The economic case for Europe’s carbon border tax

OCTOBER has already brought a significant change to the global trading system: for the first time, a major trading power has placed an import tax on carbon. Since using the word “tax” (or “tariff”) would have been awkward, the European Union (EU) went with “Carbon Border Adjustment Mechanism” (CBAM). But a tax is what it is, and the economic rationale for it is straightforward.

The EU already levies an internal tax on carbon. Under the Emissions Trading System (ETS), power stations and large industrial installations pay for each tonne of carbon dioxide they emit. With emissions permits or “allowances” costing around 90 euros (S$130) per tonne, the ETS should create a powerful incentive for firms to emit less within the EU’s borders.

But the ETS does not stop Europeans from buying their carbon-intensive products from other countries – in particular, those that lack domestic carbon taxes. Such substitutions – known as carbon leakage – mean that the ETS alone is not well-equipped to bring about a significant reduction in global CO2 emissions. The CBAM is supposed to fix that, by requiring importers to pay – at ETS-allowance rates, adjusted to reflect carbon taxes paid in the country of origin – for the emissions embodied in the goods being imported.