The European Union unveiled its highly anticipated proposal to levy a fee on carbon-intensive imports last Wednesday as part of the bloc’s ambitious strategy to decarbonize over the next decade. Meanwhile, Democrats in the United States are floating the idea of imposing their own “carbon tariff” or “polluter import fees” on certain products. The EU seems to be ahead of the game in its climate mitigation actions. How should the U.S. respond? Absent an economywide carbon price, enacting so-called carbon tariffs is not a good or effective response. U.S. lawmakers can help incentivize decarbonization in the most effective and efficient way — implementing a carbon tax that is truly border-adjusted.
The EU “carbon border adjustment mechanism” (CBAM) would impose an import tax on carbon-intensive imported goods in certain sectors, including cement, iron, steel, aluminum, fertilizer, and electricity. The import tax would mirror the costs domestic producers are subject to under the existing EU emissions trading system. This overview, based on a draft leaked last month, explains how it will work. The newly released proposal is similar to what was leaked, with some updated details. For example, the official proposal states that a reporting system will be put in place for data collecting by 2023, but importers won’t be required to pay for emission certificates until 2026. The proposal’s language is a little vague on what the European Commission plans to do with the existing free allowances handed out to certain EU producers. Based on the proposal, it appears that the EU is going to phase out the free allowances entirely by 2035. If an EU producer’s goods are exempted from the bloc’s emissions trading system due to the free allowances, then a foreign producer exporting the same goods to the European market would be similarly exempted. Unlike the leaked proposal, the official version indicates that only direct emissions will be covered for now. Indirect emission associated with purchased electricity might be included in the future.
The Biden administration has mentioned the idea of a carbon border adjustment on different occasions but has not provided much detail on such a proposal. Coincidently, the same day the EU released its CBAM proposal, Democratic legislators announced that they would include an import tax on carbon-intensive imported goods in their pending $3.5 trillion budget plan. Details are murky, but it appears Democratic lawmakers are trying to incentivize other countries to enact ambitious climate policies through a stand-alone carbon tariff without implementing a domestic carbon price.
The EU has officially designated its policy a “border adjustment,” and American policymakers have floated similar language. In fact, these proposals are not standard border adjustments, but import tariffs. In a well-designed border adjustment under a carbon tax, import taxes are paired with export rebates that are at the same rate as the domestic carbon tax. Taxing imports protects domestic producers from being undermined by competitors who do not face carbon pricing overseas, but it does nothing for exporters. An export rebate allows manufacturers shipping goods out of the country to similarly keep their edge against foreign competitors who are not subject to a carbon price. Combining an import tax and an export rebate with a domestic tax ensures goods are taxed based on where they are consumed rather than where they are produced.
The EU proposal would adopt a differential treatment approach on imported goods based on whether there is a carbon price in the country of origin. Since a differential treatment approach would likely violate the World Trade Organization’s most-favored-nation rule, the EU may try to justify this approach on environmental-protection grounds. According to the EU CBAM proposal, if exporters have already paid for a carbon price in their countries of origin, they would be eligible to claim a credit against the required import tax amount. The credit would be equal to the carbon price they have paid in other jurisdictions. The proposal defines a carbon price as “the monetary amount paid in a third country in the form of a tax or emission allowances under a greenhouse gas emissions trading system.” The United States currently does not have an explicit carbon price through a carbon tax or a cap-and-trade system. Instead, it relies on a hodgepodge of performance standards, mandates, and tax incentives to reduce emissions. Therefore, U.S. exporters would not qualify for any credit in the EU CBAM.
Since there is not a carbon tax in the United States, there is really nothing to adjust at the border, and any stand-alone import taxes enacted on imported goods would be tariffs. But responding to a de facto tariff with another de facto tariff would be unwise. As a matter of policy design, it does not make sense to impose tariffs on imported goods when domestic producers are not subject to a national carbon price. Legally, it would likely violate WTO rules. Administratively, it would seem an arbitrary exercise to determine the amount of the levy on any given imported product. Last but not least, economists agree that tariffs would have a negative impact on the economy. Back in 2019, CBO projected that “higher trade barriers — in particular, increases in tariff rates — implemented by the United States and its trading partners since January 2018 (would) reduce the level of real (that is, inflation-adjusted) U.S. gross domestic product (GDP) by roughly 0.3 percent by 2020.”
U.S. policymakers need to keep in mind that imposing carbon tariffs on top of the EU’s proposed tariffs would not help achieve our net-zero emission goals effectively and would lead to unintended consequences. A good response to the EU CBAM proposal would be to enact a border-adjusted carbon tax in the United States that would incentivize decarbonization quickly and effectively.