Last October, the European Union began implementing the transition phase of the Carbon Border Adjustment Mechanism, or CBAM. This policy will eventually impose a fee on the carbon content of imported goods, with the objective of ensuring that energy-intensive manufactured goods consumed in the European Union face the same carbon price regardless of where in the world they are produced. This reflects the growing salience and concerns about how international trade could undermine the environmental outcomes and political support for domestic climate policy.

Over the past three decades, the carbon content of international trade has shifted quite considerably. In 1990, U.S. exports had greater embedded carbon emissions than U.S. imports. By 2020, this had reversed and U.S. imports’ emissions exceeded exports’ emissions equal to about 10 percent of aggregate U.S. emissions. Likewise, the EU’s net trade position shifts emissions equal to about 20 percent of aggregate EU-wide emissions to other countries. In contrast, China’s emissions would be lower if it did not manufacture energy-intensive goods for export to developed countries.

Since 2005, the European Union has employed the Emissions Trading System, a cap-and-trade program covering a vast array of EU sources, including energy-intensive manufacturing plants. Over 2023, EU ETS allowance prices ranged between €80-100 per ton carbon dioxide, while manufacturing facilities in China and the United States (outside of California) bear a zero carbon price. This large carbon price differential poses competitiveness risk: energy-intensive manufacturing may relocate to zero carbon price jurisdictions, where they can produce at lower cost and then export finished goods back into the high carbon-price jurisdictions.

Through the design of the ETS, the EU has managed competitiveness risks through free allocation of emission allowances to energy-intensive firms. The EU establishes an industry-specific benchmark emissions intensity based on a set of the top-performing firms in each industry. Each manufacturing company covered by the ETS then receives free allowances as a function of this benchmark and the firm’s output. This approach does not completely eliminate the carbon price differential between EU-based manufacturing facilities, especially those with higher emissions per unit of output, and those located in their major trade partners. Moreover, free allowance allocations forego raising revenue that could enable targeted support of low-income households, clean energy innovation programs, etc.

The CBAM is intended as a substitute for the free allocation of allowances. The EU is implementing this program in two stages. In the initial implementation stage, the EU began a reporting-only requirement. This will highlight for firms and for governments of major trade partners what the potential border adjustments could be as a result of the emission intensity of goods and quantity of trade. The EU starting point for estimating emissions intensity for most goods will be default measures based on the country of origin.

A firm will have the opportunity to document lower emissions intensity of the goods it exports to the EU. If these data are verified by the EU as lower than their default value, then that firm pays a lower carbon adjustment, but the EU adjusts up the emission intensity for all other firms from that country. This creates a positive incentive for the next leanest firm to publicize its emissions data, since this would effectively lower its CBAM bill. And so on.

By designing a carbon adjustment on imported goods, the EU has prompted an array of policy responses. For example, Turkey sends nearly half of its exports to the European Union. After the EU announced its CBAM plans in 2021, the Turkish government proceeded to ratify the 2015 Paris Agreement and began deliberations over a domestic climate change policy intended to reduce if not eliminate the border adjustment on their exports to the EU. In November, the Turkish energy minister announced its plans to design and implement a domestic emissions trading system.

The United States launched a negotiation with the EU that focused on the two regions’ relatively low emission intensity in manufacturing—an implicit contrast with higher emissions intensity in Chinese manufacturing— instead of the large differences in carbon prices between these jurisdictions. Several Republican and Democratic senators have proposed a U.S. CBAM. One U.S. proposal would impose a carbon price on domestic and imported energy-intensive goods, while a second would only apply to the carbon embedded in imports.

These initial responses by trade partners illustrate how the EU’s CBAM has leveraged trade and economic incentives in an effort to spur greater emission mitigation among trade partners and address domestic political concerns about high carbon prices.