## Introduction and Summary ## Source details **Canonical URL:** [Introduction and Summary](https://www.imf.org/-/media/files/publications/staff-climate-notes/2021/english/clnea2021004.pdf) ## Other formats - [Markdown version](/-/media/files/publications/staff-climate-notes/2021/english/clnea2021004.pdf.md) - [Structured JSON version](/-/media/files/publications/staff-climate-notes/2021/english/clnea2021004.pdf.json) --- ### Overview - Carbon pricing (carbon taxes or emissions trading systems, ETSs) is widely accepted as an economically efficient mitigation instrument, providing across-the-board incentives to reduce energy use and shift to cleaner fuels. - Containing global warming to below 2 degrees Celsius—the central goal of the 2015 Paris Agreement—will require phasing in measures equivalent to a global carbon price of around $75 per ton by 2030. - Although some schemes have carbon prices above $40 per ton, the global average carbon price is still only $3 per ton. - Slow progress in scaling carbon prices reflects strong political resistance to unilateral increases above trading-partner levels, driven by concerns about industrial competitiveness and carbon leakage (shift of carbon-intensive production abroad offsetting domestic emissions reductions). ### Abstract — Key findings and framing - This Climate Note examines the rationale, design, and impacts of border carbon adjustments (BCAs): charges on embodied carbon in imports potentially matched by rebates for embodied carbon in exports. - Large disparities in carbon pricing between countries raise competitiveness and leakage concerns; BCAs are a potentially effective instrument to address such concerns, but design details are critical. - Design choices include coverage, measurement of embodied carbon, treatment of exports, adjustments for mitigation abroad, use of revenues, and exemptions for low-income countries. - BCAs pose legal risks and may conflict with the Paris Agreement’s differentiated responsibilities; BCAs provide only modest incentives for other large emitters to scale carbon pricing—an international carbon price floor would be far more effective. - A pragmatically designed carbon price floor among large emitting countries would be the most effective way to scale up global mitigation, largely avoid competitiveness and leakage issues, and would benefit from collective acceptance and buy-in; such a coalition might itself adopt a BCA to avoid leakage in trade with nonparticipating countries. - A well-designed BCA could help interim competitiveness and leakage concerns for unilateral ambitious carbon pricers and could provide some incentives for trading partners to scale up their own carbon pricing, but careful design and upfront dialogue are essential to limit risks of retaliation or disputes. ### Rationale for Border Carbon Adjustments (BCAs) - Growing cross-country dispersion in carbon prices has prompted policymakers to consider BCAs; the European Union has proposed plans for a BCA to be gradually implemented starting from 2023. - A well-designed BCA could enable early mover countries to implement higher carbon prices than trading partners while: - Limiting losses in competitiveness, - Addressing carbon leakage, - Possibly incentivizing mitigation actions in other countries. - However, BCAs: - Are challenging because of legal uncertainties and potential conflict with differentiated responsibilities of developing countries under the Paris Agreement. - May be less effective than an international carbon price floor at incentivizing other large emitters to scale pricing. ### International competitiveness — mechanisms and evidence - Carbon pricing raises industrial production costs through: - Direct tax payment or allowance purchase requirement for direct emissions. - Abatement costs when firms switch to cleaner but costlier technologies and fuels. - Indirect payments for carbon charges on emissions embodied in inputs, especially electricity. - At modest abatement levels, direct tax payments are expected to be much higher than abatement costs; this is less likely at deeper levels of decarbonization. - Significant carbon price differentials across countries may distort production, consumption, and trade decisions, especially for energy-intensive, trade-exposed (EITE) industries. - Empirical literature mostly finds very small competitiveness impacts of carbon pricing relative to other factors, though limited scope of existing schemes may explain this finding. ### Carbon leakage — scope and limitations of BCAs - Carbon leakage: reductions in domestic emissions partially offset by higher emissions from increased production abroad. - Leakage is most relevant for EITE industries; domestic emissions from transportation, buildings, and power generation are generally less mobile. - Leakage can also occur via global fossil fuel price effects, but this channel is not addressed by BCAs (applies regardless of mitigation instrument). - The Paris Agreement may in principle address leakage if foreign countries strengthen mitigation to maintain their pledges, but in practice pledges are voluntary with no enforcement mechanism. - Empirical evidence on leakage: - Most empirical literature finds modest or no evidence of leakage; one recent study reports average carbon leakage of 25 percent (that is, increased emissions abroad are 25 percent of the domestic emissions reductions due to carbon pricing). - Leakage rates in that study vary: 20 to almost 50 percent in individual European countries, less than 15 percent in China, an EU14+UK aggregate, India, and Japan, and 7 percent in the United States. - The study’s period referenced for leakage measurement is the 2005–15 average. - Leakage via trade is the primary channel BCAs target; BCAs do not address leakage via global fossil fuel price effects. ### Design trade-offs and administration - Key design decisions affect environmental, legal, and administrative outcomes: - Limiting BCA coverage to energy-intensive, trade-exposed industries facilitates administration but does not comprehensively address leakage. - Using industry-level rather than firm-level measures of embodied carbon simplifies administration but may blunt precision. - Initially benchmarking BCAs on domestic emissions intensities can ease the transition for emissions-intensive trading partners. - Applying BCAs across countries with different mitigation approaches requires careful treatment. - Legal and administrative notes: - BCAs for indirect taxes are compatible with international trade law, but legal uncertainties remain over whether carbon pricing is an indirect tax and whether alternative approaches for assessing embodied carbon could violate nondiscrimination principles. - BCAs are more complex to administer than common existing instruments (for example, free allowance