On page 176 of Budget 2021, there is one small paragraph that could have far-reaching implications. There, the Government of Canada announced that it would soon begin consultations on a new carbon pricing measure, known as a “border carbon adjustment.”
At its simplest, a border carbon adjustment – or BCA – is a way of applying carbon pricing to international trade. Its key purpose is to “level the playing field” between businesses from countries that have carbon pricing and from countries that do not.
BCAs have been studied for many years, but until recently, few governments had seriously considered adopting them. Now, as countries look for additional tools to reduce greenhouse gas (GHG) emissions, there is more support for implementing BCAs. Canada is not alone in studying this policy. In the United States, President Joe Biden is said to be “particularly interested” in BCAs, while the European Union could implement its own BCA as soon as 2023.
Origin of the Idea
While carbon pricing is widely considered the most cost-effective policy for reducing GHG emissions, it creates new costs for emissions-intensive industries. This means that when a country imposes a higher carbon price than its neighbours, its industries could have a harder time competing with foreign businesses. These costs can even encourage “carbon leakage,” which occurs when local businesses relocate to places with weaker controls on emissions.
One way to reduce the risk of carbon leakage is to set worldwide carbon prices. The countries that signed the Paris Agreement in 2015 have agreed to do something similar by creating a global “carbon market.” However, they have been unable to agree on how this would work.
In the absence of a common solution, governments are studying other policies that will incentivize businesses to reduce emissions and will not encourage carbon leakage. They are also looking for policies that address concerns about the costs created by carbon pricing. BCAs are among these policies.
How Border Carbon Adjustments Work
BCAs apply an “adjustment” – either a fee, or a rebate – to traded goods, based on their estimated GHG emissions. The adjustment helps account for the difference between policies to reduce emissions around the world.
In this way, BCAs make it less appealing for businesses to relocate to countries with weaker controls on emissions, since a carbon price would be applied to their goods when exported to a country with BCAs.
BCAs can apply to imports, exports, or both. For example, if Canada applied a BCA to imports, the adjustment could reflect the difference between the carbon price in Canada and the carbon price in the country where the import was made.
If Canada applied a BCA to exports, the adjustment could reimburse the manufacturer for any carbon price that was charged on the good in Canada.
BCAs would likely apply to emissions-intensive industrial goods such as steel, aluminum, cement, and refined petroleum products.
A Canadian Border Carbon Adjustment?
Canada does not use BCAs. However, the federal government has adopted one of the main policy alternatives to a BCA, which is known as output-based allocation, or output-based pricing.
Canada’s federal carbon price has two elements: a fuel charge, paid by consumers; and an output-based pricing system (known as the OBPS) for heavy industry.
The OBPS requires specific industrial firms to pay a carbon price if they exceed an emissions benchmark. Firms that emit less than the benchmark earn credits that they can trade with other firms, or bank for future use. This system is less costly for businesses than a straightforward price on carbon, but it gives them less incentive to reduce their emissions.
If Canada adopted BCAs, they could complement the existing federal system, or even replace parts of it (Figure 1). Canada could also develop a BCA in collaboration with its trading partners.
Figure 1 – Current and possible carbon pricing systems in Canada
Source: Figure created by the Library of Parliament, 2021.
Designing Border Carbon Adjustments
Creating a BCA is no simple task. To price emissions, they must be measured – and it is difficult to measure emissions on traded goods, since manufacturing processes vary across the world, and many goods are made with inputs from different countries.
A BCA must also respect Canada’s international trade obligations. In general, these obligations prevent Canada from adopting policies that treat foreign goods less favourably than domestic goods.
If a BCA somehow did not meet these criteria, it might still qualify for an exception. International trade law contains several exceptions, including an exception that is relevant for environmental policy. To qualify for this exception, a BCA must be:
- “necessary to protect human, animal or plant life or health,” or relate to “the conservation of exhaustible natural resources;” and
- be pursued in good faith, not be arbitrary, and not be a “disguised restriction on international trade.”
When thinking about how to design a BCA, it could be useful to consider the following questions:
- What is the scope of the BCA? A BCA can apply to imports, exports, or both. It is necessary to decide which industries the BCA covers, and whether certain trading partners are exempted from the BCA.
- How does the BCA measure emissions? A BCA could measure the emissions associated with producing a good, or it could even measure the emissions created by extracting resources for the good. It would be important to account for the different emissions intensity of industries from different countries, and the differences between the best and worst performers in those industries.
- How does the BCA account for measures in other countries? A BCA should be adjusted based on the climate policies or carbon pricing of one’s trading partners. This would be fairer and might reduce the risk that countries retaliate against the country that adopts a BCA.
- How should the revenues from the BCA be used? Depending on the government’s goal, it could use revenues from a BCA in Canada or send the funds to the countries affected by the BCA.
Effects of Border Carbon Adjustments
BCAs would have different effects depending on how they are designed, but it is possible to draw some general conclusions about their impacts.
Research suggests that BCAs could be more effective at reducing carbon leakage than related policies, such as output-based pricing. BCAs might also help relieve some of the competitiveness problems caused by having higher carbon pricing than other countries.
However, evidence from one of the only real-world BCAs, in California, indicates that, to avoid carbon leakage, a BCA should discourage companies from exporting their most emissions-intensive goods to places that do not price carbon.
Researchers have sounded a further note of caution. They have pointed out that BCAs would likely be adopted by wealthier countries. This makes it more likely that BCAs would penalize more carbon-intensive goods from developing countries, undermining economic growth in those countries.
Policy makers could help address this problem by sending the revenues from BCAs to the countries that are most affected by the policy, or by investing the money in sustainable development abroad.
Governments around the world are increasingly committed to reducing their emissions. However, they are equally determined not to hand an advantage to competitors with weaker rules. BCAs are intended to address both challenges, which helps explain the unprecedented interest in this policy. While BCAs may not appear around the world in the immediate future, the rationale that inspired them is here to stay.
Angelo Katsoras, National Bank of Canada, Is a carbon border tax inevitable?, 22 March 2021.
European Parliament, Committee on the Environment, Public Health and Food Safety, Report: towards a WTO-compatible EU carbon border adjustment mechanism, A9-0019/2021, 15 February 2021.
Author: Ross Linden-Fraser, Library of Parliament