In recent years, there has been growing international concern over ‘carbon leakage’ – that is, where efforts to reduce carbon emissions in one country are counteracted by the displacement of emissions to countries with weaker climate policies. This may happen because industries in countries with stricter climate rules decide to relocate to countries with less stringent legislation to save on costs. Countries are concerned that, as they ramp up efforts to tackle climate change, they will face a competitive disadvantage and their efforts to reduce emissions will be undermined by carbon leakage (Morris and Nanda 2021).
There is limited empirical evidence of carbon leakage in practice, though this may be as a result of pre-emptive measures taken by governments to protect against it. One recent study, however, which looks at changes in country- and sector-specific energy prices, has found that carbon leakage can be significant for some countries, particularly in small, open economies (Misch and Wingender 2021). Moreover, despite limited empirical evidence, there are clear political implications for carbon leakage, given that fears over the risk of carbon leakage can restrain the scale of government ambitions on climate action.
In response to concerns about carbon leakage, some countries and trade blocs have proposed adopting carbon border adjustment mechanisms (CBAMs) as part of their response to the climate crisis. CBAMs are policy tools designed to impose charges on imported goods in line with their carbon content (ie the carbon dioxide emitted during their production). Their purpose is to prevent carbon leakage by placing the same costs on importers as domestic producers in energy-intensive industries (Lowe 2019). Most significantly, the EU has put forward detailed proposals for a CBAM to be integrated into the emissions trading system (ETS), the EU’s ‘cap-and-trade’ carbon pricing policy. This proposal targets carbon-intensive sectors such as iron and steel, cement, fertiliser, aluminium, and electricity.
CBAMs are not the only tools for addressing carbon leakage. Up until now, the approach typically taken by the EU/UK has been to offer a greater share of free allowances under the ETS for industrial installations deemed at high risk of carbon leakage. However, this approach weakens incentives to investing in the green transition and the EU has indicated that free allowances will now be phased out as the CBAM is introduced (EC 2021). Another approach, which faces similar issues to CBAMs, involves introducing mandatory product standards to prevent imports of products with high levels of embodied carbon emissions (HMT 2021).
Finally, perhaps the most effective long-term approach to carbon leakage involves greater coordination on carbon pricing and climate regulation between trading partners. In principle, if common approaches can be found on climate policies (eg a common system of carbon pricing), this will reduce the risk of carbon leakage and limit the need for a CBAM. One area where initial progress could be made is coordinating approaches for calculating and tracking carbon content (Lee and Baron 2021). However, given the diplomatic challenges involved, it is likely that these efforts will need to be complemented by unilateral action in the short to medium term.
We support the introduction of a carbon border adjustment through a UK trading scheme connected to the EU ETS. There are three main reasons for introducing such a mechanism in the UK. First, it would reduce the risk of carbon leakage from any future domestic increases in carbon pricing. Second, it would help to stop domestic industries from being at a competitive disadvantage due to more ambitious climate policies. Third, by linking to the EU ETS the UK could reduce additional trade barriers for UK exporters with respect to goods subject to the EU’s CBAM (Burke et al 2021).
There are, however, some important mitigation measures which should be put in place. Before introducing the CBAM, the government should provide a five-year warning to give supply chains time to adapt. Moreover, the adjustment should be introduced on a multilateral basis that includes discussion with key trading partners and developing countries. This advanced warning and cooperation would be critical to give the UK time to develop low-carbon domestic supply chains and limit the risk of trade tensions (IPPR 2021).
There are a range of practical challenges involved in implementing carbon border adjustments – from determining their industry and product coverage to accurately calculating how much CO2 has been emitted in the production process of imports. Depending on the design, there are also likely to be considerable administrative burdens for businesses. Even where businesses import less carbon-intensive products, there are likely to still be new reporting requirements to qualify for a reduction in costs. Lastly, as with any import tariff, successful implementation will also require government investment in domestic supply chains.
There are also considerable geopolitical challenges. For many countries, CBAMs are viewed as a potential cover for protectionism. Developing countries are concerned that they could be especially disadvantaged, given they face greater barriers to financing a green transition (Durant 2021). One particularly contested area is when to provide exemptions for countries from a CBAM on the basis of their approach used to reduce carbon emissions – ie whether to only provide exemptions for trade partners with similar carbon pricing mechanisms or to also provide exemptions for countries that have regulatory and other non-pricing policies with equivalent effects. As a result, there is a risk that, without careful diplomacy, carbon border adjustments could lead to retaliatory tariffs and a rise in global trade tensions.
IPPR, the Institute for Public Policy Research, is the UK’s leading progressive think tank. We are an independent charitable organisation with our main office in London. IPPR North, IPPR’s dedicated think tank for the north of England, operates out of offices in Manchester and Newcastle, and IPPR Scotland, our dedicated think tank for Scotland, is based in Edinburgh.
Our primary purpose is to conduct and promote research into, and the education of the public in, the economic, social and political sciences, science and technology, the voluntary sector and social enterprise, public services, and industry and commerce.
We are submitting this evidence on the basis of our current work on trade policy, in particular our recent report ‘Towards a Progressive US-UK Trade Partnership’. The report explores how the UK and the US can work together on trade and climate initiatives, including in relation to tackling carbon leakage.
Burke J, Sato M, Taylor C and Li F (2021) What does an EU Carbon Border Adjustment Mechanism mean for the UK?, Grantham Research Institute on Climate Change and the Environment and the Centre for Climate Change Economics and Policy. https://www.lse.ac.uk/granthaminstitute/publication/what-does-an-eu-carbon-border-adjustment-mechanism-mean-for-the-uk/
Durant I (2021) ‘The developing world must get ready to adapt its trade to climate change’, article, UNCTAD. https://unctad.org/news/developing-world-must-get-ready-adapt-its-trade-climate-change
European Commission [EC] ‘Carbon Border Adjustment Mechanism: Questions and Answers’. https://ec.europa.eu/commission/presscorner/detail/en/qanda_21_3661
HM Treasury [HMT] Net Zero Review: Analysis exploring the key issues. https://www.gov.uk/government/publications/net-zero-review-final-report
Institute for Public Policy Research [IPPR] (2021) Fairness and opportunity: A people-powered plan for the green transition, final report of the Environmental Justice Commission. https://www.ippr.org/research/publications/fairness-and-opportunity
Lee B and Baron R (2021) ‘Why the EU’s proposed CBAM must not be used to launch a carbon club’, article, World Economic Forum. https://www.weforum.org/agenda/2021/06/eu-carbon-border-clubs-climate-cbam/
Lowe S (2019) ‘Should the EU tax imported CO2?’, insight, Centre for European Reform. https://www.cer.eu/insights/should-eu-tax-imported-co2
Misch F and Wingender P (2021) ‘Revisiting carbon leakage’, International Monetary Fund. https://doi.org/10.5089/9781513593029.001
Morris M and Nanda S (2021) Towards a Progressive US-UK Trade Partnership, IPPR. https://www.ippr.org/research/publications/towards-a-progressive-us-uk-trade-partnership
October 2021