allocations), and could face legal challenges. - Measurement and benchmarking trade-offs: - Firm- or plant-specific measurement is least likely to raise WTO concerns but is administratively burdensome. - Country-specific benchmarks better target leakage and incentivize foreign mitigation but increase complexity. - Domestic or common benchmarks simplify administration and may aid political acceptability but risk over- or undertaxing imports and weakening incentives abroad. - Rebuttability provisions allowing exporters to demonstrate lower emissions can reduce legal risk and preserve incentives. ### Distributional and incidence considerations - The incidence of BCAs is expected to be partly passed forward to domestic consumers. - Depending on how embodied carbon is assessed, charges on emissions-intensive imports could be significant, potentially fueling trading partners’ concerns. - The trading partner’s level of development needs to be considered; BCAs imposing uniform carbon pricing across trading partners may be difficult to reconcile with differentiated responsibilities of developing countries. - Exempting least-developed countries (LDCs) can be justified on grounds of small economic size, very small contributions to historical CO2 emissions, and well-defined international status, but exemptions risk relocation and circumvention. ### International cooperation and policy implications - Global cooperation on practices for measuring embodied carbon, resolving legal uncertainties, and understanding administrative aspects of BCAs could enhance functioning and reduce contention. - Recent discussions about border measures on countries with laxer climate policies heighten the need for dialogue and cooperation to avoid trade tensions. - BCAs may need to adapt to countries pursuing regulatory approaches that are similarly ambitious to carbon pricing; measuring regulatory cost equivalents will be contentious. - While BCAs can be more efficient than free allowance allocations for addressing competitiveness and leakage, they carry higher complexity and legal risk. - A carbon price floor among large emitters remains the preferred route to scale global mitigation and limit competitiveness and leakage problems; a coalition could voluntarily adopt BCAs for trade with nonparticipants. ### Box highlights — EU, other initiatives, and product coverage - European Union: - The European Commission proposes a carbon border adjustment mechanism (CBAM) to be piloted during 2023–25 and phased in over a 10-year transition period during which ETS free allowances would be phased out (2026–35 transition period noted). - Importers would buy emissions certificates at the ETS price to cover embedded emissions; importers can deduct verified carbon prices already paid in production. - Proposed CBAM focuses on iron and steel, aluminum, electricity, cement, fertilizers, possibly other sectors. - Other countries: - Canada is exploring BCAs and discussing them with like-minded economies. - The US administration has indicated exploration of carbon border taxes as part of trade policy. - Product coverage: - Limiting initial coverage to EITE industry products is practical to focus on leakage rationale, reduce administrative burdens, and limit legal risks. - Broader coverage could better address leakage and competitiveness but faces severe near-term administrative challenges, especially for services and non-EITE goods. ### Box highlights — firm-specific BCAs, export rebates, and revenues - Firm- or plant-specific BCAs: - Advantages: clearer WTO legal status, better targeting of embodied carbon heterogeneity, stronger incentives for foreign exporters to decarbonize. - Challenges: large administrative complexity, frequent updating needs, gaming and circumvention risks, strong lobbying incentives. - Export rebates: - Recommended to be based on firm-wide emissions or industry/global good-practice benchmarks to avoid perverse export incentives. - Example: Export rebates would offset 25 and 60 percent of the revenues from import charges on EITE products in the United States and EU-27, respectively (inferred from Figure 5, before behavioral responses). - For BCAs imposed in China or India, revenue losses from export rebates would substantially outweigh revenues from import charges. - Revenue use and magnitude: - Earmarking revenues for domestic green investment, just transitions, or assistance for developing countries could reduce legal risks and enhance environmental credibility. - Revenue scale: A $50 per ton BCA on manufacturing imports would have raised revenues of 0.1–0.2 percent of GDP in China, India, EU-27, and the United States in 2015 (excluding potential revenue losses from export rebates). - Under a $50 per ton BCA imposed by the European Union, annual revenues formally collected on imports from China would be $4 billion or $1 billion under the country-specific and domestic benchmarks, respectively; these correspond to 0.03 and 0.007 percent of China’s GDP, respectively. - Net BCA revenues will be lower if export rebates are included. ### Alternatives to BCAs and comparative assessment - Alternative instruments include: - Exempting EITE industry emissions from carbon pricing, tradable emissions rate standards, free allowance allocations under ETSs, and output-based rebates. - Comparative conclusions: - Well-designed BCAs are a natural instrument for maintaining integrity of carbon pricing schemes and can be more effective than other instruments at addressing competitiveness and leakage, especially if BCAs vary across trading partners by embodied carbon and include export rebates. - Other instruments tend to reduce domestic producer costs and thus weaken domestic mitigation incentives; free allowances preserve incentives but forgo revenue. ### Legal context and WTO considerations - WTO rules aim for a transparent, nondiscriminatory global trade system; legal scholars suggest BCAs can, in principle, be designed compatible with WTO rules if National Treatment is respected. - Key legal uncertainties: - Whether carbon taxes and ETSs are indirect taxes eligible for border adjustment. - Whether taxes on inputs not physically incorporated into final products (like carbon) can be adjusted at the border. - Whether differing embodied-carbon measurement approaches violate nondiscrimination obligations. - Legal design elements to reduce risk: - Firm- or plant-specific externally verified methodologies are least likely to raise WTO concerns. - Rebuttability provisions for exporters can improve legal compatibility. - GATT Article XX exceptions (Articles XX(b) and XX(g)) could justify BCAs limited to EITE industries to reduce emissions leakage, subject to the Article XX chapeau that precludes disguised trade restrictions and arbitrary discrimination. - Differentiated responsibilities: - Paris