Photo Credit: iStock, Grafissimo

This week marks a critical moment in the global response to climate change. In Glasgow, world leaders are meeting at COP26 to chart a workable path forward on global climate mitigation strategies. In Washington, Congress is deciding the fate of President Biden’s domestic climate agenda, which even in its scaled-back form includes significant tax incentives for wind, solar, and clean energy and new regulations to limit pollution from power plants and automobiles.

The urgency of these measures has never been more clear. As a new report released by the U.N. last week demonstrates, governments’ existing plans to curb carbon emissions are insufficient to meet the Paris Climate Agreement’s goal of limiting the rise in global temperatures to 1.5 degrees C above pre-industrial levels by 2100. Instead, current climate mitigation measures put the world on track to cap global temperature rise at closer to 2.7 degrees by the end of the century—potentially enough to avoid the most calamitous effects of climate change but still well above the goals established by the Paris Agreement. These outcomes, though, are far from set in stone, and the U.N. concluded that countries can still limit warming by another half a degree, to 2.2. degrees C if they adopt and implement new net-zero emissions policies in the coming years.

The question then becomes this: What policy tools are available to the U.S. to incentivize other countries to move towards these net-zero outcomes?  There are a broad range of tools, but it is increasingly clear that trade policy and other border policies will play an outsized role. Trade policy can both incentivize good behavior and penalize bad behavior, in many cases leading to swifter outcomes than those achieved through purely voluntary commitments. In the climate context, we will see many ambitious commitments unveiled this week in Glasgow—but emissions know no borders, and until all countries are aligned on the urgency of the problem and have agreed to share the responsibility of reaching net-zero emissions, trade policy will likely remain a critical tool.

Using a system of carrots and sticks, the United States can leverage its climate leadership to develop an alliance of environmentally like-minded countries who enjoy preferential terms of trade and pursue deepened cooperation, including in how they work together to help developing countries meet their own climate commitments.  We have seen the first evidence of this approach just this week with the U.S. - EU announcement to negotiate a sectoral arrangement for steel and aluminum that will for the first time address carbon intensity as part of a trade initiative. And for those countries playing the short game, trade policy offers several templates to introduce carbon border adjustment mechanisms—or CBAMs—a class of trade measure designed to support climate mitigation policies by addressing carbon leakage (i.e. the migration of carbon-intensive production from areas with stricter emissions standards to those with weaker standards).

To CBAM or not to CBAM?

Although CBAMs are not on the formal agenda in Glasgow, several countries are considering implementing them, including the EU, Japan, and Canada. The idea of the U.S. implementing a CBAM has also been gaining traction among some trade experts and policymakers in Washington. The reason for CBAMs is clear: compliance with stricter emissions standards and deeper investments in environmental technologies leads to far more favorable environmental outcomes, but they come at a cost. A CBAM can help level the playing field so that producers in countries with a carbon advantage are not placed at a competitive disadvantage.  Yet a patchwork of uncoordinated CBAMs—including measures that are directed at like-minded allies—has the potential to be counterproductive by creating incentives for carbon arbitrage and reigniting a race to produce in the cheapest carbon markets. The United States has an opportunity to steer the global path forward on CBAMs, but it must do so both expeditiously and thoughtfully, taking into consideration the following critical questions for a U.S. CBAM framework.

1. How should the U.S. measure carbon content?

Before adopting a carbon border adjustment mechanism, regulators in the U.S. will have to decide how to measure the total carbon content of manufactured products. There are two major schools of thought when it comes to calculating carbon content: point-of-production analyses and life-cycle analyses. As the name suggests, point-of-production analyses account for the amount of carbon emissions produced at the site of production, including direct energy inputs. Life cycle analyses, by contrast, are additive and account for the total carbon footprint of a product across the entire value chain, including the emissions produced by the energy that was needed to produce and distribute the components and final goods in question.

Of course, a life-cycle analysis is more comprehensive than a point-of-production analysis, but there are still several question marks about how a life cycle analysis would work in practice. For instance, life cycle analysis methodologies vary greatly between and within international jurisdictions and can prejudice geographically equitable accounting of carbon output/savings. The starting point and scope of inputs included also vary by methodology, making an ‘apples-to-apples’ comparison of carbon output between countries impractical.

2. Which type of carbon emissions does the U.S. want to offset with a CBAM?

Carbon border mechanisms can address carbon leakage in one of two ways: either by applying a price or tax on either positive carbon output (i.e. the amount of carbon that that is “saved” through mitigation techniques and compliance compared to an unmitigated circumstance) or by applying a price to negative carbon output (i.e. the amount of carbon emitted in excess of what is mitigated).

