, the international climate change regime encourages heterogeneous climate change policies across jurisdictions – some countries will implement more stringent greenhouse gas constraints than others. The approach encourages broad-based participation but creates a risk of carbon leakage. Economic activities with significant GHG emissions may be displaced from high-standard countries to places with less ambitious climate change requirements (Bellora and Fontagne 2022). This dynamic both undermines the competitiveness of the high-standard jurisdictions and diminishes the effectiveness of their climate change policies.

To address the risk of carbon leakage, various nations and the EU are now considering border carbon adjustments on imported products. These mechanisms impose a special tax on imported goods from low-standard nations, based on the difference in the stringency of climate change-mitigating policies in the exporting country and the more extensive (and expensive) GHG controls applied domestically. In designing border carbon adjustments, jurisdictions face important design choices. A critical question is how to determine the relative stringency of the climate-change policies in the importing and exporting countries – and thus the level of the border tariff (Mehling et al. 2019).

Current proposals in the EU and the US answer this question differently. The European Commission proposal – and the approach adopted by the Council of the EU in March 2022 – is to look at the difference between the EU’s GHG price established by the EU Emissions Trading Scheme and any explicit GHG pricing in the exporting country. In other words, only GHG costs established through carbon taxes and emissions allowance trading systems will be credited. The US legislative proposal offers credit for a broader set of climate change mitigation policies beyond explicit carbon prices. Which approach should be favoured?

In a forthcoming article (Dominioni and Esty forthcoming), we analyse various border carbon adjustment structures and distinguish four options:

(1) No crediting for climate policies: No credit is offered for any GHG mitigation measures in the exporting nation.

(2) Explicit border carbon adjustment mechanism: Credit is only provided for explicit GHG prices, i.e. prices applied through carbon taxes and GHG emissions allowances trading systems. This is the approach proposed by the Commission.

(3) Effective border carbon adjustment mechanism: Credit is provided for effective carbon prices, i.e. the sum of explicit carbon prices and carbon prices applied implicitly, such as costs that arise from fuel taxes without regard to a product’s carbon content or GHG emissions released in burning fuels (Dominioni 2022).

(4) Wide open: Credit is provided for an even broader set of policies that reduce GHG emissions, even those without readily identifiable cost effects. This is the approach embraced by the US legislative proposal.

Two of these four options seem to give rise to significant political and administrative challenges. On the one hand, not giving credit (option 1) for any climate change policy in the exporting nation poses a significant risk of backlash from exporting counties and would be seen as fundamentally at odds with General Agreement on Tariffs and Trade (GATT) non-discrimination rules. Such a one-sided border carbon adjustment calculation would also likely undermine international efforts to cooperate on climate change.

On the other hand, the wide-open approach (option 4) presents significant methodological challenges. It requires quantifying the GHG price equivalence of a variety of climate policies, including policies that have no visible price effects. In light of the significant administrative, legal, and political challenges of the no-credit and wide-open options, we see little viability for these approaches. 

Our analysis therefore compares the other two options – credit for explicit carbon prices (option 2) and credit for effective carbon prices (option 3) – in terms of their environmental effectiveness, administrative feasibility, and compatibility with WTO law.

The environmental benefits of crediting for effective carbon prices

Well-designed border carbon adjustment mechanisms incentivise exporting countries to adopt more stringent climate policies, so their exporters would not have to pay the special climate change tariffs on their goods. Part of this incentive stems from the possibility that these policies will be credited by the importing country when applying the border carbon adjustment. Thus, crediting explicit carbon prices would incentivise the uptake of explicit carbon-pricing policies in exporting countries but would not encourage the adoption of other climate change policies, as those would not gain any credit. 

Since explicit carbon prices are a more sharply focused instrument for mitigating climate change than effective carbon prices, one might think that giving credit for just the narrow set of policies based on explicit GHG pricing will yield better environmental outcomes. This conclusion, however, does not take into account the possibility – indeed, probability – that greater policy flexibility might lead more nations to adopt GHG mitigation strategies of some sort.

Simply put, effective border carbon adjustment mechanisms leave more freedom for exporting countries to address climate change based on their domestic political realities and policy traditions. They may therefore result in greater climate action than narrowing the scope of credited policies to explicit carbon prices. Indeed, in many nations, explicit carbon prices encounter political resistance while other policy options might be easier to implement. Similar political challenges may not attach to effective carbon prices. Many developing countries routinely have fuel taxes in place, cut fossil-fuel subsidies, and take other actions that translate into GHG prices – for which they should be given credit. The effective carbon-pricing approach to border carbon adjustment may therefore result in more climate action in exporting countries than crediting exclusively for explicit carbon prices.