Agreement principles raise questions on favorable treatment for developing countries; broad exemptions could undermine climate objectives, but distinctions for low-income or least developed countries may be justified where “the same conditions” do not prevail. - BCAs and tax treaties: - BCAs should be outside the scope of tax treaties because they are likely not income taxes or “substantially similar” taxes; parties would have no access to bilateral dispute mechanisms in existing tax treaties regarding BCAs. ### Implementation guidance and capacity-building - Recommended practical steps: - Invest in data and common standards for measuring embodied carbon, building on ISO and Greenhouse Gas Protocol standards. - Cooperate on clarifying trade rules to reduce legal uncertainty and provide guidance on border adjustments for indirect taxes or equivalent internal regulations. - Enhance customs cooperation and information-sharing to reduce circumvention and administrative burdens. - Engage in extensive prior discussions with trading partners to ensure fair, transparent, and inclusive implementation and limit risks of disputes or retaliation. ### Conclusions and policy implications - BCAs have appeal for preserving integrity of carbon pricing and addressing competitiveness and leakage as deeper industrial decarbonization proceeds, but design faces legal, administrative, and equity challenges. - Pragmatic early-stage design features: - Limit initial coverage to EITE industries; - Apply common emissions intensity benchmarks across countries to avoid disproportionate burdens on EMEs; - Allow relatively clean foreign firms to rebut industry-level benchmarks. - The scale of competitiveness and leakage effects in early stages of carbon pricing may not justify the complexity of BCAs; this assessment could change with deeper decarbonization. - A growing push for BCAs may highlight the superiority of international carbon price floors among large emitters to scale global mitigation more effectively; BCAs could nonetheless serve as interim measures or as part of coalition strategies. - Strong upfront dialogue, coordination, and clarification of trade rules are essential to limit legal risks, retaliation, and adverse impacts on climate cooperation. *IMF | Staff Climate Note — Introduction and Summary* ### Introduction and Summary ### Introduction and Summary ### Overview - Carbon pricing (carbon taxes or emissions trading systems, ETSs) is widely accepted as an economically efficient mitigation instrument, providing across-the-board incentives to reduce energy use and shift to cleaner fuels. - Containing global warming to below 2 degrees Celsius—the central goal of the 2015 Paris Agreement—will require phasing in measures equivalent to a global carbon price of around $75 per ton by 2030. - Although some schemes have carbon prices above $40 per ton, the global average carbon price is still only $3 per ton. - Slow progress in scaling carbon prices reflects strong political resistance to unilateral increases above trading-partner levels, driven by concerns about industrial competitiveness and carbon leakage (shift of carbon-intensive production abroad offsetting domestic emissions reductions). ### Abstract — Key findings and framing - This Climate Note examines the rationale, design, and impacts of border carbon adjustments (BCAs): charges on embodied carbon in imports potentially matched by rebates for embodied carbon in exports. - Large disparities in carbon pricing between countries raise competitiveness and leakage concerns; BCAs are a potentially effective instrument to address such concerns, but design details are critical. - Design choices include coverage, measurement of embodied carbon, treatment of exports, adjustments for mitigation abroad, use of revenues, and exemptions for low-income countries. - BCAs pose legal risks and may conflict with the Paris Agreement’s differentiated responsibilities; BCAs provide only modest incentives for other large emitters to scale carbon pricing—an international carbon price floor would be far more effective. - A pragmatically designed carbon price floor among large emitting countries would be the most effective way to scale up global mitigation, largely avoid competitiveness and leakage issues, and would benefit from collective acceptance and buy-in; such a coalition might itself adopt a BCA to avoid leakage in trade with nonparticipating countries. - A well-designed BCA could help interim competitiveness and leakage concerns for unilateral ambitious carbon pricers and could provide some incentives for trading partners to scale up their own carbon pricing, but careful design and upfront dialogue are essential to limit risks of retaliation or disputes. ### Rationale for Border Carbon Adjustments (BCAs) - Growing cross-country dispersion in carbon prices has prompted policymakers to consider BCAs; the European Union has proposed plans for a BCA to be gradually implemented starting from 2023. - A well-designed BCA could enable early mover countries to implement higher carbon prices than trading partners while: - Limiting losses in competitiveness, - Addressing carbon leakage, - Possibly incentivizing mitigation actions in other countries. - However, BCAs: - Are challenging because of legal uncertainties and potential conflict with differentiated responsibilities of developing countries under the Paris Agreement. - May be less effective than an international carbon price floor at incentivizing other large emitters to scale pricing. ### International competitiveness — mechanisms and evidence - Carbon pricing raises industrial production costs through: - Direct tax payment or allowance purchase requirement for direct emissions. - Abatement costs when firms switch to cleaner but costlier technologies and fuels. - Indirect payments for carbon charges on emissions embodied in inputs, especially electricity. - At modest abatement levels, direct tax payments are expected to be much higher than abatement costs; this is less likely at deeper levels of decarbonization. - Significant carbon price differentials across countries may distort production, consumption, and trade decisions, especially for energy-intensive, trade-exposed (EITE) industries. - Empirical literature mostly finds very small competitiveness impacts of carbon pricing relative to other factors, though limited scope of existing schemes may explain this finding. ### Carbon leakage — scope and limitations of BCAs - Carbon leakage: reductions in domestic emissions partially offset by higher emissions from increased production abroad. - Leakage is most relevant for EITE industries; domestic emissions from transportation, buildings, and power generation are generally less mobile. - Leakage can also occur via global fossil fuel price effects, but this channel is not