Is Europe’s new carbon border tax fair for everyone?

The European Union’s carbon market has shown remarkable success in encouraging industries to green their production processes. Known as the Emissions Trading Scheme (ETS), it has helped reduce the EU’s greenhouse gas (GHG) emissions by more than 40% in covered sectors.

The largest environmental-commodities market in history, it covers 31 countries (the 27 member states plus Iceland, Liechtenstein and Norway) and more than 10,000 power plants and industrial installations. These include oil refineries, steel works, and production of iron, aluminium, metals, cement, glass, ceramics, pulp and paper, among others. Based on the “cap and trade” principle, it sets an absolute limit on the total amount of certain greenhouse gases that can be released each year by the entities regulated by the system. Critically, that cap is tightened over time. Companies can buy or receive emission allowances, which they trade with one another as needed.

However, the policy has also had some undesirable side effects. Industries have looked to outsource their production to countries that do not adopt similar policies, which can lead to a rise in emissions outside Europe, potentially even exceeding the EU’s emission reductions.

To avoid this, in December the European Commission voted on a preliminary agreement to set up a border carbon adjustment mechanism (CBAM). Instead of charging for GHG emissions only within the European Union, the CBAM will also tax emissions embodied in imports of the high-emission industries. Aluminium, electricity, cement, fertilisers, iron and steel are particularly targeted, while hydrogen was recently added because it was chiefly produced with coal in non-EU countries.

This may look like a smart move to motivate the EU’s trading partners to decarbonise their production alongside the 27-state bloc. It is true the adoption of the CBAM could lead to a wave of similar policies in other developed economies, such as Japan and North America, as well as in developing countries with the capacity to decarbonise their industries, such as China. Adopting a similar line will allow them to avoid paying a carbon tax at the border when exporting their goods and services to the EU.

However, some of the underlying assumptions remain controversial. Promoting the substitution of highly polluting technologies by green technologies seems notably easier in Europe than in Africa.

Strong dependencies

Combining an enthusiasm for green politics and engineering traditions, Europe is a leading manufacturer of green technologies. The continent is home to top wind turbine producers (Vestas, Nordex and Siemens Gamesa) as well as green power generators (Enel, EDP, Iberdrola and Orsted).

The replacement of old industries by green ones therefore creates new employment opportunities and leads to a positive cycle of income growth and environmental progress. Elsewhere, by contrast, green technologies are more likely to be imported, which means that this process will weaken the economy rather than create opportunities.

For those unable to keep up, there will be further damage as they lose access to the EU market or become less competitive and no longer export. Many jobs, tax revenues and export revenues will be lost if the CBAM is implemented without taking into account the specificities of the EU’s trading partners.

Some studies have already addressed this issue with macroeconomic models, but these are flawed in their analysis of developing countries. They generally assume that all countries have a relatively high capacity to migrate from one industry to another.

In recent work, we try to avoid these assumptions by focusing on economies with less mature industries and therefore less capacity to adapt. We therefore analyse the consequences of the implementation of the CBAM on employment, wages, tax and trade revenues, following an approach developed to understand the macroeconomic consequences of developing economies in the context of a global transition.

The results show that African countries such as Mozambique and Zimbabwe and some Eastern European countries, such as Bosnia and Herzegovina, Ukraine and Serbia, are highly dependent on exports of products subject to the CBAM. In the case of Mozambique, almost a fifth of its total exports are aluminium to the EU. Zimbabwe and Ukraine depend on iron and steel exports to the EU, while Serbia and Bosnia’s exports of CBAM products are more varied (iron and steel, electricity and aluminium) but still account for more than 5% of their total exports.

Jobs at risk

Our method allows us to analyse not only the industries producing such products, but also those supplying inputs farther up in the production chain, hence leading to cascading impacts. This is possible by using intercountry input-output matrices, which show the productive relationships between sectors within and between countries.

Based on this approach, we find that the potential job losses and the share of wage income exposed to CBAM. Mozambique and Moldova are the countries in which wage income is most likely to be impacted, accounting for around 6% of the wage bill. On the other hand, Serbia and Bosnia and Herzegovina can experience job losses of around 3% if the CBAM is implemented without taking into account the specific constraints of these countries.

If one considers the share of the population benefiting from a welfare security net, one finds additional socio-economic vulnerability. In Mozambique or Zimbabwe, only a small part of its population is covered by social protection policies. This is not quite the case for countries such as Ukraine, Bahrain and Armenia: even though they are highly exposed to the consequences of the CBAM, at least 50% of their population enjoys some form of social protection.

What if others do the same?

This will also significantly increase the exposure of developing countries, particularly in Africa, Asia and Latin America. In the case of Zimbabwe and North Korea, for example, exports to China of these high-emitting industries play a very important role, and in the case of Trinidad and Tobago and Bahrain, their sales to North America are very significant as a proportion of total exports.

This potentially regressive nature of the CBAM therefore requires careful attention to its institutional design, especially if the objective is to reinforce global climate ambitions with the EU’s own decarbonisation strategy. One possible way to minimise its side effects is to exempt the so-called least developed countries from the CBAM. Instead, they should receive targeted support from the EU to reduce their dependence on highly emitting industries, via transfer of technologies, climate subsidies or concessional lending.

The design of a development-friendly CBAM, such as the one discussed, is key to the success of this emblematic part of the Fit for 55 package, which aims to slash the continent’s emissions by 55% by 2030 compared to 1990 levels. The effectiveness of this measure will therefore need to be accompanied by a broader set of development policies to accompany the most exposed countries toward their own carbon neutrality strategy.

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