Editors’ note: MarketMinder Europe doesn’t advocate for or against any government initiative. Our aim is only to diagnose policies’ potential economic and market impact.
The world’s first carbon border tax became EU law this week.[i] Whilst not technically a tax in the traditional sense, this new mechanism aims to force importers to buy certificates based on their estimated carbon footprint.[ii] There is a wide range of views on this policy. But importantly for investors, it looks smaller than most commentators we follow portray and, after years of negotiation, its formal, gradual implementation doesn’t seem likely to upset markets, in our view.
The European Parliament and the 27 EU member countries agreed a climate deal in December, including the Carbon Border Adjustment Mechanism (CBAM).[iii] Last week, EU lawmakers passed draft legislation, which the European Council—comprising heads of member state governments, European Commission President Ursula von der Leyen and European Council President Charles Michel—approved Tuesday.[iv]
The CBAM will eventually (more on this soon) assess fees on imports that don’t meet the EU’s greenhouse-gas emissions standards.[v] It will enter into force 1 October this year.[vi] Then, importers will declare their prior year goods’ quantity and associated emissions embedded in their products—both direct (their actual energy use) and indirect (those in their supply chains, using a heretofore undefined methodology).[vii] Importers would buy CBAM certificates for those emissions.[viii] Meanwhile, certificates’ prices fluctuate depending on the auction value of allowances in the EU’s carbon market—the Emissions Trading System.[ix] The CBAM’s three-fold objective: Cut emissions, level the playing field so EU firms aren’t disadvantaged by adhering to stricter emissions rules and compel other countries to adopt the EU’s standards.[x]
Some may see this as justified. Others not. Whatever their views, we think this is a protectionist policy. The border tax is tantamount to a tariff, and tariffs—whatever their aims—tend to cause trade distortions, creating winners and losers outside market mechanisms. But some headlines we read carry it too far, in our view, suggesting the CBAM risks imperilling world trade with the EU. Although the policy may seem wide-ranging and far-reaching, to us, a look under the CBAM’s bonnet reveals it is rather low powered—and why fears surrounding it are unfounded.
As it stands, the CBAM covers only iron, steel, cement, aluminium, fertilisers, electricity and hydrogen.[xi] This amounts to only a tiny slice of total EU goods imports (which are less than its services imports).[xii] In 2022, this would have been below 5%.[xiii] Also note what the CBAM list doesn’t include: Fossil fuels—over a quarter of goods imports—are conspicuously missing.[xiv] The list could expand. For instance, chemicals and agricultural products have been floated for inclusion, but those are similarly tiny—the impact would still likely be limited.[xv]
Moreover, the CBAM will be phased in gradually from 2026 to 2034, giving markets oodles of time to weigh the policy and move on.[xvi] Although importers must start disclosing their carbon footprint this year (again, methodology TBD), carbon certificates covering them will initially be free through 2025.[xvii] In 2026, the free allowances will slowly be reduced every year—to 90% by 2028, 51.5% in 2030 and zero in 2034.[xviii] This is why we said the policy eventually assesses fees. It doesn’t happen right at the jump in October.
As the European Commission takes pains to emphasise: “The gradual phasing in of CBAM over time will allow for a careful, predictable and proportionate transition for EU and non-EU businesses, as well as for public authorities.”[xix] Of course, that doesn’t guarantee it will be. But the whole process seems to us designed to deliver as few surprises as possible. Very little that we see here is unexpected based on our observations of the public debate over the years and since its formal proposal in 2021. In our view, forward-looking markets likely priced in the probable consequences long ago.
Still, there are some question marks about how it will all work. For example, the US has mostly foregone carbon taxes in favour of subsidising carbon reduction efforts.[xx] Besides the EU’s public criticism of US subsidies giving American companies an allegedly unfair advantage, it isn’t clear how CBAM will treat them.[xxi] The CBAM allows importers who can “prove” they have already paid a carbon price to deduct that amount from their required certificates.[xxii] Under current rules, American-made imports wouldn’t qualify for deductions, but talks are underway as to whether US tax incentives might be equivalent enough to the EU’s carbon pricing system.[xxiii] If US imports don’t qualify, that could create trade friction with the EU. But we doubt that would escalate into anything approaching a trade war. It might ruffle some feathers, much as America’s infrastructure spending plans’ Buy American provisions do the other direction, but we think that is about it.
However, compliance for carbon-intensive Emerging Markets (EM) producers is looking more costly—which has drawn complaints for years.[xxiv] But here, too, we think the scope is less than meets the eye and worth scaling for perspective. EU imports from China and Turkey are among the most affected by the EU’s CBAM, yet this would touch only about 4% of Chinese imports and less than 15% of Turkey’s.[xxv] EM countries have also had years to prepare. Faced with potentially steep costs that could curtail their EU shipments, some like China have launched their own carbon pricing and emissions trading schemes.[xxvi] Turkey is also working on establishing one ahead of the EU’s phase out of free CBAM certificates.[xxvii]
New policies always carry the risk of unintended consequences. Hence, we actively look for potential hidden snags. But given the CBAM’s limited scope and slow rollout, especially relative to the press coverage it is receiving, we don’t see much here to wallop markets.
[i] “A New Tax on Greenhouse Gases,” Manuela Andreoni, The New York Times, 25/4/2023. Accessed via the Internet Archive.
[ii] “Carbon Border Adjustment Mechanism,” Staff, European Commission, 13/12/2022.
[iv] See note i.
[v] See note ii.
[xii] Source: UN Comtrade database and FactSet, as of 25/4/2023.
[xiii] Source: UN Comtrade database, as of 25/4/2023.
[xv] Ibid. “Analyzing the European Union’s Carbon Border Adjustment Mechanism,” Emily Benson, Joseph Majkut, William Alan Reinsch and Federico Steinberg, Center for Strategic & International Studies, 17/2/2023.
[xvi] See note ii.
[xviii] “The EU Agreement on a Carbon Border Adjustment Mechanism,” David E. Bond, James Killick, Sara Nordin, William De Catelle, Guillermo Giralda Fustes, William Grazebrook and Matt Solomon, White & Case LLP, 16/3/2023.
[xix] See note ii.
[xx] “Building a Clean Energy Economy,” John D. Podesta, The White House, January 2023.
[xxi] See note xv.
[xxii] See note ii.
[xxiii] See note xv.
[xxiv] “Shore Thing - 2023 Global Trade Themes,” Chris Rogers, S&P Global, 20/1/2023.
[xxvi] “China’s Emissions Trading System Will Be the World’s Biggest Climate Policy. Here’s What Comes Next.” Chris Busch, Forbes, 18/4/2022.
[xxvii] “EU’s Looming Carbon Tax Nudged Turkey Toward Paris Climate Accord, Envoy Says,” Zia Weise, Politico, 6/11/2021.
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