Negotiations over phasing out fossil fuels at the recently completed COP28 climate summit in Dubai have highlighted once again just how difficult it is for the international community to coordinate their climate policies. From an economic point of view, global cooperation would be the efficient approach to driving greenhouse gas (GHG) emissions to net zero, yet free riding incentives and unresolved distributional issues stand in the way (Weder di Mauro 2023). Against this background, the EU has tightened unilateral climate policy in its ‘Fit for 55’ policy package (EU 2023). Thousands of manufacturing firms regulated in the EU Emissions Trading Scheme (EU ETS) face an accelerated schedule for reductions in the emissions cap. The resulting higher EU ETS price strengthens their incentives for abating CO2, but it might drive some firms to relocate carbon intensive production and the associated emissions to countries with lower or zero carbon prices. This past October, aiming to prevent such carbon leakage, the EU launched a new policy instrument, the Carbon Border Adjustment Mechanism (CBAM).

CBAM seeks to level the playing field between domestic and foreign producers of carbon intensive goods. It taxes emissions embedded in imports at a rate equal to the difference in carbon prices in the ETS vis-à-vis the source country (Figure 1). While border carbon tariffs like CBAM have long been discussed in the literature (Markusen 1975, Hoel 1996), they have thus far been regarded as incompatible with WTO rules. With the launch of CBAM last October, the EU changed this paradigm. ¹    

Figure 1 CBAM attempts to create a level playing field

a) Unilateral carbon pricing