As the world seeks to address climate change, there are various approaches which can be used. Carbon pricing is one tool for influencing behaviors; incentivizing green development is another. Ideally, when it comes to carbon pricing, there would be a global agreement on a minimum price, allowing for differentiated responsibilities between jurisdictions.

However, this appears hard to achieve in practice and, as there are differing aspirations and approaches, unilateral actions need to be taken by jurisdictions with high ambitions for climate action in order to maintain momentum. As the carbon price increases―for example in the EU―so do certain challenges, such as the concern about carbon leakage and the impact on exports. A carbon border adjustment mechanism (CBAM) is one, but only one, approach to addressing carbon leakage. Any CBAM needs to be compliant with World Trade Organisation rules, and this does raise various complications.

Proposals to introduce a CBAM in the EU have raised concerns in other parts of the world about green protectionism and, in particular, the potential impact this could have on developing economies would need careful consideration. Whatever instruments are used, there is a call to allow industries to transition to a low carbon economy, and successful transition will require ongoing dialogue, a recognition of different approaches, and investment in new technologies as well as carbon pricing mechanisms.

The key considerations of a Carbon Border Adjustment Mechanism

To help organizations and other key stakeholders explore the implications, challenges and key considerations of a Carbon Border Adjustment Mechanism (CBAM), KPMG’s Responsible Tax project convened a series of three events with written outputs.

  1. The first was a roundtable with experts to discuss the details of a CBAM, the write up of which can be found here and a briefing note here.
  2. The second was a roundtable with corporates to discuss the practical implications the introduction of a CBAM may have - the writeup can be found here.
  3. The third event was a webinar on the 26 April 2021 which was open to everyone and consisted of two panels.

The first of these panels discussed climate change issues, introduced CBAM and gave a flavor of the current political climate. This was moderated by David Linke, KPMG’s Global Head of Tax, and was participated in by Loek Helderman, KPMG’s Head of Tax for KPMG IMPACT, Stefano Moritsch, Associate Director and leader of the International Trade and Government Affairs team for KPMG in Australia, and Hannah Hawkins, Principal with the Washington National Tax desk for KPMG in the US. The second panel was moderated by Chris Morgan, KPMG’s Head of Global Tax Policy, and discussed the challenges, complexities and points of consensus of a CBAM with Kurt van Dender, Head of the Tax and Environment Unit at the OECD’s Centre for Tax Policy and Administration, Dirk Heine, Senior Economist – World Bank Macroeconomics, Trade and Investment Global Practice and Carl van der Host, Director of European Affairs, Tata Steel.

While reference was made to the various options for a CBAM which were set out in the EU Commission’s consultation launched in 2020, the discussion focused on the principles in general; they were not intended solely as a critique of any EC proposals.

Attendees spoke in their private capacity rather than on behalf of any organization. This note is not intended as advice and does not necessarily reflect the views of any KPMG firm.

Points from Panel One

189 countries1 have joined the Paris Agreement to reduce CO2 emissions. However, some jurisdictions or regions – for example the EU - have announced increased aspirations. There is a concern amongst some policy makers that increased carbon prices will lead to carbon leakage. This is where the greater carbon cost in a high ambition area results in either production being transferred to countries with lower ambition for emission reduction, or products being replaced by more carbon-intensive imports__

The most accepted way of preventing further climate change is to eradicate, or minimize, the carbon dioxide (CO2)– or Greenhouse Gas (GHG) – emissions. Some countries have higher carbon emission reduction ambitions than others and, to try and achieve that goal, have implemented carbon taxes or emissions trading schemes, with carbon priced at various levels. However, last year a World Bank study2 estimated that only 22% of emissions were priced. A recent OECD Report on Effective Carbon Pricing cites sources suggesting that we need a carbon price of €120 per tonne by 2030 if we are to become carbon neutral by mid-century.

Carbon prices, whatever form they take, tend to drive up the price of the products they are imposed on in the applicable jurisdiction. This raises the concern of carbon leakage.

Operational leakage occurs where current demand is met by products from lower ambition countries. Investment leakage occurs where producers relocate production facilities to lower ambition countries where no, or a lower, carbon price occurs. These both undermine the attempt to reduce emissions in the high ambition area and can have adverse economic consequences for the high ambition jurisdiction.

A Carbon Border Adjustment Mechanism (CBAM) can help address the carbon leakage issue by essentially charging a carbon price on imports which come from a country which has a lower carbon price than the importing country. That removes the incentive for carbon leakage as imports do not benefit from having a lower cost due to their jurisdiction of production having a lower or nil carbon price.

Charging a carbon price on imports is a difficult task with many political, technical and practical ramifications. However, in 2020 as part of the European Green deal the EU released a CBAM consultation which proposed four potential options.