These strategies, however, are not mutually exclusive, and the most equitable and comprehensive approaches use a combination of the two. An example of both positive and negative carbon adjustment would be a carbon price applied to the full unmitigated value of emissions in order to address domestic industry concerns about the imbalance between relative compliance costs or a combination of compliance costs adjustment (for negative values) and a carbon price/tax (for positive values).

3. How does the U.S. avoid facilitating adverse arbitrage between the cost-of-compliance and the price for carbon?

Complying with new or existing environmental regulations creates significant costs for manufacturers in highly-regulated markets like the U.S., placing those manufacturers at a competitive disadvantage relative to their competitors in less stringent regulatory environments. CBAMs may be designed to remedy this imbalance by pairing the cost-of-compliance (i.e. the price of complying with mitigation regulations) with the price of unmitigated carbon to create a more even playing field.

But regulators have to walk a careful tightrope in determining these costs. Pricing the cost-of-compliance provides the benefits of harvesting the U.S. carbon advantage, leveling the playing field to what U.S. firms already invest in environmental compliance. Moreover, setting a base price on the cost-of-compliance is both technically feasible and straightforward because values can be objectively determined from the capital and operational costs of relevant process technologies. However, if cost-of-compliance is imposed in conjunction with a price for carbon that is too low—and without appropriate regulatory guardrails—it could undermine regulatory effectiveness over time with pollutants other than greenhouse gas emissions and encourage off-shoring by incentivizing manufacturers to pay for the price of carbon rather than comply with regulation, resulting in adverse environmental/carbon arbitrage.

4. Which instrument(s) should the U.S. use to implement border adjustments?

In order to implement a border carbon adjustment, the U.S. can draw from a variety of new or existing border instruments, either independently or in conjunction—including a commoditized carbon price, tax/fee, specific tariff, a value-added tax (VAT), and import licensing fees, and/or various trade remedies like countervailing duties. Existing border instruments carry the benefit of administrability and efficiency, but market mechanisms have bold potential to accelerate decarbonization by creating secondary carbon markets and financial instruments that promote speedier and more efficient deployment of technologies for carbon elimination.

5. Product Coverage: upstream components and/or downstream components and products?

Taxing or pricing upstream commodities in isolation would likely have the unintended consequence of offshoring industries as manufacturing follows cheap inputs and operating costs to low-standard jurisdictions that face no border adjustment on downstream products. Full product value chains would need to be included in order to avoid carbon and/or environmental arbitrage.

6. How should a CBAM raise revenue: through the market or through fees/taxes?

The approach to raising revenue can make or break the effectiveness of carbon pricing and border adjustment mechanisms. Market-based approaches treat greenhouse gas units as a commodity unto themselves, allowing the market to set a “true” price for carbon mitigation. Under a market-based scheme, carbon credits become fungible assets that can be traded or hedged through financial instruments like options and futures with a market premium on pulling more carbon out of the air today than in the future.

Fees or taxes, by contrast, are collected by the government, which then redistributes those assets to correct for externalities (like higher energy prices or displaced workers) created by internalizing carbon costs in industry.

7. How would the U.S. use the revenue from a CBAM?

Revenue from taxes and fees can be either consumer- or industry-corrective and either balanced or unbalanced. Consumer-corrective options include direct subsidies to households to adjust for higher energy and fuel costs. An example of an unbalanced consumer-corrective mechanism would be a direct and equal payment to all households in all jurisdictions, where jurisdictions with higher energy transition costs receive a corrective payment while those in lower-cost areas—where the sun shines, the wind blows, and atoms react—receive a windfall. Alternatively, a balanced consumer-corrective approach would seek to level energy prices nationwide by providing payment credits to high transition-cost jurisdictions.

Industry-corrective approaches are similar but seek to adjust costs at the industry level before higher prices are passed onto the consumer. A balanced industry-corrective approach would include capital credits and subsidies to fund transition technologies and address legacy infrastructure overhang to keep the price of energy level across jurisdictions. An unbalanced industry-corrective approach would be an equalized feed-in tariff or subsidy for all utilities irrespective of local climatic conditions and the age and viability of existing energy infrastructure.

Revenue from a CBAM can also be used to provide “climate adjustment assistance” benefits to workers displaced by a shift to new energy sources, including retraining and extended health benefits.

An answer to the drawdown showdown?

Thinking expansively about the tools available to policymakers to incentivize a rapid and equitable drawdown will be essential to achieving the world’s economic and climate goals. Time is short and the stakes are high, but the practicability and potential of carbon pricing and border adjustments are promising and deserve the full attention of governments and stakeholders.