Carbon: What Politicians Don’t Like Talking About

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Senior Fellow - Economy

On February 10, the Foreign Affairs Committee of the French National Assembly invited me to speak on the EU decarbonization policy and its evolution, subjects that are dear to my heart, yet hardly mentioned in the current electoral debate. The following is a summary of my remarks to members of Parliament.

Carbon pricing - where the trouble begins

My words followed those of Prof. Valérie Masson-Delmotte, a world class paleoclimatologist and co-author of many IPCC reports. She is unambiguous about the need for urgent global action to achieve carbon neutrality. The question is: how do we get there? A variety of tools can be used, including carbon taxes, decreasing emissions trading quotas, tax penalties and rewards, enforceable environmental standards and increased public investment. These can all be characterized by an implicit carbon price. For instance, the cost of any subsidy, standard or investment can be estimated by calculating the monetary cost per ton of CO₂ emissions that are prevented.

However, while each of these tools may be judged by their respective economic cost, it is only carbon pricing that does this explicitly, giving it the decisive advantage of aligning all decision-makers-consumers, producers, investors and governments-without the need of always using the carrot and stick approach.

We also need to recall the inevitable fact that consumers will bear the costs of decarbonization. This becomes abundantly clear with direct carbon taxes, but it is also true of other means. Paying for emission rights is a cost that producers will eventually pass on to their customers, and restrictive standards will force consumers to spend more on greener technology. In essence, decarbonization is something you have to pay for.

There is a way to make carbon pricing more socially acceptable: by returning the revenues of decarbonization policies to citizens.

Against this backdrop, why are public authorities so reluctant to adopt widespread carbon pricing policies? Evidently, because of the difficulty in gaining public acceptance, as demonstrated by the "gilets jaunes" (Yellow Vests) movement. However, there is a way to make carbon pricing more socially acceptable: by returning the revenues of decarbonization policies to citizens. Proponents refer to this as a "climate income" or "carbon dividend," which could take the form of an annual check sent to every citizen.

If such a policy had been enacted prior to the announcement of carbon tax increases, the protestors may not have taken to the streets of French cities in the significant numbers that they did.

Carbon leakage: a tricky question

However, even if such a "climate income" policy were to be implemented, there would remain a significant obstacle. If the price of goods produced within the EU reflects the carbon costs involved in their production, we can safely assume that consumers will gravitate towards imported substitutes that are unburdened by such costs. For EU producers, this would incentivize relocating their carbon-intensive activities to countries with less stringent requirements. The result would be decreasing emissions within Europe-but only through shifting those emissions to other parts of the world. This is referred to as a "carbon leakage", an issue that was identified a while ago. Since COP21 abandoned attempts to reach a global carbon price, it is an obstacle that can only be tackled at a local level.

Until now, the European market in emission rights, namely the EU Emission Trading System (ETS) has circumvented this by allocating free emission allowances to producers competing with foreign producers that are not subject to emission controls. According to the European Environment Agency, in 2019, 35% of emissions subject to the EU ETS were covered by these free permits. Unfair competition is hereby avoided-but at the cost of a significant cut in emission reductions. Extending the ETS to other sectors (as proposed in the Commission’s "Ready fo 55%" agenda), moving towards the inevitable inclusion of methane emissions, or even making ETS a requirement for all industries, is not compatible with the maintenance of free allowances.

Preventing leakage through carbon border adjustment

The solution is charging the carbon content of imports, as with the Commission’s proposal for a carbon adjustment mechanism at the EU’s borders (referred to as CBAM). This proposes that importers pay the same rates as those paid by domestic producers for emission rights, according to the carbon content of their imports.

Three key points should be emphasized. First, border pricing is the sole protection against carbon leakage. Second, it is not a protectionist policy. And lastly, it is not a tax.

Regarding the first point, without such an adjustment mechanism, we are forced into either continuing to offer free pollution permits to EU producers, or else accepting that imports not subject to carbon pricing will dominate the market. In either case, there will be an increase in global emissions for which the Union is responsible. The second case also sees the Union losing businesses and jobs. Carbon adjustment at the border is therefore essential to achieving decarbonization without leakage.

Carbon adjustment at the border is therefore essential to achieving decarbonization without leakage.