The first option is some kind of carbon tax, probably structured as a customs duty. The duty would be paid on imports on selected products in industries which are at risk of carbon leakage. It is likely that this would be based either on an average benchmark for the carbon intensity of particular products or that the importer would be able to demonstrate the carbon intensity of the product to determine the charge.

There are two options based on the EU Emissions Trading System (ETS). The ETS operates by setting a cap for how much greenhouse gas pollution can be emitted each year in the EU and then selling portions of that cap to emitters through auctions (or providing allowances free of charge in some cases). These portions are called European Emission Allowances and companies covered by the ETS must return an allowance for every tonne of CO2 they emit during that year.

The second option in the EU consultation involved extending the existing EU ETS to include importers. Loek Helderman noted that would create a number of complications and thought it is unlikely that this option will be chosen.

The third option is to create a shadow ETS of some kind. In this case, importers would buy shadow allowances, from an unlimited pool available to importers only, based on the prevailing EU ETS carbon price.

The fourth option would introduce a new carbon excise tax on the consumption of selected products at high risk of carbon leakage. This would apply both to EU produced products and to imported products.

The ‘selected products’ have not been confirmed as yet; however, frequently mentioned by EU officials and parliamentarians are steel, aluminum, cement, chemicals, paper, glass and fertilizers.

Each of these types of CBAM come with their own issues but whichever is pursued, it will need to be compliant with the World Trade Organisation (WTO) rules or it could be challenged by affected importers

Any CBAM must comply with WTO terms. Critically a CBAM must not: have the effect of favoring domestically produced goods over imports, otherwise known as the non-discrimination rule (e.g. by imposing a higher carbon price on importers than domestic producers); or discriminate against any individual trading partner, otherwise known as the most favored nation principle (e.g. by applying a CBAM only to certain countries but not to others). These principles indicate a CBAM should not prevent producers from demonstrating the embedded carbon content of imported goods to reduce any CBAM charge and should not impose an unduly heavy compliance burden (e.g. making certification of embedded carbon content extremely difficult).

The CBAM regime could be acceptable even if, prima facie, it breaches a WTO requirement if it meets one of the WTO legitimate public policy exceptions (GATT Article XX). The most likely would be the conservation of exhaustible natural resources, or to the protection of human, animal and plant life or health by contributing to mitigating the risks of climate change. However, for the exception to be applicable, environmental objectives would have to be the main reason for the measure and any purpose to address business competitiveness would likely undermine this defense. Additionally, any measures would have to be necessary to achieve the said environmental objectives and enforced without unjustifiable discrimination, i.e. favoring domestic producers , where a less trade restrictive measure is available to achieve the same public policy objectives.

KPMG panelists thought that the EU is most likely to pursue a shadow ETS regime. Firstly, because that option would not need unanimous consent of member states (as it is not technically a tax); and secondly it could be implemented without significant change to the existing ETS in Europe.

In the feedback to the EU consultation, business respondents preferred option one – a carbon tax/customs duty. Whereas at KPMG’s first CBAM roundtable, with institutions such as the World Bank, OECD, UN, the academic world and one company, there was a lot of support for option four – an excise tax.

For a CBAM to be structured as a tax, it would have to be approved by a unanimous vote of all the member states in the EU. Whereas, if it was not structured as a tax, and instead as a shadow ETS, it would only need the approval of a qualified majority of member states.

It was also noted that the EU ETS is currently the main carbon pricing tool in the EU. If CBAM was introduced as a carbon tax (customs duty) or an excise tax, it could raise questions about how comparable it would be with the ETS and therefore WTO compliance. Therefore, it was thought most likely that any CBAM would be implemented as a shadow ETS regime.

Panelists noted a historical difference in approach to decarbonization between the US and Europe. While the EU has focused on carbon pricing, typically the United States of America (US) has preferred to use incentives to drive green investment. However, recent events in the US have begun to indicate that perhaps, in the longer term, they too will consider some kind of Carbon Border Adjustment Mechanism

The US approach when it comes to decarbonization has typically been through incentives, largely through the tax code. The recently released Biden infrastructure plan does not include carbon pricing, rather it proposes to extend and enhance the various existing tax incentives for clean and renewable energy. Historically incentives have been successful in the US, for example wind and solar power increased from 4% of the nation’s electric generating capacity in 2010 to nearly 13% in 2020. There is data showing that when the credits were allowed to expire, green infrastructure development almost ceased until the credits were reintroduced.