addressed by BCAs (applies regardless of mitigation instrument). - The Paris Agreement may in principle address leakage if foreign countries strengthen mitigation to maintain their pledges, but in practice pledges are voluntary with no enforcement mechanism. ### Design trade-offs and administration - Key design decisions affect environmental, legal, and administrative outcomes: - Limiting BCA coverage to energy-intensive, trade-exposed industries facilitates administration but does not comprehensively address leakage. - Using industry-level rather than firm-level measures of embodied carbon simplifies administration but may blunt precision. - Initially benchmarking BCAs on domestic emissions intensities can ease the transition for emissions-intensive trading partners. - Applying BCAs across countries with different mitigation approaches requires careful treatment. - BCAs for indirect taxes are compatible with international trade law, but legal uncertainties remain over whether carbon pricing is an indirect tax and whether alternative approaches for assessing embodied carbon could violate nondiscrimination principles. - BCAs are more complex to administer than common existing instruments (for example, free allowance allocations), and could face legal challenges. ### Distributional and incidence considerations - The incidence of BCAs is expected to be partly passed forward to domestic consumers. - Depending on how embodied carbon is assessed, charges on emissions-intensive imports could be significant, potentially fueling trading partners’ concerns. - The trading partner’s level of development needs to be considered; BCAs imposing uniform carbon pricing across trading partners may be difficult to reconcile with differentiated responsibilities of developing countries. ### International cooperation and policy implications - Global cooperation on practices for measuring embodied carbon, resolving legal uncertainties, and understanding administrative aspects of BCAs could enhance functioning and reduce contention. - Recent discussions about border measures on countries with laxer climate policies heighten the need for dialogue and cooperation to avoid trade tensions. - BCAs may need to adapt to countries pursuing regulatory approaches that are similarly ambitious to carbon pricing; such countries may seek BCA-equivalent mechanisms, raising distinct legal issues. - While BCAs can be more efficient than free allowance allocations for addressing competitiveness and leakage, they carry higher complexity and legal risk. - A carbon price floor among large emitters remains the preferred route to scale global mitigation and limit competitiveness and leakage problems; a coalition could voluntarily adopt BCAs for trade with nonparticipants. *IMF | Staff Climate Note — Introduction and Summary* ### Box 1. Main Principles of the Paris Agreement in Relation to Border Carbon Adjustments ### Box 1. Main Principles of the Paris Agreement in Relation to Border Carbon Adjustments ### Paris Agreement goals, responsibilities, and obligations - 195 parties signed the 2015 Paris Agreement, which seeks to contain future global temperature increases to 1.5–2 degrees Celsius above preindustrial levels. - Parties submit voluntary climate strategies in Nationally Determined Contributions (NDCs), which are revised (preferably with greater ambition) every five years. - Ahead of COP26, many countries have made emissions neutrality pledges for mid-century (International Energy Agency 2020). - Current global pledges for 2030 fall well short of what is needed for consistency with warming targets. - Under the Paris Agreement, countries are responsible for domestic production emissions released within their own borders rather than consumption emissions (which would include embodied carbon in imports and exclude embodied carbon in domestic exports). - Developed countries collectively are required to mobilize $100 billion a year (through public and private sources) to help developing countries (Article 9). - The legally binding aspects of the Paris Agreement are largely procedural: the “ambition mechanism” requires contracting parties to assess collective progress on mitigation, adaptation, and support measures, and communicate new NDCs (Articles 4 and 14), and to report publicly and track progress through a transparent system. - There is no sanction system to ensure countries meet mitigation commitments; considerable cross-country dispersion exists in the emissions prices implicit in mitigation pledges. ### Emissions leakage and empirical evidence - Existing modeling literature shows little agreement on carbon leakage rates; most empirical literature finds modest or no evidence of leakage, though this may reflect limited scope of policies adopted so far and methodological limitations. - One recent study suggests higher leakage rates; on average in this study carbon leakage amounts to 25 percent (that is, increased emissions abroad are 25 percent of the domestic emissions reductions due to carbon pricing). - Leakage rates in that study vary: - 20 to almost 50 percent in individual European countries, - less than 15 percent in China, an EU14+UK aggregate, India, and Japan, - 7 percent in the United States. - Leakage rates are larger for small open economies, such as most individual EU countries. - The study’s period referenced for leakage measurement is the 2005–15 average. ### Potential for BCAs to promote mitigation abroad - BCAs might incentivize trading partners to adopt domestic carbon pricing to reduce charges on their exports; trading partner governments would effectively transfer tax revenue to themselves if they adopt pricing. - Foreign producers might choose less carbon-intensive methods to reduce export charges. - Broader coordination could follow unilateral BCAs, potentially creating border free trading zones with a common external tariff. - Financial incentives from BCAs alone may be small: - Carbon embodied in EITE exports from China and India to the European Union and United States are about 3 percent of China and India’s domestic carbon emissions, respectively (2015). - Embodied carbon in EITE exports to all trading partners from China and India is 10 and 8 percent of their domestic carbon emissions, respectively. - Embodied carbon in the EU-27 and US EITE industry exports to the world are 5 and 2 percent of domestic emissions, respectively. - Overall, these shares appear unlikely to be large enough to decisively impact decisions on domestic carbon pricing. ### Legal background and WTO considerations - WTO rules (including GATT) aim to ensure a transparent, rules-based, and nondiscriminatory global trade system that reduces trade barriers and avoids trade distortions and protectionism. - Legal scholars suggest BCAs can, in principle, be designed to be compatible