Carbon Adjustment Mechanisms: Empirics, Design and Caveats

Abstract

This article explores the design of Carbon Adjustment Mechanisms based on an analysis of historical data, the existing literature as well as theoretical considerations. In an empirical analysis we quantify territorial emissions as compared to the CO₂ footprints for countries within the EU ETS area and globally. We show which (mostly upstream) industries account for the majority of emissions, and identify how their emissions are imported embedded in final or intermediate products from more downstream industries. We furthermore analyze carbon leakage and estimate the effects of the EU ETS on trade flows and CO₂ embedded in trade flows in a gravity equation framework. We find that imports and CO₂ embedded in imports slightly increase in industries covered by the EU ETS. Exports significantly decrease in the most carbon-intensive industries, but not in the EU ETS-covered industries on average. Furthermore we find significant phasing-in-effects as carbon leakage increases over time, possibly due to costly adjustment of production capacity. Our own analysis and insights from the current literature suggest that – if a Carbon Adjustment Mechanism is to be established – focusing on emissions-intensive industries could balance excessive bureaucratic burden and carbon leakage mitigation. To be effective, such a system should also extend to embedded emissions in downstream industries to avoid a shift of imports down the value chain. Due to costly adjustment of production capacities a shift of imports down the value chain could also be prevented by a Carbon Adjustment Mechanism that initially covers only direct emissions of emissions-intensive and trade-exposed (EITE) industries in conjunction with a credible roadmap towards a full coverage of downstream industries.

Keywords: Carbon Border Adjustment, Carbon leakage, Carbon tax, climate policy