With regards to the second point, the adjustment mechanism puts European producers on an equal footing with exporters to the Union, with each paying the same price for the carbon costs of their products. There is therefore no discrimination between domestic and foreign producers, making the mechanism compatible with WTO rules. Moreover, to ensure that EU exporters subject to the ETS are not themselves discriminated against, the same mechanism, albeit inverted, is to be applied to their exports.

Thirdly, the purpose of border pricing is to ensure that the price of carbon remains the same, regardless of which products are consumed within the Union. Besides, exporters from trading partners with a carbon pricing policy would also be exempt from paying duties, up to the price they paid in their country of production. In fact, the more trading partners that follow a carbon pricing policy, the less the border levy would bring in-proving that this is not at all about creating an additional tax resource.

Practical problems to consider

During its consultations, the Commission identified two challenges posed by the implementation of CBAM.

The first challenge involves how to measure the carbon content of imports. The Commission envisions this as being based on importers’ declarations, subject to possible further verification by importing authorities. The calculation of payable carbon duties would be based on weekly average carbon market prices. If an importer is unable to assess the carbon content, a Commission-set rate, standardized according to the product, would be applied. The Commission has considerable expertise in this area due to its years of involvement in the ETS. It should be noted that the question of measurement methods is not solely technical. If the methods are too lax, this would allow carbon pricing leakage to continue; if they are too tight, they could be reported to the WTO as non-tariff barriers.

A second challenge is raised by the transition period. The Commission proposes implementing CBAM only in 2026 and for a limited range of imports, including cement, iron and steel, aluminum, fertilizers and electricity. Between 2023 and 2026, the system is intended to operate without any pricing mechanism, in order to better prepare for the 2026 implementation. In addition, the gradual elimination of free allowances and extension of CBAM should go hand in hand, which should allay the fears of industrialists. Extending the CBAM to a broader range of goods and services should also be evaluated based on the ongoing results of the policy.

A European carbon club is underway

In December 2019, Institut Montaigne published a report I wrote, titled How Europe Can Lead the World to Reduce its Carbon Footprint. This may sound hyperbolic, but I was building on an idea theorized by the Nobel laureate William Nordhaus, whose work on climate change and carbon pricing dates back as far as the 1970s.

The sheer size of the EU market gives us a great deal of leverage in persuading our partners to embrace more ambitious climate policies.

Disillusioned by the lack of results from successive COP summits, Nordhaus suggests that in the absence of a global carbon price agreement, the formation of "Carbon Clubs" by large economic entities, imposing high carbon prices within their borders, could convince their trading partners to follow suit. On a practical level, only the European Union and its ETS partners in the EEA and Switzerland can achieve this, because it is the only current "carbon club" that follows Nordhaus’s proposal of high and ever-rising carbon prices, with plans to impose those prices at its borders.

The sheer size of the EU market gives us a great deal of leverage in persuading our partners to embrace more ambitious climate policies-and the ground is more fertile than one might think. In the US a bipartisan Congressional Commission has long been advocating both a domestic carbon price and border adjustments for carbon. China has recently implemented its own domestic emissions trading system. As for the United Kingdom, it has retained the system inherited from the ETS and is considering expanding it, making it possible for the UK to associate with CBAM without political issues.

Resolve towards the United States and China, cooperation with low-income countries

Undoubtedly, negotiations with the United States and China will be tough. These two countries alone account for more than 40% of the world’s carbon footprint, compared to less than 10% from the European Union. Europe’s central argument should be that border pricing is a crucial tool to implement climate policy - one which the Americans and Chinese will benefit from just as much, if not more, than Europe - if we believe the IPCC’s projections for the local consequences of global warming. If Europe communicates its strategy effectively - particularly in stressing that border pricing is not a protectionist policy - the Union will also have the underlying support of populations that are already experiencing the effects of climate change.

On the other hand, it’s easy to understand the reticence-even hostility-of low-income countries worried that their exports towards Europe might decrease. Concerns have already been expressed by India, as well as several African and Latin American countries. The Union will only be able to obtain their consent if it facilitates the transfer of both decarbonized and decarbonizing technologies. It is unavoidable, as well as being essential to our own interests, that Europe pays in part for these transfers.

France’s support for the Commission’s project, as well as its announcement of an ambitious low-carbon electricity production plan, are clear steps in the right direction. Even more so than in 2019, I believe that the stars are aligning for Europe to truly shift the world towards a decarbonized future.

Copyright: LOIC VENANCE / AFP