The Impact of CBAM on EU Trade Partner Emissions

The CBAM legislation addresses the European Union’s (EU) concerns about domestic firm competitiveness and carbon leakage. By incentivising EU trade partner firms to reduce emissions and EU trade partner states to adopt carbon-forward policies, the legislation may be instrumental in reducing carbon emissions across the globe to meet the 1.5C target. However, risks of retaliation from the developing world may do more harm than good.

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What Is the EU’s Carbon Border Adjustment Mechanism?

The European Union’s Emissions Trading Scheme (EU ETS), rolled out in 2005 and gradually expanded since then, sets a cap on greenhouse gases (GHGs) emitted by firms based in the EU by providing them a quantity of Emission Allowances. Firms producing relatively lower emissions can sell their excess allowances to firms producing relatively higher levels of emissions, creating a secondary market for trading these emission allowances.

Announcements geared towards expanding the scope of the EU ETS, along with the phaseout of free allowances, raised concerns that the subsequent increased costs to domestic producers would place them at a competitive disadvantage compared to foreign firms producing goods without a corresponding carbon price. 

Competitive disadvantages for domestic firms could result in carbon leakage, a process in which domestic enforcement of a price on carbon increases emissions elsewhere, either by domestic firms moving production offshore or external firms increasing production to meet the growing demand. In response, the European Commission legislated the Carbon Border Adjustment Mechanism (CBAM) to enforce a carbon price on imported goods in certain industries.

The rationale for the CBAM is that a carbon “tax” on imports of goods covered under the ETS would maintain the domestic competitiveness of European Union (EU) firms and prevent carbon leakage towards EU Trade Partner Countries – countries exporting CBAM related goods to the EU – thereby not undermining the EU’s ambitious emissions reduction goals. 

Initially, the six industries most susceptible to carbon leakage – i.e., emissions-intensive and trade-exposed (EITE) industries – have been included in the mechanism. During the transition phase between October 2023 and late 2025, importing firms will have to report the quantity and emissions intensities of CBAM goods imported. The definitive phase, which is set to commence in January 2026, will require importing firms to pay a price on the carbon emissions on imported goods, linked to the price of EU ETS Emission Allowances.

More on the topic: The Implications of the EU Carbon Border Adjustment Mechanism on the Environment and Global Trade

Firm-Level Incentives and Emissions Reductions

The CBAM Implementing Regulations (2023) require trade partner firms to report their direct as well as indirect emissions, such as those from the generation of electricity consumed for production and from certain production precursors. There are concerns that to minimize their carbon tariffs, firms may engage in “reshuffling”, i.e., exporting to the EU from plants with “cleaner” production (relatively lower direct and indirect emissions) and sending goods from “dirty” plants (relatively higher direct and indirect emissions) to other parts of the world. This could create a two-tier system where relatively “clean” goods are exported to CBAM regimes while “dirty” goods are shipped to non-CBAM regimes with lax climate policies, potentially resulting in relatively lower emissions reductions than anticipated. 

Firm-level emissions reduction incentives also depend on their levels of export dependence on the EU and the carbon emissions intensities of their exports relative to EU goods. The figure below, produced using data from the World Bank CBAM exposure index, provides some useful insights.

Countries with higher levels of export dependence on CBAM products to the EU (measured on the horizontal axis as the share of a country’s total exports of CBAM products that go to the EU) may find it difficult to find alternative export markets. Some African countries (Cameron, Zimbabwe and Mozambique) and Non-EU European countries (Albania, Belarus and the UK) have more than 50% of their CBAM related goods going to the EU. The vertical axis represents CBAM product related emissions intensities relative to EU manufacturers (measured as the excess carbon price to be paid per dollar of CBAM product exports to the EU relative to EU manufacturers). Higher relative emissions intensities signal a competitive disadvantage for a country’s producers and vice-versa. Trinidad and Tobago and Colombia face disproportionately higher (26%) and lower (-11%) relative CBAM tariffs, respectively.

More generally, firms in countries positioned higher up and towards the right would be more susceptible to CBAM tariffs. Countries including India, Georgia, and Ukraine, although not as export dependent, face a cost increase greater than 10% relative to EU manufacturers. Zimbabwe and Belarus face both significant export dependence and higher CBAM tariffs.

Policymaker Responses

Trade partner governments highly dependent on CBAM product exports to the EU may be incentivised to implement their own carbon pricing schemes. In Figure 2, the size of the bubbles indicates the share of a country’s GDP dependent on CBAM product exports to the EU, serving as a proxy for CBAM’s potential spillover effects on a country’s economy. Governments in relatively highly exposed economies may face less domestic resistance towards carbon pricing initiatives, increasing the chances of adoption. Moreover, implementing their own carbon pricing schemes would not only help firms offset CBAM tariffs, but also provide governments with an additional revenue stream. Some countries, including Argentina, China, Chile and South Africa, already have some form of carbon pricing, with many more following suit, including India, Indonesia, Turkey, Brazil, Mozambique and Zimbabwe.

On the other hand, the negative impacts of the CBAM on developing economies, the largest exporters of EITE goods to the EU, may lead to opposition, and potentially retaliatory measures against the policy. Simulations have shown that, in addition to the regulatory burden of CBAM, such countries could face significant welfare losses, exacerbated by lower safety nets. This shift of the burden of fighting climate change towards developing economies disregards their “historical responsibility” for causing the most amount of climate damage. In addition, indirect “sanctions” on (mostly developing) countries violate the principle of “common but differentiated responsibilities and respective capabilities” by coercing them to take action, which most certainly may be beyond their current means. Unsurprisingly, the CBAM has seen negative reactions from many developing economies, particularly from the BASIC group comprising China, India, Brazil and South Africa.

Looking Ahead

The CBAM is just the beginning of a series of climate-related legislations. Similar carbon border tariffs have been proposed by other countries such as the US, Canada, UK, and Australia. As these carbon border legislations increase in scope and geographical coverage, the road will only get tougher for developing countries and for the future of international climate diplomacy. It is too early to say if CBAM is the right way forward. While such policies may be necessary to reach the Paris Agreement goals, the risks of global disorder and the potential unraveling of the global climate agenda may do more harm than good.