Reconciling countries' varying climate ambitions with a transparent, fair, and efficient global trading system

Global progress in reducing greenhouse-gas emissions benefits from the flexibility given to countries to set their own level of ambition and choose policy instruments. This nationally determined approach, as outlined in the Paris Agreement, helps maximize the effectiveness of climate action by allowing each country to tailor its efforts to its administrative ability and unique political context.  

At the same time, this flexibility calls for border carbon adjustments (BCAs) to prevent “carbon leakage,” which occurs when one country’s relatively stricter environmental regulations create an incentive to import goods from countries where regulations are looser. The Carbon Border Adjustment Mechanism introduced by the European Union is the first of its kind, and other countries, including Canada and the United Kingdom, are considering similar programs.

BCAs pose challenges for exporters, particularly in developing countries that do not benefit from the quality infrastructure and environmental and tax administrative capacity of the same level as in advanced economies putting in place BCAs. With a BCA, exporters must surmount three hurdles that may unfairly put them at a competitive disadvantage: (i) excessive compliance costs against a low risk of carbon leakage; (ii) the possibility that the carbon intensity of their export products is overestimated; (iii) the possibility that carbon taxes already levied in the exporter’s country are not accurately accounted for by the importing country.

These issues are now being brought to the forefront of environmental discussions, according to some reports. Countries exposed to BCAs and concerned about unfair treatment could be prompted to retaliate by reducing access to their own markets or to divert their trade to less environmentally ambitious jurisdictions. Either way, the ultimate consequence would be to hamper economic development and slow progress in curbing GhG emissions at the global level.

BCAs will inevitably hurt exporters of carbon-intensive products. Yet a number of actions can be taken to ensure that these exporters remain fairly treated, as discussed in a recent report, Working Together for Better Climate Action: Carbon Pricing, Policy Spillovers, and Global Climate Goals, produced jointly by five international organizations including the World Bank.

Its recommendations boil down to clarifying and potentially agreeing on the following points:

• The extent of carbon leakage risk which justifies applying a BCA to a given sector or product. Evaluating the risk requires a simultaneous assessment of the cost impact of the climate policy on that sector or product, its exposure to international competition, and the potential for relative price changes to cause foreign production to expand and the likely emissions associated with that expansion. Careful assessment of these dimensions, using agreed criteria, could constitute a prerequisite to the introduction of a BCA.
  
  
• The carbon intensity of traded products. Criteria for measurement, reporting, and verifying a product’s carbon intensity under BCA vary considerably, depending on the jurisdiction and the mitigation policy instruments put in place in that jurisdiction. This may raise compliance costs for exporters trading with different jurisdictions and put them at a competitive disadvantage, depending on how accurately emissions intensity is measured at the sector, firm or product level, and whether indirect emissions are included (e.g., scope 2 emissions, which are the result of the energy generation process for electricity, steam, heating, and cooling that a company purchases).
  
  
• The equivalence and interoperability of mitigation policies. Intensified discussions around carbon leakage and BCAs have raised awareness of the need for equivalence and interoperability of carbon pricing mechanisms and related emissions data, measurement, and reporting requirements. Recognizing equivalence in carbon pricing mechanisms between trading partners would make it easier to certify that a carbon price already paid domestically is equivalent to price in the market imposing the BCA. Interoperability would decrease the costs of reporting to multiple jurisdictions. Interoperability could also help address differences in economic and institutional systems and reduce costs of compliance of developing countries and SMEs while building trust.

While the Paris Agreement’s bottom-up, nationally determined approach to climate action means that a certain degree of fragmentation is a natural feature of the policy landscape, plenty of opportunities exist to coordinate some key policy metrics and forge common understanding on some issues —notably carbon leakage and intensity. Greater international cooperation will be needed to reconcile policy fragmentation with a transparent, fair, and efficient global trading system. International organizations can be instrumental in advancing this agenda by helping address key policy areas discussed in this blog post.

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