Why all the fuss about carbon leakage?

First, a quick definition:

Carbon leakage can occur if the competitiveness impacts that arise from carbon policies leads to emissions reduction from domestic firms combined with increases in emissions in other jurisdictions where carbon policy is either less ambitious or does not exist. This can lead to a net increase in global emissions.

The Financial Secretary to the Treasury recently announced that Government will “consult later in the year on a range of carbon leakage mitigation options, including on whether measures such as product standards and a carbon border adjustment mechanism (CBAM) could be appropriate tools in the UK’s policy mix”. For those of us who have been thinking about this stuff for a while, this is good news.

The UK has ambitious climate targets and increasingly ambitious carbon policies. At the heart of this is the UK Emissions Trading Scheme (ETS), which if Government’s current consultation is anything to go by, shows how serious it is about achieving Net Zero. But with increased ambition comes higher carbon prices – be it either directly or indirectly. The complex mix of policy in place affects activities across the economy differently, which results in some sectors – by nature of being carbon intensive – more exposed to a carbon price than others. Crucially, some of these activities produce goods that are traded on the global market and are, therefore, trade exposed – that is to say, sensitive to the cost of production of international competitors.

In a bid to level the playing field between domestic producers of goods, who pay a carbon price, and their international counterparts, Government have employed the use of subsidies, rebates, exemptions, and the free allocation of UK ETS allowances. At this point, it is worth remembering that carbon is only one of the many considerations when making investment decisions (and often a quite minor one), with natural resources, skills, access to customers, business rates, and labour costs often playing a bigger factor.

Unsurprisingly, the use of exemptions and other tools reduces the incentive to decarbonise, thereby reducing the potential for innovation and ultimately slowing progress in emissions reduction. It also reduces the longer-term opportunity for British industry to become leaders in low carbon industrial practices and products.

Government publications such as Treasury’s Net Zero Review and the current Developing the UK ETS consultation have teased that Departments are indeed thinking about which policies can be applied at the border, but to date little has been said beyond that. Without providing a clear signal of what could replace policies such as free allocation, industry are less likely to make the long-term investment decisions required for Net Zero.

How do standards or a CBAM work?

Instead of levelling the playing field by reducing the incentive to decarbonise at home – the approach utilised most today – the use of standards or CBAMs are intended to level the playing field by applying the same incentive for everyone. This is done by implementing the same policies as seen by domestic producers on equivalent imported international goods. This would mean that domestic industry would not be punished versus their international competitors, but there also remains a strong incentive for them to innovate to cut emissions.

There are commonalities between standards and CBAMs. For one, both rely on robust monitoring, reporting, and verification (MRV) of emission data from domestic and imported goods. Ensuring emissions from another jurisdiction are consistent across like-for-like products is challenging from both a technical and a political standpoint, while ensuring compliance with WTO rules.

It is in their application in which things differ.

Carbon Border Adjustment Mechanisms

In its simplest terms, a CBAM applies a carbon price to imported goods. However, much like a carbon tax, while the economic theory is sound (and not ignoring the fact a CBAM could be applied through the UK ETS), the political economy is at odds with the theory. Even the carbon tax advocates HM Treasury – the Department that a few years ago was in favour of the replacing the UK’s place in the EU ETS with a Carbon Emissions Tax at home – were cautious when publishing their views in the Net Zero Review on the potential of CBAMs:

• “CBAM policy development will be complex, and as proposals evolves the government will continue to evaluate the impact on the UK and engage with the EU accordingly” and,
• “While CBAMs can have an intuitive appeal, they are not straightforward. Furthermore, the fundamental driver of carbon leakage is international trading partners moving at different speeds on emissions mitigation and carbon pricing. This means that the starting point is to work with other countries to agree and implement ambitious emissions mitigation goals.”

