With the curtain having fallen on the U.N. Climate Change Conference, the world’s attention is turning to how—and if—governments can remediate the structural challenges that stand in the way of realizing the ambitious agreements they reached in Glasgow. One takeaway from the conference was clear: the U.S. and its allies need to use all the policy tools that are available to them to reduce their own carbon emissions while using both carrots and sticks to encourage their global trading partners to do the same.

In the abstract, the U.S. and the majority of its trading partners share the objective of reducing global carbon emissions. Yet in reality, not all countries share the same incentives to decarbonize. As we discussed in last week’s blog, trade policy presents a powerful set of tools that the U.S. can use to level the international playing field and encourage trading partners to adopt higher environmental standards. One particular set of trade tools—carbon border adjustment mechanisms, or CBAMs—has garnered much attention in recent months as a way for the U.S. to create a fairer trade environment for American producers.

CBAMs are a class of trade measures 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). There is no single model for a successful CBAM, but in general, CBAMs should aim to level the international playing field by placing a tax, fee, or price on the carbon content of imported goods (to the extent the imported good has not already been subject to equivalent measures). Although CBAMs on their own will not allow the U.S. to meet its emissions reductions goal, they can be a flexible tool that, if deployed strategically, would ensure that U.S. manufacturers can fairly compete in domestic and foreign markets while the U.S. and its partners invest in longer-term climate solutions.

When it comes to the success or failure of carbon border adjustment mechanisms, the devil's truly in the details, and the U.S. will have to answer several critically important questions as it considers implementing its own CBAM. This week, however, we’re taking another step back to ask the more fundamental question of what the U.S. should hope to accomplish—and what it should hope to avoid—in designing a CBAM.

What should the U.S. seek to achieve with a CBAM?

1) Crediting the U.S. carbon advantage and rewarding like-mindedness

The U.S. still has a long way to go to meet its own net-zero goals, but even at its current levels of carbon efficiency, the U.S enjoys a significant carbon advantage over almost all of its trading partners and global competitors. By some estimates, goods manufactured in the U.S. are 40 percent more carbon efficient than the global average, and the U.S. currently imports 75 percent of its goods from less carbon-efficient countries.

A U.S.-imposed CBAM would allow the U.S. to realize its carbon advantage by ensuring that U.S. products compete fairly with foreign products relative to their carbon content. A CBAM would also help to remove the economic incentive for other countries to maintain weaker emissions standards or turn a blind eye to emissions enforcement and would strengthen economic ties to like-minded countries bolstering climate cooperation overall.

2. Creating a fair and transparent system that incentivizes carbon neutrality in manufacturing

Before actually crafting a CBAM, it’s worth asking what the ultimate policy objective of U.S. carbon measures should be. The subtext of the ongoing debate around CBAMs and carbon pricing more broadly is divided between those who believe that carbon pricing should serve as a punitive tax on carbon polluters, and alternatively, those who believe that it should serve as a mechanism to incentivize and accelerate decarbonization. The latter is a more legitimate objective since it advances tangible environmental and economic outcomes for critical sectors while avoiding normative judgments of those industries. Moreover, it envisions a level international playing field on which carbon-neutral systems can compete with carbon-intensive analogs from other jurisdictions.

3. Creating a system that prevents international carbon arbitrage and related offshoring

Because it costs less to produce goods in countries with low environmental standards, current market dynamics encourage environmental arbitrage (i.e. the transfer of production to countries with lower environmental compliance costs) and, incidentally, carbon leakage, as production in carbon regulating and carbon efficient markets shifts from highly-regulated markets to poorly-regulated markets. A CBAM should remedy this dynamic by adjusting the price of exports to account for the cost that producers would have borne if they had been operating in more robust regulatory and carbon-restrictive environments, thereby removing the economic incentive for producers to use trade to lower environmental accountability and compliance costs.

4. Designing a system that is compliance-efficient, practicable, and consistent with U.S. law and international trade obligations

A CBAM should not be overly burdensome for industry to comply with, and it should set forth an enforcement system that is predictable and transparent. Moreover, CBAMs shouldn't be a disguised restriction on trade or a form of protectionism. They should be used sparingly and strategically and only for the purpose of leveling the playing field and preventing carbon leakage, not for giving U.S. producers a leg up.

To fully address the twin issues of carbon leakage and carbon arbitrage, 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 the potential to accelerate decarbonization by creating secondary carbon markets and other financial instruments that promote the more efficient deployment of technologies for carbon elimination.