with WTO rules; WTO rules should allow countries to apply import charges and export rebates not exceeding indirect domestic taxes on “like” domestic products or their inputs, provided National Treatment is respected. - Key legal uncertainties include: - Whether domestic carbon taxes and ETSs can be viewed as indirect taxes eligible for border adjustment. - Whether taxes on inputs not physically incorporated into final products (like carbon) can be adjusted at the border. - Whether alternative approaches to measuring embodied carbon across countries are consistent with nondiscrimination obligations. - Evidence and legal discussion indicate: - BCAs can be applied to carbon taxes imposed on products (domestic and imported) if objective methods are used to measure embodied carbon. - ETSs are more complex: they could be characterized as either indirect taxes or internal regulations; if viewed as regulations, equivalent regulatory border adjustments (for example, requiring purchase of allowances for embodied carbon) might be needed. - Benchmarking approaches and rebuttability: - Firm- or plant-specific externally verified emissions methodologies are least likely to raise WTO concerns. - Country-specific industry benchmarks are an objective alternative but may raise “like” treatment issues and require cross-border cooperation for data collection. - Rebuttability provisions allowing rebates for foreign exporters demonstrating lower emissions can improve legal compatibility. - Using a common industry benchmark (domestic industry benchmark or international average) can guarantee greater uniformity of treatment but may still expose below-average imported products to “like” product violations. - Export rebates and subsidies: - Exemptions for exports from indirect taxes borne by “like” products sold domestically, or rebates not exceeding amounts paid, are not deemed subsidies. - ETS rebates for exports are legally uncertain if ETSs are viewed as regulations rather than taxes. - GATT Article XX exceptions: - GATT Article XX provides exceptions for environmental and health purposes (Articles XX(b) and XX(g)) and could be invoked to justify BCAs designed to reduce emissions leakage, particularly if limited to EITE industries. - The Article XX chapeau precludes disguised trade restrictions and arbitrary or unjustifiable discrimination between countries where the “same conditions” prevail. - Differentiated responsibilities: - The Paris Agreement’s principles of equity and “common but differentiated responsibilities and respective capabilities” raise questions on whether and how BCAs should treat developing countries more favorably. - Broad exemptions irrespective of countries’ mitigation action could undermine the climate objective, but distinctions for low-income or least developed countries may be justified where “the same conditions” do not prevail. - BCAs should be outside the scope of tax treaties because they are likely not income taxes or “substantially similar” taxes; parties would have no access to bilateral dispute mechanisms in existing tax treaties regarding BCAs. ### Design and implementation considerations - Multiple objectives for BCA design include addressing competitiveness and leakage, promoting pricing elsewhere, preserving domestic mitigation incentives, raising revenue, and limiting administrative burdens and legal risks. - Important design features and their implications (as summarized in Table 1 of the source) include: - Domestic vs. country-specific benchmarks: - Domestic benchmarks preserve competitiveness for all trading partners and preserve competitiveness of exports; they may better preserve a level playing field. - Country-specific benchmarks address leakage more efficiently and provide stronger incentives for foreign producers and governments to reduce emissions, but are more complex and increase administrative burden. - Broader benchmarks increase incentives but the extra benefit may be modest and broader approaches may be very complex. - Rebuttability provisions are broadly relevant to reduce legal risk and preserve incentives. - Measuring embodied carbon: - Firm- or plant-specific measurement is least likely to raise WTO concerns; industry benchmarks are an objective alternative. - Verification and rebuttability provisions can reduce legal exposure. - Sectoral coverage: EITE industries versus broader coverage: - Limiting BCAs to EITE industries may enhance permissibility under GATT Article XX and better target leakage rationales; broader coverage may raise legal and administrative challenges and dilute leakage rationale. - Rebates for domestic exporters: - Rebates for indirect taxes on exports are generally permissible when not exceeding amounts paid; treatment may differ depending on whether the domestic system is a tax or an ETS. - Adjusting BCAs for carbon pricing abroad: - Adjustments to reflect carbon pricing policies abroad can be appropriate but must be designed to reinforce the central climate objective and avoid arbitrary discrimination. - Metric and administrative burdens: - Use of objective, transparent methods and external verification can limit legal risks and administrative burdens; country-specific approaches increase complexity and data burdens. - The source emphasizes coherent design choices that align with the climate objective (for example, addressing carbon leakage) and recommends extensive prior discussions with trading partners to ensure fair, transparent, and inclusive processes prior to implementation. *IMF | Staff Climate Note (Box 1).* ### Box 2. Current Initiatives for Border Carbon Adjustments ### Box 2. Current Initiatives for Border Carbon Adjustments ### The European Union - The European Commission has presented a series of options for a border carbon adjustment (BCA), which it calls a carbon border adjustment mechanism (CBAM), as part of a broader legislative package (including a review of the emission trading system (ETS)) for consideration by the European Parliament and European Council. - Under the preferred approach, the CBAM would be gradually phased in beginning with a pilot phase during 2023–25, and then a 10-year transition period (during which the ETS free allowances would be gradually phased out). - This effort originated in 2019 as part of the European Union’s “Green Deal”. - The European Commission has stressed: - the importance of compliance with WTO rules; - that any BCA will first and foremost be an environmental measure; - that revenues generated could be a source of “own resources” to help service debt relating to the NextGenerationEU. - The proposed CBAM focuses on sectors deemed most at risk of carbon leakage: iron and steel, aluminum, electricity, cement, fertilizers, possibly other sectors. - Operational details: - Importers would buy emissions certificates at the ETS