One of the best ways to tackle climate change is for governments to do what markets cannot — put a price on greenhouse gases. A “cap-and-trade scheme” where companies must buy permits for emissions, which they can then trade among themselves, or an outright carbon tax leaves businesses to focus on what they are good at: deciding, based on prices, what to produce. Yet where governments have followed this course, they have confronted a new problem. In the absence of a global carbon price, companies face competition from exporters elsewhere who can produce at a lower cost.
This makes a carbon border tax a necessity. A functioning emissions trading scheme needs some means of adjustment at the border to make sure imports and domestic production are treated the same. This is vital to create a level playing field for competition and prevent “carbon leakage” where measures to reduce emissions in one country lead producers to relocate to another with looser standards.
While they are an environmental imperative, carbon border taxes will, however, be difficult to implement. Depending on their design they could fall foul of World Trade Organization measures designed to prevent importing countries from discriminating against particular exporting countries — granting an advantage to some WTO members that have a better record on climate change. For companies, it will raise the administrative burden of crossing borders and increase trade frictions, especially for small businesses. That will inevitably reduce choice and raise costs for consumers.
The EU’s leaked proposal for a carbon border adjustment mechanism looks to be a good first step. Under the proposals companies would have to make up the difference between their carbon price at home and the EU’s own emissions trading scheme, ensuring fair competition. This, officials argue, would be permitted under WTO rules as it would be levied on individual companies rather than countries. Countries that object could flag up that the EU hands out some free permits to domestic producers, giving them an unfair advantage. The arguments will inevitably be tested at the WTO.
Other parts of the proposals are also welcome. The scheme would be phased in gradually and only apply to a handful of sectors. That would give businesses time to adjust but also provide an ironclad commitment that would reduce the incentive for production to gradually relocate elsewhere. The scheme would include the most polluting sectors, such as electricity and steel — heavily affecting many of the EU’s nearest neighbours but not the US, potentially heading off at least some of the international backlash.
There are also flaws. There is no allowance for the least developed countries — although including one could lead to further objections at the WTO. While only a handful of poorer countries export substantial amounts of carbon-intensive products to the EU, incorporating such an allowance would be sensible — especially given rich countries’ foot-dragging over providing financial aid to help with the energy transition.
Fighting climate change will inevitably be difficult, politically as well as technologically. The proposal is partly about the EU’s domestic politics: as the cost of permits in the EU’s emission trading system have risen, Europe’s steel producers have pushed for a border tax. It is also a means to pressure other countries to do the same. Compared with all the other challenges involved in ending global warming, designing a carbon border tax should not be insurmountable.