By Stefano Riela

The Commission is expected to unveil its proposal in a few weeks’ time, but some exporting countries of carbon-intensive products have already expressed their disappointment at a new form of European protectionism.

In hands off sovereignty, each country can design its own socio-economic model based on a constitution or on a political manifesto. According to this principle different models co-exist among countries of different levels of development. But sovereignty, in the international context, is subject to constraints to prevent the so-called ‘race to the bottom’, ie, sacrificing rules and standards on the altar of domestic competitiveness. These constraints derive, in some cases, from the prevailing ethics (for example, prohibiting the exploitation of workers), in other cases, from the incontrovertible physics. Emissions of greenhouse gases (GHG), responsible for global warming, have the hateful characteristic of not respecting political borders and sovereignties. This explains the rules that the European Union (EU) has adopted and is about to propose on emissions.

A market mechanism for limiting emissions in Europe

On 21 April, the day before the launch of the Summit on Climate organised by US President Joe Biden, the EU committed to more ambitious GHG emissions targets: a reduction of at least 55% by 2030 compared to the levels of the 1990 (the previous target was a 40% cut). This is to make the ‘zero net emissions’ goal by 2050 more attainable.

The EU’s commitment on limiting emissions dates back to well before the Paris Agreement as demonstrated by the adoption, in 2005, of the Emission Trading System (ETS). It is a ‘cap and trade’ system whereby firms purchase GHG emission allowances below a maximum ceiling that decreases over time. Allowances can be bought and sold between firms and the cap guarantees their value. With this system, firms internalise the cost of emissions and are pushed to more efficiency and less polluting production.

Currently, the ETS covers only a few sectors – eg, electricity generation, energy-intensive industries such as refineries, aluminium and steel mills – and about 40% of GHG emissions in the European Economic Area (EEA): the EU States, plus Iceland, Liechtenstein and Norway. The effectiveness of this system is demonstrated by the fact that the approximately 15,000 plants involved in the ETS have reduced emissions by about 35% since it came into force. At the same time, the sale of allowances brought over 57 billion euros into the coffers of EU countries, resources invested mainly in the energy sector and in policies to fight climate change.

The EU is not alone on this front. Worldwide, 64 mechanisms ‘price’ carbon (World Bank, 2021) and New Zealand maintains one of the most ambitious carbon pricing mechanisms in the world, besides the EU’s ETS. However, the EU is a net carbon importer: the carbon content of exported goods is lower than that of imported goods.

If other countries have fewer restrictions on emissions, the purchase of ETS allowances is a burden on European firms squeezing their international competitiveness. To remain in the market and to avoid a doomed destiny, European firms, ceteris paribus, can save themselves by shifting production where legislation is less strict.

The act of replacing internal production and emissions with foreign ones goes under the name of ‘carbon leakage’. This negatively affects the European economy and employment in favour of other countries, but it is not a zero-sum game as it may sound. Foreign productions will be more polluting due to less stringent constraints on top of the additional emissions related to transport (in our case, more exports from non-EU countries to the EU).

To prevent carbon leakage, European firms most exposed to international competition have benefited from free ETS allowances. However, this exception, in addition to creating intra-EU asymmetries, is not consistent with the now more significant commitment to reduce emissions. For this reason, the EU intends to make the ETS fully work with auctioned allowances. Moreover, the European Commission will propose expanding the ETS to other sectors such buildings and transport (flights within the EEA are already part of the ETS).

The market has already reacted to this proposed restriction of the ETS and the allowances have reached record values. At the beginning of May, the reference price exceeded 50 euros per tonne of CO2 equivalent; more than double the price in the same period in 2020 and 2019.

Towards a EU tax on polluting imports?

To close the competitive gap to the detriment of European industry, the EU is considering introducing a carbon border adjustment mechanism (CBAM). Non-EU imports produced with a price for GHG emissions lower than the European one based on the ETS will have to pay the differential. It is therefore about restoring fair competition between European productions burdened by the ETS and imports – a level playing field to avoid an arbitrage that is harmful to the European economy and to the fight against climate change.

The algorithm of the CBAM shall not violate the principles of the World Trade Organization: it cannot favour European products against imported ones and it cannot discriminate between trading partners since any other WTO members should receive the Most-Favoured-Nation treatment.

The Commission is expected to unveil its proposal in a few weeks’ time, but some exporting countries of carbon-intensive products – such as Ukraine, Turkey, China and India – have already expressed their disappointment at a new form of European protectionism.

Although the EU has planned to make CBAM a new ‘own resource’ for the EU budget, paradoxically the ultimate goal is its elimination. The uselessness of the CBAM will indicate that all countries have adopted legislation on GHG at least equivalent to that of the EU.

It will take months for the Commission’s proposal to become legislation (it needs the approval of the European Parliament and the Council of the EU), but in the meantime it will be excellent food for thought for the United Nations Conference on Climate Change (COP26) to be held in Glasgow from 1 to 12 November 2021. The clock is ticking and a new balance between national sovereignties and common supra-national interest is needed.

Stefano Riela is an Honorary Research Fellow at the European Institute of the University of Auckland. He is an expert in European integration and EU trade policy. 

Disclaimer: The ideas expressed in this article reflect the author’s views and not necessarily the views of The Big Q. 

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