The Role of Trade Policy in Climate Mitigation: Carbon Border Adjustment Mechanism (CBAM)

In this paper, we explore the dual goals of CBAM – to level the playing field for the EU and to encourage decarbonization in countries with high CO2 emissions. To do so, we consider the effects of carbon taxes and carbon tariffs. Carbon tariffs are differentiated by exporting country and are based on carbon emitted per unit of output. We consider the following scenarios: all regions introduce a carbon tax of $75 per ton – this is the first best outcome when the policy objective is to reduce global carbon emissions. Countries also increase tax revenue collected so experience a “double dividend” and may choose to reduce other taxes. Next, we consider a carbon tax in developed countries and a carbon tariff against imports of commodities with high CO2 per unit of output – fertilizer, iron & steel, aluminum, cement, and electricity – from all countries without a carbon tax. Finally, we consider a carbon tax with different tax rates by country income levels, as suggested in a recent IMF report on carbon pricing. For the analysis, we use a comparative static multi-region, multi-sector computable general equilibrium (CGE) model. Data are from GTAP v10, 2014, aggregated to focus on major polluting regions such as India, China, and SACU, and sectors subject to a CBAM tariff: iron & steel, aluminum, cement, fertilizers, and electricity. We use GTAP’s satellite energy accounts data which record the CO2 emissions associated with each energy commodity and using agent. Production behavior includes incentives to substitute away from energy inputs as prices change. Preliminary results suggest carbon taxes are effective at reducing CO2 emissions and generating tax revenue. CBAM provides some assistance in reducing leakage in countries with a carbon tax. However, countries punished by CBAM tariffs can divert exports to other regions which do not impose CBAM tariffs, so the impact of CBAM on decarbonizing is limited.