Frank Fannon, the assistant secretary for the Bureau of Energy Resources at the U.S. Department of State, commented at an Atlantic Council virtual event in May: “The last thing anyone would want to see is … additional tariffs or regulations that would limit the robust energy trade.”

Fannon’s comment was a response to the EU’s plan to implement what they called a “carbon border adjustment mechanism.” The EU announced last year that it is planning to roll out a carbon border adjustment mechanism to meet its 2030 emissions targets. The mechanism could potentially levy taxes on imports from sectors such as steel, cement, and paper. However, the design of the policy is unclear. The proposal of the border mechanism is expected to be completed next year. Its main objective is to prevent European companies from moving their products to jurisdictions with less strict carbon pricing policies. 

Before we find out the full details of the proposal, it’s hard to tell whether it will be an import tariff or a carbon border adjustment, which are two distinct policies. Therefore, it’s too early to determine the proposal’s potential impact on energy trade, or trade generally. 

An import tariff is a tax levied by a government on imported goods. By design, an import tariff increases imported goods’ cost for domestic buyers and distorts trade flow in the affected sectors by discouraging imports. 

A well-designed border adjustment mechanism ensures all goods consumed within a jurisdiction are taxed. It works by applying a tax on imports and a rebate on exports. Unlike a tariff, an ideal border adjustment mechanism is trade-neutral, which means it doesn’t encourage or discourage imports or exports. As the economist Alan Auerbach noted: “Unlike tariffs on imports or subsidies for exports, border adjustments are not trade policy. Instead, they are paired and equal adjustments that create a level tax playing field for domestic and overseas competition.”

Some scholars believe that a European “carbon border tax” might not take the form of a newly created tax despite the term “Carbon Border Tax” used by the President of the European Commission. Based on the current EU legal framework and earlier relevant policy proposals, this measure might extend the EU emissions trading system to include importers from selective sectors. 

As Fannon mentioned, if the European carbon border tax were an import tariff, it would disrupt the trade flow for energy. However, if it were a border adjustment mechanism, it would likely not cause the same disruption. It will likely be a couple of years before the EU’s carbon border adjustment goes into effect, giving the U.S. time to step up its national effort to mitigate climate change. The U.S. could choose to continue its current patches of regulations or take an overdue step in implementing meaningful carbon prices. When the pandemic dissipates, and we are on track to economic recovery, starting with a modest carbon tax with a commitment to increasing the carbon tax rate over the long run would put us on the right path towards achieving meaningful carbon emission reduction.