The European Union (EU) is moving ahead with the world’s first border tax on the carbon content of imported goods which aims to strengthen its increasingly ambitious climate targets and policies, but is attracting criticism. How would it work and which trading partners are most vulnerable to its impacts?

The EU is accelerating its climate ambition over the coming decade to support its 2050 long-term strategy of reaching net-zero greenhouse gas (GHG) emissions. Key aspects of this acceleration include raising its emissions reduction target from 40 per cent to at least 55 per cent below 1990 levels by 2030 and implementing a sweeping set of policy changes – especially to its flagship emissions trading system (ETS) which puts a price on pollution by requiring companies to purchase allowances for their emissions.

The costs of the allowances have skyrocketed recently and now hovers around record levels of €50 per tonne of carbon dioxide equivalent or above. This is due – at least in part – to those participating in the market expecting a tighter supply of allowances as the EU increases its climate targets. Prices are expected to continue rising over the coming decade as the EU implements its ambitious climate agenda.

These concerns about rising allowance prices have motivated the most controversial aspect of the EU’s 2030 climate agenda – a charge on imported goods based on their carbon content. The carbon border adjustment mechanism (CBAM) would be the world’s first system of carbon tariffs, and aims to address the risk of ‘carbon leakage’, whereby EU firms either lose market share at home to more emissions-intensive competitors abroad, or have to shift production to places with little or no carbon pricing.

Carbon leakage undermines global climate efforts because it offloads emissions elsewhere with no net reduction overall. Although little evidence currently exists that it happens, there are good reasons why it has not measurably come to pass and why the decade ahead presents greater risks.

The EU – as with other places which price carbon emissions such as the UK – has protected certain domestic industries facing international competition by awarding them allowances for free to offset carbon costs. But this system of free allocation becomes limited as climate targets increase and the supply of allowances dwindles, and it also weakens incentives to reduce emissions domestically.

With the CBAM, the EU signals its transition away from free allocation in favour of a system of leakage protection that instead tries to create a level playing field between goods produced domestically and those from abroad – which could also better spur investment in climate mitigation. The European Commission recently released a proposal outlining how the CBAM will work, although changes are likely during the legal process which involves both the EU Parliament and Council.

The CBAM is expected to apply to a list of imported products from a narrow set of industrial sectors which are both emissions intensive and highly-traded, making them more vulnerable to the risk of carbon leakage – cement, iron and steel, aluminium, and fertilizers. Electricity is also included given the rising imports and interconnections with the EU’s more emissions-intensive neighbours, and more industrial sectors such as chemicals and refineries will likely be added later.

How the EU CBAM will work

The aim is, starting in 2026, importers need to purchase special, non-tradable allowances, or CBAM certificates, each year based on the volume of goods they bring in and the independently-verified emissions content. CBAM certificates will closely mirror the prices of an allowance in the EU ETS, so that the charge importers face largely comes down to their overall volume of imports to the EU, the emissions intensity of the goods where they were produced, and the cost of an EU ETS allowance.

However, importers can reduce their CBAM obligations by using the carbon costs the goods face in the country of origin. Although the precise methodology is yet to be determined, it is likely to encompass only the actual costs from an ETS or carbon tax in the country of origin, which in practice means those incurred beyond any free allocation or exemptions rather than a reduction based on market price alone.

This is crucial for the CBAM to be effective and fair as it will avoid ‘double burdens’ and should incentivise carbon pricing as a clear path to reducing exposure to a carbon tariff. But it is also one of the most controversial aspects of the CBAM because many – especially in developing and emerging economies – see it as forcing climate policy choices onto other countries and undermining the Paris Agreement which relies on individual country commitments based on their own national circumstances. The only countries exempted from the CBAM will be those participating in the EU ETS but not as EU member states and those having linked their own ETS to the EU’s.

Therefore, a key consideration is which countries are the most exposed to the CBAM, which can be analysed by compiling total imports to the EU of the products identified in the five initial CBAM sectors, drawing on data from the United Nations (UN) Comtrade database and taking an annual average from 2015-2019.