How to stop carbon leaking out of our imports: A lesson from Brussels?

Senior Consultant Daniel Wright explains the EU’s new carbon tariff, and discusses the potential impact if a mechanism like this were used here in Aotearoa.

The government is currently consulting on some significant changes to our Emissions Trading Scheme, aiming to address the problem that it’s currently cheaper for many of our industries to pay for their emissions than to invest in reducing them. The Government is looking at ways to increase demand for ETS units and drive up the price, like reducing the number of units available for sale, and allowing the government or overseas buyers to buy them.

But one of the biggest criticisms of Emissions Trading Schemes is the additional cost they place on emissions-intensive domestic industries compared to competitors exporting from other countries. All else being equal, this makes those overseas competitors more competitive — and not only against domestic heavy emitters but also against domestic producers who have invested significantly in new low-emissions technology rather than just paying for their carbon.

More fundamentally for the goal of reducing global emissions, if we give a boost to emissions-intensive producers overseas by allowing them to undercut more climate-friendly local producers, this means that carbon is effectively just “leaked” across the border.

The European Union thinks it has the solution that will plug any carbon leaks in its borders.

The EU’s new Carbon Border Adjustment Mechanism

This year the EU is giving effect to its long-anticipated, long-debated Carbon Border Adjustment Mechanism (CBAM). The EU’s website describes this as:

our landmark tool to put a fair price on the carbon emitted during the production of carbon intensive goods that are entering the EU, and to encourage cleaner industrial production in non-EU countries.

Essentially, the CBAM collects a tariff that’s equivalent to what would have been paid under the EU’s Emissions Trading System had those goods been produced inside the Union:

… the CBAM will ensure the carbon price of imports is equivalent to the carbon price of domestic production, and that the EU’s climate objectives are not undermined.

The EU is initially applying the CBAM to goods it has assessed as having the highest risk of carbon leakage — this includes cement and steel, and also electricity and hydrogen. But the EU has already signalled it intends to apply the mechanism more widely.

Testing the new CBAM against international trade rules

The EU is a stickler for international trade rules, and it seems to have designed the new Carbon Border Adjustment Mechanism to be compliant with them. However, the mechanism is still untested, and there are likely to be two key tests.

First is the “most-favoured-nation” rule, that a concession made to one country must be made to all (from Article I of the General Agreement on Tariffs and Trade).

The second rule is that any domestic taxes or charges should not give preferential treatment for domestically produced goods over “like” imports (Article III of GATT).

For the CBAM to function well, it will need to reliably account for carbon released in the production of the imported goods. But this will naturally vary from country to country — even factory to factory — and will depend on things like the energy source used. This will mean that different imports of the same “like” goods will face different tariffs, and that could expose the EU to challenge under the “most-favoured-nation” rule in GATT, Article I.

Countries exporting to the EU might also argue that the EU’s new carbon tariff breaches Article III of GATT, in that domestic producers of “like” goods are not subject to the border charge.

Of course, the EU will argue that the CBAM doesn’t discriminate, because it’s based on an objective measure of carbon emissions, so that equivalent domestic industries face equivalent charges. But past rulings on production methods have also shown the willingness of WTO appellate bodies to review claims case by case, rather than at a policy level (see the late 1990s case, European Communities — Asbestos). So the EU may be exposing itself to a run of complicated litigation.

Calculating and verifying importers’ carbon emissions:
The impact on New Zealand exporters

The EU regulations for CBAM prescribe how importers should calculate the emissions applicable to their imports (Article 7), and they also require those calculations to be verified (Article 8). The regulations set out default assumptions for when it’s not possible to calculate or verify emissions.

NZTE is informing New Zealand exporters of affected goods to the European Union that they will need to register with the EU’s CBAM authority, have their emissions calculations verified by an accredited body, and pay the difference in carbon price between New Zealand’s ETS and that of the EU.

This additional compliance step will impose new administration costs for exporters trading to the EU, on top of the carbon tariff. This could have a chilling effect on trade, depending on how onerous the EU’s accreditation expectations are in practice.

The potential impact of a New Zealand carbon tariff on our own carbon-intensive industries

So what might be the effect of a carbon tariff like the European Union’s CBAM if adopted in Aotearoa?

We do have some emissions-intensive industries that are subject to domestic carbon charges and also exposed to international competition (“emissionsintensive, trade-exposed” is the term).

Take our steel industry, which has been making leaps towards decarbonisation. NZ Steel recently hit the headlines with its joint investment with the Government in an electric arc furnace.

A carbon tariff adopted by New Zealand would ensure that competing steel imports from abroad would be subject to the same carbon charge as NZ Steel. This would add a further competitive advantage for the firm in converting to an electric furnace.

The Aberdeen Angus in the corner: The potential impact of a carbon tariff on our agriculture emissions

One elephant — or cow — in the room with the latest proposals for New Zealand’s ETS is the question of what to do with agriculture emissions.

These emissions — biogenic methane — are currently excluded from our ETS, so because of that, introducing a carbon tariff in New Zealand would unfortunately have no effect on carbon in agriculture.

But even if biogenic methane were included in our Emissions Trading Scheme, New Zealand imports relatively small volumes of agriculture goods compared to what we export, and so again a carbon tariff would not have much impact.

Agriculture will continue to be a thorny sector across the world. It’s subject to the highest trade barriers across markets, as countries look to protect their farmers’ livelihoods. We’re therefore unlikely to see agriculture emissions to start appearing in ETSs around the world, and in the European Union’s CBAM.

Could the EU’s new carbon tariff work in Aotearoa?

The European Union has some specific features that make its Carbon Border Adjustment Mechanism more likely to be workable and effective in achieving its aims. Notably, New Zealand shares none of those features.

First, the EU is a very large and wealthy market, and so other countries have a big incentive to trade and do business with it. This includes paying carbon tariffs and jumping through verification hoops as a cost of doing business with the EU.

Second, the EU has close neighbours that produce a lot of carbon-intensive industrial goods, like Turkey. This puts the problem of carbon leakage very much on the table for the EU, where there’s a very real risk of factories moving out of the EU to its neighbours to avoid carbon charges. The CBAM could have a significant impact in keeping a level playing field for EU producers, avoiding carbon leakage, and incentivising high-emissions producers overseas to convert to more climate-friendly technology.

Finally, the EU has a large bureaucratic machine to iron out the inevitable early creases in a new scheme like the CBAM. It needs, for example, to make sure all the calculation and verification processes are auditable and done to EU standards. And again, as well as having the necessary administrative machinery and experience, the EU has the trading clout needed to ensure its trading partners work to its requirements.

A watching brief

Despite all the work Brussels has put into its new carbon tariff scheme, there will inevitably be some wrinkles to be smoothed out along the way. This isn’t surprising, as the EU is charting a new path in emissions pricing.

It’s thinking globally, taking the lead in finding ways to prevent emissions trading schemes simply triggering an environmental race to the bottom. There’s no gain for the planet or humanity if the aggregate effect of domestic carbon-pricing schemes is simply moving high-emissions production around the world without significantly reducing it.

Here in Aotearoa we too need to ensure our industries aren’t punished for their decarbonisation efforts, and, even more importantly, that carbon saved here doesn’t just mean carbon emitted somewhere else. So perhaps we should position ourselves as a fast-follower of the EU.

The new EU mechanism may not be appropriate for Aotearoa, and there are also not yet any signs that our regional trading partners are likely to adopt similar carbon tariffs. But that could change — and in general it’s important that we keep a watching brief on climate leaders like the EU and ensure we stay at the forefront of climate action internationally.