Recently John Kerry, the US’s Special Presidential Envoy for Climate, expressed some concern over the EU’s intention to implement a CBAM saying that a CBAM should be “a last resort, when you’ve exhausted the possibilities of getting emission reductions and joining in some kind of compact by which everybody is bearing the burden”. Nevertheless, Biden’s presidential campaign materials3 did reference an intention to pursue border adjustment fees and the US submission under the Paris Agreement (related to its nationally determined contribution) includes a reference to considering a border adjustment mechanism. Furthermore, earlier in April John Jerry, in an interview, indicated that the US could be interested in evaluating a border adjustment mechanism.

Concern about the introduction of a European CBAM has also been expressed by other countries with suggestions that it could be a form of green protectionism.

In April, at a meeting of the BASIC Nations – Brazil, South Africa, India and China — the ministers jointly expressed concern saying CBAM would be a trade barrier and opposed the Paris Agreement principles of equity and common but differentiated responsibilities.

Concern has been expressed by less developed nations that a CBAM may disproportionately impact them by forcing the cost of decarbonization onto poorer nations, even though their country contributes very little emissions overall.

At KPMG’s second roundtable, it was also noted that in less developed countries it may not be possible to decarbonize quickly due to infrastructure and technological insufficiencies, so they would continue to suffer a carbon border adjustment on their products. Where this cost could not be passed on to consumers the increased cost would be absorbed by poorer countries.

It was noted that, for this reason, it is sometime suggested that CBAM revenues should be used to help low income countries to decarbonize – but that does not seem to be the case with the EU where the EU Commission has said the revenues are earmarked for the EU’s own resources.

__A multilateral, or indeed global, approach to carbon pricing would be the best way to ensure a level playing field was achieved and decarbonization goals met; however, the political difficulties of achieving this are considerable __

As discussed during both the roundtables, a global agreement on a minimum carbon price would be superior to individual countries implementing CBAMs. Even if the five largest economies/economic areas (US, China, EU, Japan and India) could agree a carbon price, this would cover 51.4%4 of global emissions. This would allow less developed smaller nations to implement their own carbon price over a longer period. This approach would allow countries to make progress according to the Paris agreement’s principal of equity and common but differentiated responsibilities.

In terms of the global approach, it was also commented whether the OECD should get involved and “apply” the Inclusive Framework, which served a purpose in the context of BEPS and other tax challenges as well.

However, as noted at one of the roundtables, it may be incredibly difficult to get consensus between countries with their own political agendas.

In any case, it was noted that the current reality is that the EU Commission has now been tasked to bring forward a proposal on the European CBAM in June this year, for implementation by 1 January 2023.

Panel Two

Participants thought there is a real risk of carbon leakage and of carbon pricing impacting export competitiveness – although possibly restricted only to a few industries.

Carl van der Horst, from Tata Steel, confirmed that the steel industry sees carbon leakage as a real issue. He noted that while the Tata Steel plant in the Netherlands uses state of the art technology, its emissions are not fully covered by free allowances under the EU ETS and so it bears a real carbon cost which is increasing over time. Non-EU producers do not have such a cost and it is noteworthy that Europe used to be a marginal exporter of steel but is now a net importer. Some form of a CBAM may therefore be necessary. Furthermore, a rebate which assists exports was desirable so that EU producers could remain competitive internationally.

Dirk Heine, World Bank, agreed that carbon leakage is an issue for certain industries – like steel – but pointed out that certain studies have shown that looking at the economy as a whole, the impact is small overall. However, it is possible that the impact is small because current carbon prices are not yet high enough to cause large amounts of carbon leakage – in future, as carbon prices rise, this could change.

Panelists agreed that, ideally, a global agreement on carbon pricing would be the best solution to climate change and carbon leakage. However, that could be difficult to achieve, and the urgency of climate change meant countries should adopt unilateral approaches where necessary – although this did not necessarily have to be a CBAM. Various options were raised in the discussion

Kurt van Dender, OECD, referred to the OECD paper “Climate Policy Leadership in an Interconnected World” which notes that any CBAM will be impacted by political, technical and legal issues and is likely to be different from the pure theoretical measures which are usually discussed. The paper counsels against assuming a CBAM is the only way to address carbon leakage and notes it is important to avoid trade wars which will be bad for both the environment and the global economy.

Panelists discussed various other measures. Kurt van Dender noted that the OECD considers that free allowances under an ETS are an alternative mechanism to a CBAM but it is hard to see how the two mechanisms could be used together. Carl van der Horst however thought that free allowances under an ETS could be combined with a CBAM based on a shadow ETS; as free allowances were reduced over time the CBAM charge would be increased accordingly and this may make the transition easier as the price of carbon became more expensive for everyone at the same rate. It was agreed the two approaches could co-exist provided there was no double protection for exports. Free allowances, however, do not fit well with high carbon emission reduction ambitions as they have the effect of reducing the carbon price and therefore environmental goals; thus, keeping the two together should be seen only as a transitional phase.

