Do We Trade Too Much or Do we Tax Carbon too Little?

The reduction in trade needed to achieve our climate ambitions would be out of reach.  Border Carbon Adjustment is the way to go, but leakages remain sizeable.
Number: 21
Year: 2023
Author(s): Lionel Fontagné

The reduction in trade needed to achieve our climate ambitions would be out of reach. Border Carbon Adjustment is the way to go, but leakages remain sizeable.

carbon leakaged


The sluggishness of world trade is causing increasing concern, but it might be that we trade too much. Too much in relation to the social optimum, as environmental externalities are disregarded.  

This is because trade induces two externalities on the climate. It increases CO2 emissions through the shipment of goods, and it contributes to global emissions insofar as it undermines some of the decarbonization efforts undertaken in an uncoordinated way at the international level.  

As market mechanisms do not price these two externalities that trade imposes to the planet, should one reduce trade, i.e. introduce trade barriers? Or should one put a global price on carbon?  

Ask any economist, and you'll get the obvious answer: carbon pricing is the most effective instrument. Ask again: how can this be achieved? The rationality of a Border Carbon Adjustment (BCA) lies in the perplexity of the economist you asked. Let's take a closer look. 

The issue of collective action 

Not all countries tax carbon. Quite the contrary, in fact. Currently, only 73 carbon pricing instruments in 39 national jurisdictions (and 33 subnational) are in operation, covering around 23% of global Greenhouse Gas (GHG) emissions according to the World Bank Carbon Pricing Dashboard. And only 5% of global emissions of GHG are covered by a carbon price equal to or higher than the price compatible with a temperature increase of below 2 Celsius degrees. 

Not pricing the externality of fossil fuel burning theoretically amounts to an export subsidy as argued by the Nobel laureate Joseph Stiglitz. As this subsidy is hardly actionable at the World Trade Organization (WTO), it is wiser to involve as many countries as possible in a cooperative approach. This is what the Paris Agreement is all about. Each country announces what it considers it can do, and the sum of the emissions reductions announced makes up the deal.  

The intrinsic flaw is that the agreement cannot be legally enforced, and the announced reductions are uncoordinated: the sum of the announced reductions does not correspond to what is needed, as pointed out by the Nobel Laureate William Nordhaus

Are we reverting to the option of throwing sand in the gears of international trade to mechanically reduce emissions? Certainly not.  

The reduction in trade needed to achieve our climate ambitions would be out of reach, as most of our emissions are domestic. We would also lose the benefits of trade, notably in terms of access to green technologies for all countries.  

Here comes the BCA. In simple terms, it's a matter of putting a price on imported carbon, equal to that which would have been paid, had the products not been imported, but produced in the domestic economy. Is this WTO compatible? It all depends on the details of implementation. Is it effective in reducing carbon leakages and restoring a level playing field? The answer is that the BCA is doing only part of the job.  

The Fit for 55 package

Depending on assumptions, a leakage rate above 50% for the Fit for 55 package is not out of reach

Two birds, one stone 

International trade contributes to global emissions insofar as it undermines directly or indirectly the uncoordinated decarbonization efforts. Directly, if the carbon content of products does not have the same price in different countries, which causes the shift of production to countries where this price is lower. Indirectly, if the effort to reduce the use of fossil fuels by certain large countries lowers the world price of these fuels and fosters consumption in countries not participating in the effort. A BCA cannot address such indirect leakage.  

But do we have evidence of sizeable leakages? Fontagné and Schubert recently surveyed the literature and concluded that looking for ex post evidence by comparing regulations and assessing their stringency is not an easy task.  

Cap-and-trade markets, where emission quotas are exchanged, may however offer a good case study as the price of auctions is observable. But here again, we run into difficulties: this price is only part of the cost incurred by firms (abatement costs must be considered as well), the cap on these markets was not very binding until recently leading to low prices, and businesses exposed to international competition were receiving free allowances precisely to prevent leakages. This being said, the average 25% leakage rate retrieved by Misch and Wigender relying on sector-country-specific data on policy-induced changes in energy prices is not negligible.  

More fundamentally, when the issue at stake is what would be the leakages of policies such as the Fit for 55 package adopted by the EU, ex post evidence is helpless, and one has to turn to ex ante simulations. Results obtained with simulated general equilibrium models are contrasted and depend very much on the assumptions made on the actual countries’ commitment to reduce emissions, on the presence of free allowances, and on the substitutability between domestic goods and foreign goods. Depending on assumptions, a leakage rate above 50% for the Fit for 55 package is not out of reach, as shown by Bellora and Fontagné.  

Who’s got the instruction manual? 

Having established the potential for leakages, the next question is whether a BCA can substantially reduce those and fix the competitiveness issue. 

Absent WTO compatibility concerns, a complete BCA would essentially be an import carbon tariff combined with an export subsidy, amounting to a tax on consumption, without the political cost of the latter.  

Alas, WTO compatibility makes the BCA less attractive. As underlined by Pauwelyn, the EU-ETS should be thought of as an internal EU regulation indirectly affecting products, and not as a tax (unlike, for example, VAT). It is therefore possible to apply an equivalent regulation to imports (i.e. the purchase of emission certificates by importers), in line with the WTO principle of National Treatment. However, if tax rebates on exports are allowed, abatements imposed by a regulation would probably not be. 

Also, a BCA does not solve the problem of competitiveness of industries using carbon-intensive products as intermediate inputs and facing an increase in the cost of these inputs. That's why industry representatives are so vocal about the European BCA. 

Another issue is about the incentivization of non-participating countries. A BCA aims to encourage exporter countries to also price carbon to avoid compensation. But it will only if the imposing coalition is large enough to make export diversion more difficult. 

This question of the coalition's perimeter raises the final, thorniest issue. While the US and the EU share a common goal of decarbonization, they use different tools to achieve it. Should the EU consider the implicit price of emissions reduction associated with the IRA, and thus credit US exporters for the effort already made in America? The European Commission rejects this option and considers certain provisions of the IRA to be protectionist, paving the way for difficult transatlantic negotiations. 

IEP@BU does not express opinions of its own. The opinions expressed in this publication are those of the authors. Any errors or omissions are the responsibility of the authors.

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