CO2 border tax would ‘replace’ EU ETS free allocation

The EU's plan to introduce a CO2 border tax would likely see the bloc phase out free allocation for industry in the EU emissions trading system (ETS), carbon market observers have said.

European Commission president-elect Ursula von der Leyen, who takes office in November, has pledged to introduce an EU-wide carbon border tax — a move she says would "ensure our companies can compete on a level playing field".

A border tax would apply a levy to goods coming into the EU, so that the price of imports from non-EU countries included a CO2 cost equivalent to the EU's. The idea is to avoid carbon leakage, the risk that EU companies would relocate to other regions to avoid paying carbon taxes.

Market observers said an EU carbon border tax would likely replace, rather than exist alongside, free allocation for industry in the EU ETS. The EU currently gives free ETS allowances to industrial sectors deemed at risk of carbon leakage, to reduce their CO2 costs.

"My working assumption is that border-adjustment taxes would have to be phased in over time given their complexity and as a result that free allocations would also have to be phased out over time," bank BNP Paribas' head of sustainability research Mark Lewis said.

Double protection

Introducing carbon border measures alongside EU ETS free allocation would risk "doubling up" on policies to shield industry from carbon leakage, climate change think-tank Sandbag said.

"Free allocation is generally inconsistent with a carbon border tax, not least because World Trade Organisation [WTO] law does not allow double protectionism," Sandbag analyst Dave Jones said.

Non-governmental organisation Carbon Market Watch (CMW) warned that having both measures in place would reduce the incentive for firms to cut their emissions.

"If free pollution permits were kept in place while introducing carbon border taxes, European industry would have no incentive to clean up its act," CMW policy director Sam Van den plas said.

Environmental groups say EU ETS free allocation has taken the pressure off industrial firms to cut CO2. Emissions from EU industry stood at 587mn t of CO2 equivalent last year — roughly unchanged from 2013.

High-carbon industries like steel and cement will face increased pressure to cut CO2 in the coming years, as von der Leyen rolls out her flagship "European green deal" policy — a package of measures aimed at reducing EU emissions to net zero by 2050.

Reaching net zero will require large CO2 cuts across all sectors. A border tax, by helping companies stay competitive while they decarbonise, could help address the concerns of critics who say the EU's climate ambitions will place a burden on industry and put jobs at risk.

The measure has the support of some of Europe's largest industrial companies, which say they are already struggling with carbon leakage because of the steep rise in EU ETS prices since 2018. Luxembourg-based steelmaker ArcelorMittal describes border measures as "an effective and fair way to ensure every country plays its part in reducing global CO2 emissions."

‘Diplomatic quagmire'

Von der Leyen has so far given no specifics on how an EU carbon border tax would work — aside from telling her nominee for EU economy commissioner, Paolo Gentiloni, that the measure must be compliant with WTO rules.

The complexity of setting CO2 tariff levels across a range of sub-sectors, and agreeing those levels with other countries, could become a "diplomatic quagmire" for the EU, Mark Lewis said.

But he added that the bloc's position as a large market, which other countries want access to, should give it leverage in these talks. "I think it is ultimately both technically and politically possible to implement border-equalisation taxes," he said.

Implementing the policy will be easier in some sectors than others. Europe's chemicals firms manufacture thousands of different products — applying a specific carbon duty to each one would be a practical challenge, industry representatives warn.

Another practical hurdle is that an EU-wide CO2 border tax would require unanimous support from member states. To get around this, von der Leyen wants the EU to move from unanimity to qualified majority voting on tax and energy matters.

Ultimately, a CO2 border tax is a fallback solution, seen as second best to having a global carbon price.

"In an ideal world, all countries would charge for emitting CO2, but given this won't happen for a while, the prospect of a carbon border tax is an exciting solution to this problem," Jones said.

The EU hopes border measures would incentivise non-EU countries to introduce tougher climate policies, so they can import products into the EU market without having to pay the tax. This would have the dual advantage of driving global CO2 cuts, and positioning the EU as an international leader on climate change.