Unpinning this is the fact that CBAMs are largely untested. California offers some insight from a similar system in place for electricity, where electricity importers are liable for the emissions associated with electricity generated by states outside of California. Critics of CBAMs often highlight the uncertainty that exists around potential issues of WTO compliance, for example. While these may be possible to overcome, it remains a significant barrier in the near-term.

Advocates of CBAMs highlight that the challenges are associated with trade policy more broadly and could be overcome alongside the agreement of trade deals by forming ‘Carbon Clubs’. Indeed, the very notion that CBAMs could become a reality – and in the case of the EU, a serious likelihood one will be implemented in the near future – has seen nations step up their carbon policy game as a result (see Indonesia, for example).

Standards

At ESC, we have been proponents of using standards for a few years, specifically the idea of using minimum mandatory carbon standards on domestic and imported products or ‘border carbon standards’. The role of standards and their application at the border is not a new idea. We already have strict standards on imported food and product safety standards on things like cosmetics, electrical goods, toys, etc. Basically, if an imported product did not conform to the standards of low or zero carbon production we mandated, it would not be allowed in. The idea of standards on carbon is relatively new. Government are now specifically highlighting the use of product standards, for which the CCC categorise into three types:

• Carbon Disclosure – These are standards which most commonly set a methodology for Life Cycle Assessment (LCA). Compliance with these standards can be communicated in different ways, such as Environmental Product Declarations.
• Carbon Cap (a Minimum Standard on Carbon) – Following an agreed methodology, a carbon cap or limit can be set for a product.
• Non-Carbon Measures – These include a range of standards that do not explicitly govern carbon levels, but do have an impact on carbon emissions (e.g. Eco design standards focused on energy efficiency).

For application at the border, it is the ‘Carbon Cap’ type product standard which is of interest.

While standards do share some of the same challenges as CBAMs – the need for robust MRV data and ensuring they are WTO compliant – it is the political economy aspect which might be more appealing, especially in the near-term. As I laid in a recent Twitter thread standards can be developed through established processes by which nations are already working together. For the UK this starts with the BSI and feeding into the International Standards Organisation (ISO).

There is also growing consensus that supports this view of standards when compared to a CBAM. For example, a report last year by the Government’s own Board of Trade has also highlighted the benefits of standards as a route to addressing carbon leakage where a CBAM might fail.

Government themselves also recently consulted on the role that standards (and other demand-side policies such as procurement and labelling) could play to mitigate carbon leakage. Indeed, in their Developing the UK ETS consultation, Government suggests that “if government chooses to pursue a mandatory standards regime, and potential legal and trade barriers can be overcome, mandatory standards could be introduced in some sectors over the course of the mid to late 2020s.” This is certainly more bullish than their wording on CBAMs, “we will continue to monitor global policy developments on this.”

Where does this land us?

The road ahead remains bumpy for polices applied at the border. Developing a role for standards is becoming increasingly recognised as a viable option in the near-term, but the position of CBAMs remains less clear.

While the promised consultation later this year is welcome, the global carbon policy landscape is moving at pace and the UK risks being left playing catch up. Now is the time for Government to accelerate development of its policy options for preventing carbon leakage. In the run up to COP27, the UK should also build on the success of COP26 and leverage ongoing international negotiations. If a CBAM is an inevitability of international carbon policy, then the UK should be at the heart of it and be ready to implement alternative measures if necessary.

But let’s not forget there are wider, also important considerations:

• We must recognise that standards and CBAMs – much like a carbon tax or any individual carbon policy for that matter – are not a silver bullet and cannot solve the global climate emergency by itself.
• It also requires a carrot as large as the stick. Without support for developing nations, who are only just going through their fossil fuelled industrial revolutions, the divide between the global north and south will otherwise only continue to widen.

Finally, while well implemented standards or a CBAM may give us a reason to pat ourselves on the back for a job well done at home, we may still fail to meet 1.5C. Therefore, if we do go down the route of standards and/or CBAMs – and it remains a big ‘if’ – then we must consider the role and the impact they might have on the whole global system, as well as the effect on industrial sectors at home.