European institutions are struggling to reform the failing EU Emission Trading System (ETS) – “the cornerstone of EU climate policy”. But all reforms will be inadequate, writes Emil Dimantchev, senior carbon market analyst at Thomson Reuters, unless we address the system’s key defect: the failure to impose equal rules on all producers, including those from outside the EU. According to Dimantchev, EU policymakers will never allow carbon prices to get “too high”, since they will always want to protect their domestic industries against unfair competition from abroad. The only way to solve this problem, he writes, is to create an international level playing field by imposing carbon taxes on imports.

The European carbon price is like Swiss cheese: there are quite a few holes in it. Emitters are supposed to purchase CO2 permits under the EU Emissions Trading System (ETS), but there are many exemptions. Most industrial manufacturers get most of the permits they need for free. Power producers in eight central and eastern European countries also receive free permits. And foreign manufactures who export to Europe – from Russian steel makers to Saudi Arabian oil sheikhs – are exempt altogether.

The rationale for free allocation is to keep Europe’s manufacturers from being outcompeted by rivals in other countries who do not have to pay a price on carbon. By preserving competitiveness, policymakers prevent what is called “carbon leakage” – the shifting of production to pollution havens, which would render EU climate policies ineffective.

But free allocation has wrecked the effectiveness and credibility of the EU ETS. The handout of allowances has distorted the economic incentive that the EU carbon price was meant to provide. For example, research by Climate Strategies has found that cement manufacturers in the EU have neglected investments that the carbon price should theoretically have incentivized because they received free allowances. Free allocation has another inherent flaw – it encourages companies to lobby regulators for as many free allowances as they can get. Such rent seeking has resulted in overallocation in the EU.

The only likely global climate policy regime that could be agreed on is a pledge and review system with limited binding force

A better alternative is for the EU to set a carbon tax on imported goods (also referred to as “border carbon adjustments” or BCAs). Taxing imports for their carbon emissions will preserve the competitiveness of European businesses. It will also improve EU climate policy in two main ways – it will remove the political constraints holding back the carbon price and it will put a carbon price on imports.

Ceiling of constraints

At this moment, European institutions are trying to reform the ETS so that it becomes an effective instrument of EU climate policy.  The European Parliament on 24 February voted to reform the market, by establishing a so-called Market Stability Reserve. This proposal has yet to be approved by Member States. The Commission has also launched a public consultation on a revision of the ETS rules for the period after 2020.

However, the proposed reform measures, along with continued free allocation, are unlikely to let the ETS work as intended. According to analysis from Thomson Reuters, the market stability reserve is expected to increase the carbon price from its current €7/tonne level to an average of €24/t in 2021-2030. The carbon price is thus unlikely to soon reach the 50 euro level that the International Energy Agency (IEA) says will encourage power producers to switch from coal to gas or the 30 euro level that companies say will incentivize them to reduce emissions. The price will also remain a far cry from the actual damage a ton of CO2 inflicts on the economy, estimated by PriceWaterhouseCoopers at 76 euros.

The key reason why the carbon price is unlikely to reach its potential is because policymakers will be unwilling to let it threaten domestic industry. As Member of the EU Parliament Bas Eickhout of the Green group said in a recent viEUws interview, the EU carbon price could realistically be only as high as €20 to €30 euros per tonne before it hits into a ceiling of political constraints. The recent political discussions over the market stability reserve are a case in point. Competitiveness fears weakened the Parliament’s position on the market stability reserve.  Worried about its industry, Poland has marshaled a group of eastern European member states which seeks to further weaken the reform of the carbon market.

The carbon price is thus unlikely – under current policy – to ever reach the levels that make it an effective instrument. As carbon pricing remains crippled by political constraints, second-best policy options will continue to be necessary to make up for the shortcomings of the EU ETS.

Emissions unchecked

The EU ETS does not put a carbon price on imported goods and most trading partners – with a few exceptions – do not put a price on carbon emissions. Yet the carbon embedded in the products Europe imports amounts to as much as one and a half billion tons of carbon dioxide. This is roughly a quarter of our annual European carbon footprint. A large portion of Europe’s climate impact therefore goes unchecked.

China may find the option attractive if it means they can export more of certain products to Europe at the expense of climate laggard nations such as Russia and Canada

Europe’s current answer to this issue is to engage other nations in international climate negotiations. The EU is afraid that talk of border adjustments will throw a wrench in the UN climate machinery. Jos Delbeke, Director-General of Climate Action at the European Commission, commented on BCAs early this year, implying they would endanger a global agreement in this year’s UN talks in Paris.

But today the only likely global climate policy regime that could be agreed on is a pledge and review system with limited binding force. Even the most ambitious possible outcome in Paris will fall far short of limiting global warming to 2C above pre-industrial levels. Border adjustments could fill some of this gap between the current policy ambition and the world’s commitment to mitigate climate change. They can ensure European imports reflect real carbon costs until trading partners implement their own climate policies.

Coalition of the willing

The EU has historically recognized the potential role of BCAs in its policy mix. In the 2008 EU ETS directive (article 10b), the European Council and Parliament required the Commission to consider measures targeted at importers as a way to stave off carbon leakage. However, Europe gave up on border adjustments around 2010 as it was afraid of aggravating trade partners.

Today such fears may be exaggerated. Multiple recent studies have shown that well designed BCAs can be compliant with the rules of the World Trade Organization and with the General Agreement on Trade and Tariffs (GATT) in particular. Article XX of GATT allows nations  to adopt policies that are inconsistent with GATT rules, but are necessary to protect human, animal, or plant life or health (paragraph (b)), or which relate to the conservation of exhaustible natural resources (paragraph (g)). The Montreal Protocol provides a precedent as it successfully implemented trade restrictions on ozone depleting substances, consequently preventing leakage and encouraging broad international participation.

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Still, legal or not, BCAs could prompt retaliation by other countries. And BCAs will likely fail if they lack credibility with other powerful nations. You have to look no further than the EU’s failed attempt to put a carbon price on international aviation in 2012, which faced retaliation threats from China, the U.S. and other trading partners.

However, there is an underrated opportunity for the EU to work with other nations on a multilateral agreement featuring BCAs. The recent bilateral agreement between the US and China to step up climate efforts opens the door for the EU to engage two of its top trading partners in a “coalition of the willing”. There is a high chance the U.S. will be receptive to border adjustments, which were a core part of the 2009 Waxman Markey bill – its latest attempt at national climate legislation. China and other developing nations taking some form of climate action may also find the option attractive if it means they can export more of certain products to European and American markets at the expense of climate laggard nations such as Russia and Canada.

The time is ripe for a public debate on the pros and cons of border adjustments. Putting border adjustments into practice will certainly not be easy. It will likely ensnare academics in complicated calculations of carbon footprints and entangle politicians in delicate discussions. But given the urgency of climate change, and the shortcomings of the current approach, Europe cannot afford to succumb to defeatism.

Editor’s Note

Emil Dimantchev (@EDimantchev) is a senior carbon market analyst at Thomson Reuters. The views expressed in this article are his own.