Rather than the feared depression in trade flows, the EU’s Carbon Border Adjustment Mechanism (CBAM) looks set to become a powerful climate diplomacy tool that will encourage Asian economies to clean up their industries, a new simulation finds.

With the launch of its first phase less than three months away, the EU’s Carbon Border Adjustment Mechanism is now a reality. It will gradually evolve (starting with only 2.5% of CBAM emissions being priced) to fully price all imported emissions for the covered sectors by 2034. 

Alongside the heated opposition from large polluting European industries, grievances from other parts of the world often give the impression that this new climate tool will shift global trade flows in a way that is not only unprecedented but also undesirable. 

The data that is emerging on the actual expected fees, price increases, and impact on non-EU producers tells a very different story.

Virtuous cycle

For now, the main real-world effect of the CBAM looks set to be a virtuous one. The mechanism is spurring countries all over the world to announce the creation of new carbon pricing mechanisms or the strengthening of existing ones. 

The economic effects on the EU’s main trading partners will be minimal, while the consequences in terms of the uptake of climate policies seem to be positively disruptive. For example, the top five steel exporters to the EU (India, South Korea, Turkey, China, and the United Kingdom) have all announced upcoming mandatory carbon pricing schemes or already have a carbon market.

The EU Emissions Trading System was initially set up for only a handful of sectors (power and some heavy industries), all pollution permits were given away for free, and the use of vast quantities of international carbon offset credits was permitted. 

Freebie substitute

Even though the EU ETS was initially plagued with an oversupply of emission allowances and an insignificantly low carbon price, over the course of two decades, it has been reviewed, refined and strengthened. It is now a broader, more effective, albeit far from optimal, climate tool that enables emissions reductions due to a more meaningful carbon price signal. 

However, heavy industry in the EU still benefits from free ETS allowances, which has resulted in a lack of decarbonisation in the steel, cement and chemical sectors. The EU CBAM was set up as an alternative to providing free pollution subsidies to European industries and to level the playing field between EU producers subject to a carbon price and importers that are not. 

Climate diplomacy

With new emissions trading schemes taking off around the world, the CBAM is solidifying its strength as a climate diplomacy tool, rather than a protectionist measure. And in the EU, multinationals with heavy emissions will finally start paying for their carbon dioxide pollution.

While the use of free allocations and of (international) offsets in most of these new systems is still too broad to allow for a price high enough to drive investments in decarbonisation, important markets, such as the Chinese and Korean emission trading schemes, are already introducing measures to strengthen the carbon price and plans to adopt full pricing. International pressure must increase: ETSs are a key instrument among others to effectively reach the targets set out in national climate plans.

What’s in it for East Asia?

New modelling by Sandbag suggests that the three largest East Asian economies, China, Japan and South Korea, all feature prominently as countries that will pay among the highest EU CBAM fees. In a full pricing scenario (from 2034 onwards), a little over €1 billion of CBAM revenue will be generated annually from imported Chinese products (for a sense of proportion, this is just 0.43% of the value China’s traded goods with the EU), €503 million from South Korean products (1.74% of the value of their traded goods), €285 million from Japanese products (0.96% of the value of their traded goods).

These three countries have already established forms of carbon pricing. Even though they differ significantly from the EU ETS (and from each other), over the coming years, these systems have the potential to be improved and strengthened at a much faster pace than the two decades it took the EU ETS to mature. Several pathways of convergence and co-learning are already picking up: from the establishment of the European Commission’s dedicated Task Force for international carbon pricing and markets diplomacy, to a recent proposal from Brazil ahead of COP to create a carbon market coalition including China and the EU.

Changing revenue flows

Despite its low carbon prices, the South Korean system is, in terms of architecture, arguably the most similar to the EU ETS. Around 80% of emissions are priced across the power, industry, transport, buildings, and waste sectors, covering both direct and indirect emissions from electricity consumption. 

Even though the current price averages around $7.30 per tonne of emissions, and a very low auctioning level (around 3% across specific subsectors), the carbon price on the K-ETS is likely to rise over the coming years, which would reduce the fees that Korean products subject to the CBAM will need to pay. 

With a carbon price of around €20 per tonne (around $23), the carbon fees due annually would, according to the Sandbag model, fall from €503 to €377 million per year. Considering the likely increase in the prices of goods in the EU market, this could mean a mere €7 million annually of net costs.

In China, the Chinese national ETS now also covers industrial installations, and recently established an absolute cap on emissions instead of the existing carbon intensity-based system. The system fully relies on free allocations, with plans to move to auctioning (but no clear timeline to do so). Introduction of auctioning, and again an actual carbon price paid of around $23 a tonne, would reduce the gross CBAM fees paid from a little over a billion euros to around €760 million per year.

Japan, where the voluntary GX-ETS is expected to evolve into a mandatory system, covering over 700 companies (emitting over 100,000 tonnes/ of CO2 per year) and more than 50% of national emissions. The mandatory ETS will add to the existing carbon tax on fossil fuels (natural gas, oil, and coal). With the current EU CBAM primarily focusing on direct emissions, this existing pricing is not captured. However, the inclusion of indirect emissions (which will be discussed in 2026) could change the game.

The real cost of change

It’s important to point out that, when talking about price increases, the estimate is based on modelling assumptions that don’t take into consideration how the decarbonisation of certain products could be accelerated to reflect global climate and trade concerns: some Chinese producers have already been able to provide greener steel at a price lower than previously forecasted.

Moreover, cost increases would not be significant for the final consumer: a recent study estimated that with a carbon price of around €60 per tonne, the increase would be around €85 for an average-sized car. With new cars costing around €20-25,000 in the EU, an €85 increase seems insignificant and unlikely to change purchasing behaviour. In the same study, the expected increase in total costs for an offshore windfarm is projected at 0.65% of the initial costs.

Decarbonisation begins at home

Rather than considering the EU CBAM a mere “tariff” on products, it is more helpful and productive to focus on its capacity to encourage other countries to introduce and further develop their own domestic carbon pricing systems, from emission trading systems to carbon taxes. This would allow economies that are actively decarbonising to effectively reap the benefits of taxing their own (big) polluters.  In addition, it will help raise more revenue that can be reinvested into energy savings, renewable energy, decarbonisation projects, as well as just transition schemes for SMEs and households.

The CBAM is adding momentum to an existing trajectory for countries adopting new carbon pricing systems: there are now 80 direct carbon pricing instruments operating worldwide, covering around 28% of global GHG emissions. 

However, the CBAM can be considered neither a silver bullet nor a hangman’s noose for EU industry once the ETS free allocation system is phased out, because its economic impact is minor. The CBAM is first and foremost a climate measure that steps up the ambition on CO2 reduction, acknowledging that the EU is not only a large historic polluter, but also increasingly an importer of emissions. 

In doing so, it doesn’t significantly impact larger economies: their economy is not reliant on their exports to the EU, and the relatively small CBAM fees are unlikely to significantly shift existing trade flows. 

The assessment is slightly different for developing countries, especially for the EU’s neighbours: their dependence on exports to the EU could translate into a challenging transformation of their economy once the mechanism fully kicks in. The gradual implementation of the CBAM will allow us to re-discuss, in due course, how to minimise the adverse effects for countries that are proportionally more reliant on exports to the EU, such as Ukraine, Moldova, or Uzbekistan.