price to cover the embedded emissions in products being imported into the European Union. - The scheme would run in parallel to the current ETS and be operationally equivalent to an import tariff, though the price would be linked to market conditions rather than set exogenously. - During the 2026–35 transition period, the free ETS allocations would be gradually phased out for the sectors included in the CBAM (the CBAM would be reduced proportionally to the amount of free allowances in a given sector). - Importers can deduct, based on verified information from third country producers, the amount of any carbon price that has already been paid during the production of the imported goods. ### Other Countries - Canada: - In its Fall Economic Statement, the Canadian government stated that it was exploring the potential of BCAs and intended to discuss with like-minded economies how they could fit with a strategy for meeting climate objectives while ensuring a fair environment for businesses. - United States: - The US administration’s view on a BCA is unclear, although it has recently announced that it would explore carbon border taxes as part of its trade policy agenda. - Prior to the election, the Biden campaign signaled support for imposing a BCA on imports from countries that are failing to meet their climate and environmental obligations. ### Product Coverage - Limiting the BCA to energy-intensive, trade-exposed (EITE) industry products may be the most practical, at least initially. - Rationale for a narrow focus: - Competitiveness and leakage concerns should generally be less severe for other sectors like services and non-EITE manufacturing given their relatively low carbon intensity, although this may not be the case for all sectors and industries. - Pricing schemes for agriculture have not yet emerged; as long as this persists this sector will remain beyond the scope of BCAs. - A narrow focus limits administrative burdens (for example, assessing embodied carbon is relatively straightforward for EITE industries many of which produce raw materials). - A narrow focus may limit legal risks because the environmental motivation based on leakage may be more transparent for EITE products than products with low embodied carbon. ### Measuring Embodied Carbon - Broader product coverage over the longer term could: - comprehensively address competitiveness and leakage; - possibly provide stronger incentives for carbon pricing elsewhere; - but near-term administrative challenges are severe. - Extending BCA coverage to include charges on imported non-EITE manufacturing, services, mining, and electricity, combined with corresponding export rebates, would: - address competitiveness and leakage issues for a broader range of sectors; - avoid incentives to shift imports of embodied carbon further along the value chain, to finished products. - Limitations and practical challenges: - Benefits of broad coverage may be small where carbon intensities are low. - Additional administrative and compliance burdens of collecting charges from multiple trading partners on a much broader range of sectors are significant. - There are considerable challenges to measuring embodied carbon (for example, for services and for non-EITE goods which are further down the value chain and use materials purchased from other firms perhaps in other countries). - Measurement choices and implications: - How carbon embodied in traded goods is measured for the purpose of calculating the BCA will influence a BCA’s effectiveness and burdens on trading partners, but choices depend on data availability, administrative burdens, and legal considerations. - In principle, to efficiently meet the potential for BCAs to address carbon leakage, data on embodied carbon would be calculated under an internationally agreed methodology on a product- and plant-specific basis, though in practice such systems add to administrative costs and data constraints would currently preclude their implementation. - In the meantime, using industry-level benchmarks may be a practical option. - Benchmarks only partially exploit the potential of a BCA: they may overtax imports from a foreign firm with below-average emissions intensity (overcorrecting for leakage) or undertax firms with above-average emissions intensity (allowing leakage). - On the export side, benchmarks may need adjustment to avoid excessive rebates to low-emitting firms. - Especially in the absence of rebuttability, benchmarks provide no incentives for foreign producers to cut their emission. *IMF | Staff Climate Note 10* ### Box 3. Border Carbon Adjustments Using Firm-Specific Data ### Box 3. Border Carbon Adjustments Using Firm-Specific Data ### Attractions of firm- or plant-level BCAs - Familiarity: Firm-specific BCAs closely resemble border adjustments to excise taxes and have a clear WTO legal status (example: border adjusting an excise tax on the alcohol content of liquor parallels, conceptually, border adjusting the carbon content of goods). - WTO consistency: Firm- or plant-level BCAs could reduce legal uncertainty by enabling determination of the amount of carbon that went into the specific production of particular products so all (domestic and imported) products can be taxed using the same methodology. - Addressing carbon leakage: Using firm-specific data would avoid undertaxing foreign producers with relatively higher emissions, better addressing carbon leakage given heterogeneity of production methods within many energy-intensive, trade-exposed industries. - Mitigation incentives abroad: Firm-specific BCAs would encourage individual foreign exporters to reduce emissions. ### Administrative and behavioral challenges of firm-specific BCAs - Scale of complexity: The number of potentially different product charges equals the number of foreign suppliers within a particular industry, aggregated over all trading partners and over all industries covered by the BCA. - Frequent updating: Charges would need regular updating as new data on embodied carbon becomes available. - Gaming and circumvention risks: - Firms could shift production from emissions-intensive plants to trading partners that do not apply BCAs or to domestic markets to reduce reported emissions. - Strong incentives for lobbying could arise as firms claim emissions are lower than official estimates. - Rebuttability: Better micro-level data could increase the effectiveness of the rebuttability provision. ### Benchmarking options: country-specific versus common benchmarks - Country-specific benchmarks (using emissions-intensity data specific to the exporting country): - Pros: Consumers and businesses would face the right set of relative prices across imported products with different carbon intensities; trading partners with higher embodied carbon face higher charges and stronger incentives