In 2005, the European Union established the Emissions Trading System (ETS), the world’s first, and largest, market for carbon allowances. Following a cap-and-trade approach, the ETS functions as an open market for trading emissions permits; the current price hovers around €86 (US$92) per metric ton of carbon-dioxide emissions.
With an eye towards reducing global emissions, the EU designed a carbon border adjustment mechanism (CBAM) to complement the ETS. Effectively a tax on imports from countries that do not have an equivalent carbon price, the CBAM aims to prevent EU-based companies from moving emissions-intensive production to third countries with less stringent climate policies.
Implementation will start in October, at which point importers of select goods – iron and steel, cement, aluminium, fertilizers, electricity and hydrogen – must begin to report data on embedded emissions. From 2026 onward, these importers will have to purchase permits that cover their products’ carbon content at the EU market price. The transitional period, during which the CBAM’s functionality and product scope are set to be reviewed, will continue until 2034.
Given that the United States does not currently have its own carbon-pricing mechanism, the CBAM will apply to the country’s exports to the EU, which totalled more than €350 billion in 2022. A significant share of these exports are carbon-intensive products like airplanes and spare parts (roughly 13% of the total), mineral fuels (11%), optical and medical instruments (10%), pharmaceuticals (10%) and agricultural products owing to extensive fertilizer use (4%).
Even a small exporting state like Connecticut will likely feel the pinch: sales of airplanes and spare parts (US$2.7 billion) and nuclear technology (US$2.3 billion) accounted for nearly 30% of its roughly US$17 billion in exports in 2021 (the latest year for which data are available).
In early June, Citizens’ Climate Lobby representatives met with more than 450 members of the US Senate and House of Representatives and their staffs to discuss the CBAM. Some politicians were completely unaware of the tax. Others, believing for some misguided reason that it would create an “energy supply crunch”, proposed expanding production of natural gas and nuclear energy, even though lags between investment and production in those supply alternatives would extend well beyond 2026.
But the response of a third group was more worrisome. Unperturbed by the EU action, these politicians suggested strong-arming the Europeans into granting the US an exemption from the CBAM by slapping tariffs on EU imports, regardless of carbon content.
It would be unwise to start a trade war with the EU, mainly because the bloc would retain the upper hand. The CBAM tariff on US exports would increase member states’ comparative advantage in selling low-emissions versions of American goods and stimulate the EU-wide development of carbon-saving production technologies – complicated processes in which the US already lags behind current and future competitors like China. Moreover, American exporters, not European importers, would pay the tax, raising business costs and consumer prices in the US. And this is to say nothing of the missed opportunity to provide economic incentives to reduce greenhouse gas emissions by changing the relative prices of carbon-intensive goods.
There is a better way to respond. Why not admit that the EU is setting global climate policy and effectively forming a global “climate club”? The US has abdicated its leadership role in this regard, so why not follow the bloc’s lead? Over the next three years, US policymakers could create a carbon-pricing mechanism in line with the EU’s program and thus be granted an exception for the right reason – because it joined the club. Both the US economy and the planet would benefit.
The CBAM is an early and promising approximation of the proposal that William D. Nordhaus, a Nobel laureate in economics, advocated in Climate Club: Overcoming Free-riding in International Climate Policy, his 2015 paper in the American Economic Review. Acknowledging countries’ tendency – manifest in the defunct Kyoto Protocol – to free-ride when international climate agreements lack consequences for non-compliance, Nordhaus argues that a climate club, with small trade penalties on non-participants, “can induce a large stable coalition with high levels of abatement”.
Nordhaus had imagined that China and the US would be the first members of such a club, but that is not a necessary condition. The EU has the economic and political clout to produce “high levels of abatement” while keeping penalties as low as possible. For US policymakers, joining, rather than repudiating, the EU’s approach to carbon pricing is the most sensible way forward for both the domestic economy and the international climate agenda.
Gary Yohe is a professor of economics at Wesleyan University, and Roger Kuhns is a president and founder of SustainAudit, a sustainable-practices consulting firm.
Copyright: Project Syndicate