EU in Search of a Wto-Compatible Carbon Border Adjustment Mechanism

Abstract

To meet the targets of the EU’s Fit for 55 package, the European Commission proposes to implement a Carbon Border Adjustment Mechanism (CBAM) to replace free emission allowances for the most trade exposed emitting industries. The CBAM is firstly intended to avoid carbon leakages, but it also deals with the thorny issue of the compliance by European producers in carbon-intensive industries. Its design, as voted by the European Council in March 2022, and amended by the European parliament three months later, questions the compatibility with the rules of the World Trade Organization (WTO). This paper aims to quantify the economic and environmental impacts of different choices regarding this design in the face of the dilemma between compliance with WTO rules and acceptability of the new regulation. Using a dynamic general equilibrium model featuring imperfect competition, global value chains, greenhouse gas emissions and endogenous price of emission quotas, we evaluate the various options. We show that the CBAM is effective in reducing carbon leakages. But its design leads to an increase in the price of carbon quotas in the European Emission Trading System (ETS) market. Losses in competitiveness on export markets are expected, even in the presence of rebates to the European exporters and also for downstream sectors not covered by the EU ETS nor the CBAM. Eventually, offsetting the difference in carbon prices at the border comes at a cost to the enforcing jurisdiction, suggesting that the CBAM was not designed as a beggar-thy-neighbour policy.

Keywords: Carbon Border Adjustment, International Trade, Climate Change. JEL codes: F14, F13, F17, Q56