to adopt their own pricing. - Data example: Embodied CO2 in basic metals is over 2,000 tons per $million output in China, India, and Russia and less than 1,000 tons in Canada, Germany, the United Kingdom, and the United States (Figure 4). - Administrative con: A different BCA rate must be calculated for each foreign exporter and applied by the customs agency. - Common benchmarks (domestic or global average emission intensities): - Cons: Less effective at achieving BCA objectives because they do not account for cross-country differences in emission intensities, risking over- or undertaxing imports and providing little incentive to foreign producers or governments to reduce emissions. - Pragmatic advantages: Simpler administration; may aid political acceptability; appropriate average benchmarks can be justified under WTO rules. - Proposed pragmatic approach: Use a domestic embodied carbon benchmark initially while the BCA is being established, with a view to transitioning to country-specific BCAs over time. ### Adjusting BCAs to reflect foreign mitigation efforts - Trade-offs: Adjusting import BCAs to reflect carbon pricing in the exporting country requires differentiating among trading partners and judging equivalence/adequacy of other countries’ carbon pricing systems; WTO legal risks are complex. - Non-adjustment view: Some proposals would not adjust for policies of the exporting country, noting exporting governments may use export rebates to offset the effect of their domestic carbon pricing policies on exported products; mutual export rebates eliminate incentives for BCAs to encourage carbon pricing in trading partners. - Regulatory approaches vs. carbon pricing: - Measuring carbon price equivalents or “shadow prices” for regulations is conceptually difficult and contentious (e.g., estimating shadow prices, assessing whether regulations are binding, gauging costs imposed on firms). - Cooperative, multilateral solutions would be critical to find agreement on “equivalence” between price and regulatory approaches and could reduce the need for BCAs. ### Export rebates - Rationale: Export rebates complement import BCAs to avoid encouraging reduced domestic output and increased production/emissions elsewhere. - Recommended basis: Export rebates should be based on firm-wide emissions, or industry-wide or “global good-practice” benchmarks to avoid incentives to use more emissions-intensive production methods for export. - Revenue offset example: Export rebates would offset 25 and 60 percent of the revenues from import charges on EITE products in the United States and EU-27, respectively (inferred from Figure 5 on current trade and emissions patterns, before behavioral responses). - Distributional effect: For BCAs imposed in China or India, revenue losses from export rebates would substantially outweigh revenues from import charges (reflecting larger share of industrial products in EME exports and higher emissions intensity). - WTO rules note: WTO rules should permit a full rebate of carbon taxes consisting of indirect taxes imposed on a product when that product is exported, but rebates for ETS allowance purchases may not be permissible. ### Revenue use and magnitude - Earmarking: Legal risks for BCAs might be reduced if revenues are earmarked for domestic green investment and just transitions or for financial and technological assistance for mitigation and adaptation in developing countries; earmarking could enhance credibility of BCAs as environmental measures when invoking WTO general exceptions. - Revenue scale: Revenue collections would generally be modest. - Example estimate: A $50 per ton BCA on manufacturing imports would have raised revenues of 0.1–0.2 percent of GDP in China, India, EU-27, and the United States in 2015 (excluding potential revenue losses from export rebates). - Specific country revenue illustration: - Under a $50 per ton BCA imposed by the European Union, annual revenues formally collected on imports from China would be $4 billion or $1 billion under the country-specific and domestic benchmarks, respectively. - These correspond to 0.03 and 0.007 percent of China’s GDP, respectively. - Incidence: The effective incidence of the BCA is expected to fall partly or mainly on domestic consumers because carbon pricing on both domestic production and imports can be passed on in higher domestic product prices. Degree of pass-through depends on many factors, including BCA design and measurement of embodied carbon. ### Exempting least-developed countries (LDCs) - Trade-off: Country exemptions can promote relocation and circumvention of the BCA, creating unintended administrative issues. - Rationale for exempting LDCs: Small economic size, well-defined international status (including in the WTO), and very small contributions to historical CO2 emissions argue for strong consideration of exemptions for imports from LDCs. ### Alternatives to BCAs and comparative assessment - Alternative instruments include: - Exempting all, or some, EITE industry emissions from carbon pricing (downstream) or rebating them for carbon prices implicit in fuel and electricity inputs (upstream). - Tradable emissions rate standards (firms can buy credits) in lieu of carbon pricing. - Granting free allowance allocations under an ETS (related to past emissions). - Recycling carbon pricing revenues from EITE industries in output-based rebates (proposed but not yet implemented). - Comparative performance (summary conclusions): - Well-designed BCAs are a natural instrument for maintaining integrity of carbon pricing schemes and can be more effective than other instruments at addressing competitiveness and leakage, especially if BCAs vary across trading partners by embodied carbon and include export rebates. - Other instruments mostly reduce costs on domestic producers and therefore diminish domestic price signals from carbon pricing; they often forgo revenue and reduce mitigation incentives for domestic EITE industries to varying degrees. - Full exemptions remove mitigation incentives for direct emissions; tradable emission rate standards and output-based rebates reduce emissions per unit of production but not necessarily production levels; free allowance allocations largely preserve mitigation incentives but forgo revenue-raising potential. ### Impact on trading partners and competitiveness assessments - Common concerns by trading partners: (1) their firms’ exports will be disadvantaged in BCA-adopting countries; (2) BCAs could appropriate government revenues at their expense. - Importance of dialogue: Engaging trading partners is important to limit risks of disputes or retaliation. - Competitiveness assessment principles: - Consider both the BCA and the underlying carbon pricing: the BCA addresses the trade distortion from disparities in carbon