Carbon Prices and Carbon Leakage

Over the past weeks, the conversation over a global carbon price has considerably moved up policy debates worldwide. Just half a year ago, hardly anyone would have seen such a global floor as a viable option. Now, it still comes with a big question mark, but it is on the agenda.

Recent developments have provided critical impetus to this momentum. In July, the EU adopted a proposal for a Carbon Border Adjustment Mechanism (CBAM) to limit carbon leakage from its Fit-for-55 package, specifically in the highest carbon-emitting industries. Its proposal to “put a carbon price on imports of a targeted selection of products” has added an incentive for key trading partners to review their position on carbon pricing. Similarly, the agreement reached between the EU and the US in October on Steel and Aluminium Excess Capacities and Carbon Intensity commits the two partners to further negotiations that shall also account for carbon intensities.

Calls for international cooperation on carbon pricing have since come forth at a staggering speed, specifically in the immediate lead-up to COP26. In October, the WTO’s Director-General Okonjo-Iweala urged leaders gathering in Glasgow to make solving the challenges on the road to a global carbon price a priority. Shortly thereafter, OECD Secretary-General Cormann highlighted that “carbon prices and equivalent measures need to become significantly more stringent, and globally better coordinated”. And the IMF’s Managing Director Georgieva called for the adoption of an international carbon price of at least US$ 75 per ton by 2030. Pushes for a cooperative approach to carbon pricing have also come from the business community, including the Washington-based Business Roundtable, the Brussels-based European Round Table for Industry, and the business councils of Australia, Canada and Mexico.

Steps towards a global carbon price floor

An enforceable global price on carbon that reflects its climate cost is the first best solution to eliminate net carbon emissions. Both practical and policy-related problems make this an unlikely scenario for the short to medium term, however. Nevertheless, bearing in mind the recent agreement on a minimum corporate profit tax, one should not dismiss out of hand the possibility of a global carbon price in the longer term.

Currently the global average carbon price is about US$ 3 per ton, ranging from zero to US$ 137 per ton. There is also substantial variation in the share of total greenhouse gas emissions covered by taxes (Figure 1).

Figure 1. Carbon prices and their coverage, 2021

Source: World Bank Carbon Pricing Dashboard

Unilateral carbon prices without a system to avoid leakage could trigger carbon-intensive industries to relocate to countries with lower or no carbon taxes and export their products back to the high carbon price-country. If so, setting a high carbon price could mean a loss of competitiveness for the high-carbon price country while carbon emissions would continue unabated.

To avoid such carbon leakage, high-carbon price countries consider imposing a tariff on imports from countries with a low carbon price. An example is the EU’s CBAM. It would be a complement to the internal emission trading system (ETS) where importers would buy emission quotas at the same price as the equivalent carbon tax that would be due if sourcing the product locally. Calculating the carbon content of a product is a tall order for exporters and importers alike. Therefore, CBAMs, as currently debated, are typically limited to taxing the final output of a few carbon-intensive industries. This may create carbon leakages of its own.

First, although CBAMs protect local import-competing firms from losing market share at home to imports from low carbon price countries, carbon-intensive exporting industries will lose competitiveness unless exports are exempted or get rebates on the carbon price. Rebates run the risk of undermining the objective of the carbon price, while refraining from rebates could reduce the market share of local exporting firms in third countries with lower carbon prices – or it may trigger relocation of carbon-intensive exporting firms.

Second, local downstream industries using e.g., steel intensively would also lose competitiveness and market shares relative to firms sourcing steel from low-tax countries. Downstream industries could avoid the carbon tax if they relocate from high to low-tax countries unless the tax is levied on steel used as intermediate inputs as well, which is currently not on the table.[1]

Another concern is compatibility with WTO rules and commitments. True, WTO allows tariffs to protect life, health, and public morale, but such tariffs must be non-discriminatory and not a disguised restriction on international trade. The EU claims that its CBAM will be designed in such a way that it will be compliant with WTO rules, but it is fair to say that there is widespread skepticism among trading partners as well as international organizations, including the IMF.

The CBAMs on the table have their downsides, but a solution is urgently needed. So, what can be done? One possible path is for large like-minded countries to enter an agreement on a minimum carbon price, invite all countries to join, and shelve plans for CBAMs. Carbon abatement is costly, and the benefit is a global public good. Therefore – as pointed out in the academic literature – due to the free-riding problem, such coalitions cannot be both large and stable unless there is a penalty for not joining. Furthermore, the penalty must not hurt the signatories to the agreement.

What could the penalty look like? A CBAM fits the bill but raises new problems. Furthermore, a penalty would better serve the global common good if its focus was on creating incentives for joining the coalition. One alternative proposed in the academic literature is a low and flat tax on all imports from countries that refuse to introduce a sufficiently high carbon price.[2] If the penalty serves its purpose, which is to nudge countries to join the agreement, it would remain a threat rarely used. Also for this measure, the challenge is to find a design compatible with WTO rules

Penalties could also take the form of denial of access to benefits. An agreement on minimum carbon prices could for instance be extended to include low-cost climate finance beyond what is already in the Paris Agreement, accessible conditional on having introduced the agreed minimum carbon price. Withholding such a carrot would be particularly relevant for enticing developing countries to join the agreement but would probably need to be combined with other penalties for creating a large and stable coalition.

To conclude, the large carbon emitters, starting with China, the EU and the US should agree on a minimum carbon price and work together, including in the WTO and with stakeholders, to design WTO-compatible incentives for others to follow.

References

Bellora, C., & Fontagné, L. (2021). EU in search of a WTO-compatible carbon border adjustment mechanism. Mimeo. http://www.lionel-fontagne.eu/uploads/9/8/3/3/98330770/cblf_cba_2021.pdf.

Nordhaus, W. (2015). Climate clubs: Overcoming free-riding in international climate policy. American Economic Review, 105(4), 1339-70.

Nordhaus, W. (2021). Dynamic climate clubs: On the effectiveness of incentives in global climate agreements. Proceedings of the National Academy of Sciences, 118(45).

[1] See Bellora and Fontagne (2021) for a simulation of the impact of EUs CBAM.

[2] See Nordhaus (2015; 2021)

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