A Market-Oriented View of the EU’s World-First Carbon Border Tax

Editors’ note: MarketMinder 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. While not technically a tax in the traditional sense, this new mechanism aims to force importers to buy certificates based on their estimated carbon footprint. There is a wide range of views on this policy. But importantly for investors, it looks smaller than most 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 on a climate deal in December, including a Carbon Border Adjustment Mechanism (CBAM). 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.

The CBAM will eventually (more on this soon) assess fees on imports that don’t meet the EU’s greenhouse-gas emissions standards. It will enter into force October 1 this year. Then, importers will declare their prior year goods’ quantity and associated emissions embedded in their products—both direct and indirect (using a heretofore undefined methodology). Importers would buy CBAM certificates for those emissions. Meanwhile, certificates’ prices fluctuate depending on the auction value of allowances in the EU’s carbon market—the Emissions Trading System. 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.

Maybe you see this as justified. Maybe not. Whatever your view, it is worth calling a spade a spade: This is a protectionist policy. If you dislike tariffs for their distortions (rightly, in our view), you should probably look askance at this, too. But some carry it too far, suggesting the CBAM risks imperiling world trade with the EU. Although the policy seems wide-ranging and far-reaching, a look under the CBAM’s hood reveals it is rather low powered—and why fears surrounding it are unfounded.

As it stands, the CBAM covers only iron, steel, cement, aluminum, fertilizers, electricity and hydrogen. This amounts to only a tiny slice of total EU goods imports (which are less than its services imports). In 2022, this would have been below 5%.^[i] Also note what the CBAM list doesn’t include: Fossil fuels—over a quarter of goods imports—are conspicuously missing. The list could expand. For instance, chemicals and agricultural products have been floated for inclusion, but those are similarly tiny—the impact would still be limited.

Moreover, the CBAM will be phased in gradually from 2026 to 2034, giving markets oodles of time to weigh the policy and move on. Although importers must start disclosing their carbon footprint this year (again, methodology TBD), carbon certificates covering them will initially be free through 2025. In 2026, the free allowances will slowly be reduced every year—to 90% by 2028, 51.5% in 2030 and zero in 2034. 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 emphasize: “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.”^[ii] Of course, that doesn’t guarantee it will be. But the whole process seems designed to deliver as few surprises as possible. None of this is unexpected. It has been publicly debated for years and was formally proposed in 2021. 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 favor of subsidizing carbon reduction efforts. 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. The CBAM allows importers who can “prove” they have already paid a carbon price to deduct that amount from their required certificates. 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. 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 that is about it.

However, compliance for carbon-intensive Emerging Markets (EM) producers is looking more costly—which has drawn complaints for years. But here, too, 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.^[iii] 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. Turkey is also working on establishing one ahead of the EU’s phase out of free CBAM certificates.

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.