pricing. - Benchmark sensitivity: - Domestic-industry benchmark: BCA charges imports the same cost per unit of output that domestic firms pay; combination of carbon pricing and BCA should not put foreign firms at a competitive disadvantage. If domestic firms adopt cleaner and more expensive technology, foreign firms could gain a competitive advantage. - Foreign-industry benchmark: BCA could impose substantially higher charges on imports than domestic firms pay; puts foreign firms in same position as domestic firms but may be infeasible if cleaner technology is costly or unavailable. Developing countries may question consistency with “differentiated responsibilities” under the Paris Agreement. - Comparison with existing alternatives: Many existing alternatives operate by reducing domestic producers’ costs and are likely similar in effect to BCAs based on a domestic benchmark rather than on foreign emissions intensity. ### Cross-border revenue implications (examples and magnitudes) - Large differences exist between country-specific and domestic benchmarking methods, especially for countries with higher emissions intensity such as China and India. - Total revenues may not be large: - Example: Under a $50 per ton BCA imposed by the European Union, annual revenues collected on imports from China would be $4 billion (country-specific benchmark) or $1 billion (domestic benchmark), equal to 0.03 and 0.007 percent of China’s GDP, respectively. - Net BCA revenues will be lower if export rebates are included. ### Role of international coordination and capacity-building - Investing in data and data standards: - Most effective BCAs exploit data on carbon emissions embodied in traded goods. - Governments, industry groups, and other entities are collaborating to establish detailed sector-, firm-, or plant-specific data; advances in artificial intelligence and machine learning could improve data quality. - Joint efforts toward common international standards for measuring embodied carbon in traded products are needed, building on existing standards such as the International Organization for Standardization and the Greenhouse Gas Protocol. - Better data will aid empirical studies to identify the scale of competitiveness and leakage effects. - Clarifying trade rules: - Resolving key legal uncertainties surrounding BCAs in advance could reassure governments they can formulate WTO-consistent BCAs and avoid lengthy disputes. - A key step: clarify that an indirect tax on embodied carbon or equivalent internal regulations can be border-adjusted, with supporting guidance on alternative approaches for measuring embodied carbon. - Customs cooperation: - Cooperation among national customs administrations can help address circumvention and avoidance opportunities, elaborate practical application of BCAs, and establish data- and information-sharing mechanisms to minimize such opportunities. *Source: IMF staff climate note, Box 3: Border Carbon Adjustments Using Firm-Specific Data.* ### Conclusions ### Conclusions ### Appeal and design challenges of Border Carbon Adjustments (BCAs) - BCAs have appeal over other instruments for maintaining the integrity of carbon pricing systems and addressing competitiveness and leakage as countries move to deeper industrial decarbonization. - BCA design is hampered by: - uncertainties over the compatibility of alternative options with trade law; - greater administrative burdens associated with more effective designs; - possible inconsistencies with differentiated responsibilities from common pricing of embodied carbon in products from different countries. - There is a risk of disputes or retaliation that could impact climate and trade policies. - The motivation and design of a BCA in legislation should be based on environmental (rather than protectionist, revenue-raising, or punitive tariff) considerations. - Strong upfront dialogue and coordination are needed between countries moving ahead with BCAs and others, in particular EMEs. ### Pragmatic design features for early stages - A pragmatic case can be made for some early-stage design features: - limiting the initial coverage to EITE industries; - applying common emissions intensity benchmarks across countries (to avoid disproportionate burdens on EMEs); - allowing relatively clean foreign firms to rebut industry-level benchmarks. - The scale of competitiveness and leakage effects in the early stages of carbon pricing may not be large enough to warrant the administrative, political, and legal complexities of a BCA; this assessment may change over time with deeper decarbonization. - Experience with BCAs should help to clarify methodological and policy uncertainties. ### Interaction with regulatory approaches and trade law - BCAs may need to adapt to countries pursuing regulatory approaches that are similarly ambitious to carbon pricing. - Clarification of applicable trade rules is needed to justify BCAs reflecting regulatory costs. - A recent US proposal suggests a BCA on imports to reflect the cost to domestic producers complying with emissions regulations; measurement of these costs will be contentious, notably due to the absence of a counterfactual for what production and costs would have been in the absence of regulation. - Trade law issues: - The ability to border adjust regulatory measures can be more limited under WTO rules. - Applying import charges that are not equivalent to the regulatory measure would likely need to be justified under the general exceptions in GATT Article XX. - Export rebates may not be permissible at all. ### Pressure for BCAs and the case for international coordination - Pressure for BCAs will likely rise as some regions and countries adopt more aggressive carbon pricing. - This pressure may ultimately focus attention on international carbon price floors, which would be far more effective at scaling up global mitigation. - If enough large-emitting countries adopt BCAs, this might increase interest in formal coordination mechanisms like price floors covering all emissions (rather than the small portion of emissions in trade flows), which may ultimately hold the key to effective and efficient mitigation of climate change. - BCAs might still be retained to provide some incentive for participation in comprehensive price floors, though this would complicate negotiation over price floors. ### Institutional and procedural note - An interpretation of any of the multilateral trade agreements can be adopted by a majority of three-quarters of WTO members according to Article IX and X of the Marrakesh Agreement, but in practice there has never been any instance where any decision has been adopted without consensus. *IMF | Staff Climate Note 2021/004 — Conclusions* --- _Source: https://www.imf.org/-/media/files/publications/staff-climate-notes/2021/english/clnea2021004.pdf_