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A border tax on carbon: National interests and global narratives

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Factory smokestacks in Estonia. Photo: Curt Carnemark/World Bank
Factory smokestacks in Estonia. Photo: Curt Carnemark/World Bank

The world’s wealthier nations are considering a trade tax on carbon.  One of the policies being considered to support the European Green Deal’s goal of making the EU carbon neutral by 2050, for example, is adding a border tax on carbon (CBT) in addition to capping emissions. The US is also reportedly considering such a tax. The rationale for a CBT is to prevent leakage of emissions from countries that penalize emissions strongly to lower emissions-abating countries. The concern is that domestic production would move overseas to take advantage of lower (or no) carbon taxes, which would result in domestic production being substituted with carbon-intensive imports. The lower the cap on emissions in the domestic country (or equivalently, the higher the carbon tax), the greater the possible leakage.  Together, the emissions cap and the CBT are aimed at reducing both domestic production and consumption (imports), the higher imports reflecting the “anti-competitive” effect that higher carbon prices have on domestic goods.

There are ex-ante simulation studies of the EU emissions trading scheme (ETS); this scheme caps overall emissions. These studies indicated that direct leakage would be likely. According to the University of Oldenburg, ex post simulations of the existing EU ETS have generally not found any substantial direct leakage. This may be explained by the fact that there are many elements other than the carbon tax that determine where firms locate and produce. Also, models differ in terms of the various assumptions they make about how economies respond.

An additional dimension is the loss from indirect leakage. This refers to the impact that tighter emissions standards in the EU would have on global supply and prices of carbon-intensive products (assuming these countries are large enough to affect world markets).  Leakage of carbon-intensive products into unregulated markets would presumably increase supply and lower prices in those markets, all else equal, the long-term impact is uncertain. Lower prices may be expected to increase carbon consumption in third countries.  Thus, the CBT would not be expected to reduce indirect leakage.

According to trade theory and empirical evidence, one of the effects of border restrictions between two countries-ceteris paribus- is trade diversion so that partners trade less with each other once transactions are taxed. It is possible to imagine trade markets becoming segmented with high-abaters and low-abaters, each trading more within their own groups.  It is an empirical matter how large these effects would be, but it is not at all clear that global emissions would fall more if a CBT were imposed.

Any nation has the right to adopt regulations that are consistent with its national priorities, with the understanding that pre-existing multi-country agreements will constrain what is possible. Just like carbon taxes, a variety of domestic taxes and regulations may materially affect a country’s relative advantage in international trade  and generate responses from its producers as well as its trading partners. Differences in labor standards, for example, have aroused protectionist pressures in countries that have tighter labor standards than others. In these cases, trade agreements have been used to align norms and priorities. The CBT aims to strengthen the adherence of nationals and foreign countries to the global public good- lower emissions. Yet, countries considering this option would use the proceeds to support nationals hurt by tighter carbon taxes.  An additional question is whether a CBT would be aligned with the spirit of the Paris Agreement which allows for common and differentiated responsibilities. Alignment would be enhanced if CBT imposing countries would compensate developing countries: such as by returning the tariff proceeds to them to use for adaptation policies or green investments.

It is not good practice to have trade restrictions whenever a country’s national goals or values differ from one another , especially when these differences can be legion. International trade is one of the channels through which global growth, knowledge and technology transfer may be supported. At the same time, CBTs may not achieve the best outcome in a dynamic context either; grants for green technology adoption could fare better. Engaging in trade with high-abaters only could leave the group of low-abaters to become increasingly interdependent, and reduce incentives for cooperation over time. Moreover, trade restrictions would need to be WTO compatible; unilateral trade restrictions may enhance trade-related conflicts.

Finally, around the world, it is not clear which countries have developed coherent and internally consistent strategies –with policies and funding identified-to reach carbon neutrality by 2050 (or some other date). Oil and gas pipelines under construction and pre-construction worldwide, and in key large economies committed to this goal, do not indicate such consistency. For example, the Global Energy Monitor indicates if all the gas infrastructure that is planned or under construction, is done, there will be an approximately 35% increase in the EU’s gas import capacity alone. Substantial increases are expected for key large emitters around the world. Perhaps countries should take a second look at how all the pieces fit together.



Roumeen Islam

Economic Advisor, Infrastructure Practice Group, World Bank

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