Giving credit for effective carbon prices may also make more transparent the climate change actions in exporting countries. It allows for tracking net changes in the greenhouse gas constraints of environmental tax reforms that simultaneously increase explicit prices but also reduce other forms of pricing (e.g. lowering an energy tax). This greater transparency can increase trust among countries – an essential element of a bottom-up approach to international climate change cooperation – and spur coopetition between jurisdictions.

WTO law logic for relying on effective carbon prices

A key concern for policymakers is the compatibility of border carbon adjustment mechanisms with WTO law. In our view, a well-designed border carbon adjustment mechanism that meets established criteria should be GATT-permissible and thus subject to light scrutiny under WTO law. In light of the widespread ratification of the Paris Agreement among WTO member states, we argue that flexible border carbon adjustment mechanisms that credit diverse policy approaches to mitigate climate change should be seen as acts of multilateral unilateralism. While border carbon adjustment tariffs might be unilateral insofar as they represent an individual jurisdiction’s action, they should be seen as multilateral to the extent that the overarching commitment to controlling GHG emissions has already been agreed upon through the 2015 Paris Agreement and reiterated in the 2021 Glasgow Climate Pact. 

Thus, we suggest that guidelines for border carbon adjustment mechanisms be established and the implementation subject only to an ex-ante review by a new body, to be created under the auspices of the United Nations Framework Convention on Climate Change (UNFCCC) with the WTO. Border carbon adjustment mechanisms that give credit for effective carbon prices should be assumed compliant with the GATT unless otherwise demonstrated. 

In contrast, more narrowly structured border carbon adjustments that exclusively credit explicit carbon prices do not provide flexibility in terms of policy structures that the WTO framework encourages. They are therefore less likely to be seen as compliant with GATT provisions.

In particular, giving credit for some types of effective carbon prices, such as fuel excise taxes, makes border carbon adjustment mechanisms more compatible with WTO law than crediting only explicit carbon prices. There are two reasons for this. First, the broader set of instruments included in effective carbon prices can better shield the border carbon adjustment from potential claims of de facto discrimination under the GATT’s main non-discrimination provisions. Second, the broader approach makes the instrument less arbitrary and better takes into account the prevailing conditions in exporting countries. This flexibility makes it easier to justify a border carbon adjustment mechanism under WTO law for public policy reasons if it is found to violate GATT non-discrimination provisions.

Credit for effective carbon prices: administratively impossible?

While explicit border carbon adjustment mechanisms might seem to be easier to implement than a mechanism that accounts for other types of implicit prices, this perceived advantage must be offset against the lack of flexibility and failure to accommodate the diversity of climate change strategies around the world. Moreover, calculating effective GHG prices in a particular jurisdiction need not be excessively difficult. Many WTO members, including both the EU and the US, have significant experience calculating countervailing and anti-dumping duties. These methods can be harnessed to estimate border effective greenhouse gas prices. Governments that lack capacity could be supported by international institutions with significant capacity for estimating effective carbon prices in various jurisdictions (OECD 2021, IMF 2019).

While for some types of implicit carbon prices – such as negative prices applied through subsidies to fossil-fuel consumption – lack of data can hinder their immediate inclusion in an effective border carbon adjustment mechanism, it is possible to envision a gradual expansion of the types of implicit carbon prices accounted for in the adjustment. The EU and the US could start crediting for implicit pricing instruments that pose fewer administrative challenges and gradually expand the scope of their actions as administrative barriers are overcome.

Border carbon adjustment mechanisms that focus on effective greenhouse gas prices offer a practicable response to carbon leakage. They can yield more diverse and vigorous climate change action – and thus should be preferred as better aligned with the 2015 Paris Agreement commitments and more compatible with WTO law than a mechanism that credits exclusively for explicit carbon prices.

References

Bellora, C, and L Fontagne (2022), “EU in search of a WTO-compatible carbon border adjustment mechanism”, VoxEU.org, 26 March.

Dominioni, G, and D C Esty (2022), “Designing effective border-carbon adjustment mechanisms: Aligning the global trade and climate change regimes”, Arizona Law Review 65(1), forthcoming.

Dominioni, G (2022), “Pricing carbon effectively: A pathway for higher climate change ambition”, Climate Policy.

IMF (2019), Fiscal policies for Paris climate strategies – from principle to practice, IMF Policy Paper No. 19/010.

Mehling, M, H van Asselt, K Das and S Droege (2019), “What a European ‘carbon border tax’ might look like”, VoxEU.org, 10 December.

OECD (2021), Effective carbon rates 2021: Pricing carbon emissions through taxes and emissions trading, Paris: OECD Publishing.

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Topics:  Environment EU policies

Tags:  border carbon adjustment, carbon border tax, carbon leakage, climate change, EU, greenhouse gas emissions, paris agreement

Assistant Professor, School of Law and Government, Dublin City University

Hillhouse Professor, Yale University

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