Mitigating carbon leakage – how the new carbon borders will change the game for high carbon exports

Ahead of the global climate summit in Glasgow the European Commission tabled far‑reaching and innovative carbon reforms aimed at meeting its goal of reducing EU emissions by 55 percent as early as 2030. A new carbon border adjustment mechanism and stronger targets together with greater sectoral coverage of the EU emissions trading scheme are at the centre of the reforms. Once passed, they could significantly impact both EU industry and are already setting a new precedent for global export markets.

Part of an even more comprehensive EU Green Deal, the reforms are the most substantial change to European carbon policy in over a decade. There are 13 specific reforms covering imports, tax, buildings, road transport, plastics, shipping, and aviation.

While the reforms are directed towards Europe, Australian industry and exporters will be focused on the carbon boarder adjustment mechanism or CBAM. The CBAM includes a requirement that certain covered goods imported to the EU will need to have carbon credits to account for the greenhouse gas emissions embodied in the goods. The mechanism will initially cover a limited set of imports of electricity, cement, fertiliser, aluminium, iron and steel. Ultimately, the purpose of the CBAM is to account for carbon leakage where goods produced in regions with strict emission policies are substituted with imports from a region with lower emission regulations. Consistent with this purpose, the introduction of the new policy coincides with the removal of free carbon credits for EU producers, the previous less‑focused policy to address leakage.

The direct impact of the new mechanism is not expected to be large for Australian industry. Exports of the five categories covered by the mechanism are valued less than $100 million per annum out of a total $12 billion of goods trade with the EU. Even with this set of imports, European manufacturers will broadly have their free carbon credits removed at the same time. This is unlikely to significantly impact Australia’s relative competitiveness – both imports and domestic goods will increasingly face a cost of carbon. Indeed, carbon efficient exporters of the covered goods, if they can demonstrate this, may improve their competitiveness relative to inefficient global competitors.

Importers to the EU will also face additional requirements for emission verification. For firms unable to independently verify embodied emissions, options to draw on country averages, or the EU’s own benchmarks based on low performing plants will be available.

But the border tariffs are not the only change and the overall package of carbon reforms may pose a greater indirect impact on all emission intensive exports to the EU, in addition to those covered by the CBAM. A combination of carrots and sticks, particularly a stronger and more evenly applied carbon price, is likely to make structural changes to European demand and promote the switch to low carbon fuels and materials more generally.

One potential barrier to the implementation of the CBAM is the possibility of challenge at the World Trade Organisation for breaching its rules. While the new border tariffs coincide with the removal of free permits for EU producers and are designed to impose broadly consistent domestic and international carbon requirements, the potential of a challenge still exists.

On a macro level, it is clear Europe is seeking to be a world leader in decarbonisation, both through direct action and norm-setting. This could easily establish a precedent for other countries to follow suit. Carbon leakage is often pointed to as a reason not to pursue higher ambition carbon policies. Currently over 70 percent of global GDP is covered by net zero or carbon neutrality pledges, including many of Australia’s key export markets in the Asia Pacific region.

If this EU package of policies can be implemented and prove effective, other countries could adopt similar or linked systems. The EU policy specifically includes deductions for carbon pricing implemented in export source countries, which may encourage other countries to adopt similar or linked systems. Indeed, last week China launched its national emissions trading scheme that introduces carbon pricing into our largest export market, initially covering electricity with a low starting price, building ambition over time with the intent to expand to other industries. And last week a Bill was introduced into the US Congress to establish a somewhat similar Border Carbon Adjustment to apply to certain imports like aluminium, cement, iron and steel.

These other efforts are not as developed as the reforms in the EU. Nevertheless, the combination of an integrated package in the EU with increased interest in carbon pricing and border adjustments in other key economies mark a notable change in the global climate debate.

While Australian firms may not initially be directly impacted by these announcements, the EU reform package, within this broader context of policy movement, adds to existing arguments to prepare for a new low-carbon world. The reforms will increasingly affect Asia-Pacific markets due to their close links with the EU.

Understanding your carbon footprint, your supply chain risks, and developing a robust decarbonisation strategy and pathway will be key to resilience and growth as broader carbon measures spread. Those who are on the front foot in the energy transition will be well placed as we look towards 2030 and beyond.

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