5. Creating a system with balanced distributive effects

Revenues from a U.S. CBAM and related domestic carbon taxes should be balanced, meaning they should be equitable in their distributive effect. Examples of unbalanced distributions would include programs that provide equal energy credits to all households in all jurisdictions or programs that give all utilities an equalized feed-in tariff or subsidy irrespective of local climatic conditions and age and viability of existing energy infrastructure. Programs that aim for equal distributions lack the essential quality of fairness, since they give higher energy-transition cost jurisdictions a corrective payment while lower-cost jurisdictions (i.e. regions the sun shines, wind blows, atoms react) receive a windfall. As a result, some jurisdictions would still be footing more of the bill for the clean energy transition than others.

By contrast, a balanced approach would seek to level energy prices nationwide by providing payment, capital credits, and subsidies to high transition-cost jurisdictions. The goal of such a program is to level the cost of energy as well as the capital costs associated with implementing transition technologies and retiring legacy infrastructure.

6. Including a pathway for developing countries

A fundamental shortcoming of many existing proposals for carbon border adjustments is that they fail to meet the special and differential treatment obligations owed to developing countries. To be clear, a CBAM cannot function if it fully exempts developing countries, but it should give these countries additional flexibility to meet its requirements, including through longer phase-in periods, trade capacity building to help them meet their climate commitments, and/or some tariff relief or lowering of CBAM liability if they invest in U.S. environmental products or technology that will help them climb the environmental compliance ladder.

7. Promoting of U.S. exports

Because the U.S.’s higher environmental compliance standards translate into higher prices for American-made products, and since American has relatively low market access barriers compared to many competitor markets, American-made products struggle to compete with foreign imports in the domestic market and with third-party imports and domestic producers in global markets. A CBAM should eliminate this competitive disadvantage so that high-quality, low-carbon U.S. products can compete in both domestic and foreign markets. Furthermore, a CBAM could also serve as a useful springboard to establish market access in regions where U.S. environmental technologies meet high and unreciprocated barriers to market entry.

8. Considering an excess capacity multiplier

In countries that subsidize structural excess capacity in capital-intensive sectors like steel, operational facilities need to run at high levels of capacity utilization regardless of whether there is demand for the product. The result is a glut of product that is often dumped into third-country markets, depressing prices and harming domestic producers. Not only does this excess capacity result in unnecessary emissions, but it also has a chilling effect on environmental compliance and carbon reduction, since producers in third-party countries are under pressure to cut their prices to remain competitive. A U.S. CBAM should consider a structural excess capacity multiplier to be added on top of the tax or fee to discourage this behavior.

What pitfalls should the U.S. avoid?

1. Raising revenue that is distinct from the U.S.’s primary climate objectives

The U.S. should use the revenue it raises from a CBAM to fund investments in climate infrastructure and other policies that will facilitate a worker-centric transition to a net-zero future.  Options could include consumer-corrective approaches—such as offering payment credits to households in high transition-cost jurisdictions to level energy prices—as well as nationwide industry-corrective approaches that would equalize energy prices through capital credits and provide subsidies for transition technologies and programs to address legacy infrastructure overhang. Revenue from a CBAM should also be used to provide “climate adjustment assistance” benefits to workers displaced by a shift to new energy sources, including transition income support, retraining, leveling-up retirement accounts, and extended health benefits.

2. Drastically raising compliance costs for U.S. manufacturers

The purpose of a CBAM should be to make U.S. producers more competitive, not to burden them with arcane, unpredictable, and costly compliance procedures. For this reason, the U.S. should avoid individualized firm-level fees, which function like dynamic tariffs, in favor of static product-level pricing that escalates on predictable intervals, which businesses and the financial sector can anticipate. Low compliance costs also incentivize the use of existing regulatory and revenue collection systems, since trading businesses will be able to easily integrate new compliance fees into existing firm-level processes.

3. Creating incentives to offshore downstream manufacturing

Taxing or pricing upstream commodities in isolation could have the unintended consequence of promoting the offshoring of industries, since 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.

4. Failing to provide a system of rebates when the carbon content of foreign goods is lower than that of U.S.-made products

A CBAM should reward low-carbon products regardless of where they are manufactured. In instances where foreign-made products have a lower carbon content than American-made products, a CBAM should provide them with a rebate. A carbon advantage should never be “zeroed out.”