What the EU’s new border tax could mean for carbon markets

Currently, about 25 percent of carbon released in the atmosphere is covered by some kind of carbon price — often levied in the form of a carbon tax or managed through an emissions trading system.

With a carbon tax, a fee is added to products that produce or emit greenhouse gases. With an emissions trading system, a maximum level of pollution is set, and permits to pollute are bought and sold. The cap on the number of polluting permits decreases over time, making it more expensive to pollute.

A quarter of the globe with some kind of carbon price may not sound that impressive. Don’t worry. It gets less impressive. Many carbon markets set a price on carbon that is too low to really drive behavioral changes: The current price of carbon in China is about 50 yuan per metric ton, or almost $6.50. It’s projected to rise to 139 yuan by 2030, but that’s still cheap, at $19.42. For comparison’s sake, the price of carbon in the European Union’s Emissions Trading System (ETS) topped $108 for the first time in February.

Arbitrageurs — those that see a discrepancy in markets and look to jump in to make a profit — are undoubtedly disappointed that they can’t buy CO2 credits in China and sell them in Europe. That may be the case now, but in the not too distant future, that dynamic may shift. The EU’s Carbon Border Adjustment Mechanism (CBAM), adopted last month, is one piece of legislation driving that change.

Exporting ‘climate ambition’

The aim of Europe’s new carbon border tax is to level the playing field for carbon-intensive goods imported into EU member states. The introduction of the policy is to be gradual, aligning with the gradual phase-out of free allocations to pollute with CO2 under the aforementioned ETS. Currently, about 40 percent of the allowances in the ETS are given out "free." As these free allowances are gradually taken away, EU companies could be at a competitive disadvantage if they were paying for pollution but their competitors outside the EU were not.

Here is how the CBAM will work:

• An EU importer of goods covered by the tax registers with national authorities where it can buy certificates.
• The EU importer declares emissions embedded in the goods and surrenders the corresponding number of certificates.
• If an importer can prove a carbon price was already paid during the production of the good, they wouldn’t have to pay the tax.

Let’s ponder the implications of that latter detail: If a good comes from an EU trading partner that has imposed a carbon price on production, little or no "adjustment" would need to be paid. In theory, that could encourage nations that trade with the EU to develop their own carbon market.

The mechanism will initially cover more carbon-intensive sectors such as iron, steel, cement, fertilizers, aluminum, electricity and hydrogen. Plastics and chemicals are added to the list in 2026, and all sectors covered by the existing emissions market will be added by 2030. That means that by 2030, products such as cars and other assembled goods will be included, as well as Scope 1 (manufacturing process) emission and Scope 2 (energy use) emissions.

Alex Child, partner and head of research at Carbon Cap Management LLP, a firm that invests in and trades carbon in global carbon markets, sees the new EU carbon border tax as a positive step for global carbon markets. "CBAM is a great way to export climate ambition around the world," Child said. "CBAM should incentivize carbon pricing instruments to proliferate around the world by countries looking to avoid their exports being imposed with carbon tariff at the border. This should further develop carbon as an asset class and bring greater liquidity and transparency to global compliance carbon markets."

However, there are likely to be growing pains in the implementation of CBAM.

"There are concerns and issues to be worked out," Child said. "For instance, developing countries may take time to develop the requisite monitoring and verification of GHG emissions across sectors. There are also issues relating third-party export destinations: In the current formulation of the CBAM, dirtier nation exports with zero domestic carbon price may still have a competitive advantage to EU exports, which face a domestic carbon price of nearly ($108).”

The policy could also run afoul of the World Trade Organization. India, for one, believes it violates current norms and plans to challenge it.

Minimal impact for US exporters

Experts believe the United States will be one of the countries least affected by the EU’s carbon border tax, which doesn’t provide much incentive for the nation to adopt a carbon price or tax. According to the 2021 report "A Storm in a Teacup: Impacts and Geopolitical Risks of the European Carbon Border Adjustment Mechanism," the costs to the United States related to CBAM are anticipated to be about $108 million in 2026 and only about $27 million by 2035.

Another reason the U.S. may not join the carbon pricing club anytime soon is strictly political. "There is a real aversion in the United States to taxation as a solution to a problem, when compared to other countries," said Emily Benson, director of Project on Trade and Technology at the Center for Strategic Trade and International Studies. "This leaves the U.S. in ambiguous territory when CBAM comes into effect."

It is unlikely that the U.S. Congress will addr