Other possibilities mentioned included carbon pricing with output-based rebates, feebates – i.e. a tax on high emission production which is used to subsidize low emission production - and implementing an excise tax on the consumption of products with high embedded emissions. References were also made to supporting investment in green technology and sectoral agreements – such as CORSIA (Carbon Offsetting and Reduction Scheme for International Aviation which is a scheme developed by the International Civil Aviation Organisation to reduce international airline emissions). Carl van der Horst did note, however, that sectoral agreements could take a long time to reach – for example there have been discussion about addressing over production of steel globally for many years, but no conclusions have been reached.

There was some support for the idea of using a carbon excise tax on all domestically consumed products with a high embedded carbon content, combined with a subsidy for green production. The net effect of the tax and subsidy would be like a carbon tax and, as both instruments would apply only to domestic consumption (including imports), it would not adversely impact exports but should be WTO compliant. However, being a tax measure, an excise tax would require unanimous member state approval within the EU

Kurt van Dender noted that the OECD refers to an excise tax as a separate measure to a CBAM, as it is a tax on consumption rather than a tax applied at the border however, the effect can be similar to a CBAM. Dirk Heine noted that when policy makers wish to tax a negative externality, they often put the burden on the consumer – e.g. as with alcohol taxes – rather than on the producer. The same could be applied as regards carbon emissions. A carbon excise tax could be charged on the embedded carbon content of a product which is sold in the EU, for example, steel or cement, regardless of where it was produced. The tax would be charged at a flat rate, probably based on the current carbon price.

This type of consumption-based tax solves the problem of what to do about European exports. As it would only be charge on consumption in the EU, it would not be charged on exports and so there would be no need for a refund – which would satisfy WTO rules.

Although the tax alone does not encourage green production - as it is charged at a flat rate with no variation for low carbon products – it could be coupled with a subsidy for green production. This would be given to producers, regardless of jurisdiction, provided they sold products in the EU. Dirk Heine noted that private certification schemes are already widely used. For example, electronic goods imported into the EU can be certified to comply with EU safety standards. As similar mechanism could be used to certify the carbon content of goods. By linking subsidies scheme to existing private certification schemes – for example for green steel – it may also encourage the expansion of such schemes.

Carl van der Horst noted that while there were interesting aspects to an excise tax proposal, adoption within the EU would require unanimous consent of all member states and so was unlikely to happen in the near future. What was important was to have adequate protection against carbon leakage in the short term; any CBAM which was introduced needed to facilitate a transition to a low carbon economy.

In order to be WTO compliant, it is likely that a CBAM would have to permit importers to demonstrate the embedded carbon content of imports and the panelists agreed this should be practical

Carl van der Horst noted that EU manufacturers covered by the EU ETS already have to measure and certify their carbon emissions so in principle importers could do the same – using the private certification schemes already mentioned by Dirk Heine. An alternative would be for the EU to carry out verification of company data on, say, a three- or five-year basis – as happens with for example with certain anti-dumping measures.

Kurt van Dender raised the question of how the initial benchmark for any CBAM would be set – conceivably it could be average emissions for a particular country, for the actual exporting facility or an EU average. The latter might be easier administratively but, as EU standards are likely to be more carbon efficient than in many other places, using an EU benchmark would still allow for some leakage. Allowing an importer to demonstrate the actual embedded carbon content so as to reduce the charge was probably necessary under WTO rule but could lead to “resource shuffling” – i.e. a non-EU producer would be incentivized to send product from its most efficient facilities to Europe to reduce the tax charge while sell high emission products elsewhere.

In summing up, the panelists highlighted that the goal is not a CBAM as such but facilitating a transition to a low carbon economy; it is important to learn from and build on existing measures; and there is a need for dialogue and recognition of the importance of trade relations in producing well-being and environmental quality

Carl van der Horst concluded that a CBAM is not the goal but a means to an end – which is to allow industries in the EU, but also outside the EU, to make a transition to a low carbon economy. This requires effective measures against carbon leakage if countries are not moving at the same speed and in the same way, which is currently the case. If a CBAM can help achieve this, one should be introduced as soon as possible.

Dirk Heine emphasized that countries already use various forms of border adjustments and should learn from precedent. A CBAM does not have to be highly novel and complicated. It should be possible to develop measures which are WTO compliant and not excessively complex to administer based on existing type of taxes.

Kurt van Dender thought the most important issue was to create a positive environment around climate policy and carbon pricing. Debates like this webinar demonstrate there are many options to consider. There is a risk that discussions about a CBAM can spiral downwards and damage trade relations. It is important therefore to recognize there are different approaches and aspirations and to maintain a dialogue while recognizing the importance of trade relations to economic well-being and environmental quality.