Europe Just Launched the World’s First Carbon Tariff. Will the United States Follow Suit?

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Diagram from Learn Economics UK . Full explanation below main article

In the U.S., where climate policy has been highly politicized, the concept of a carbon tariff has recently emerged with rare bipartisan support.

By Kristoffer Tigue
Shipping containers behind a fence at the Southampton docks in the UK. Credit: Matt Cardy/Getty Images
Carbon-based tariffs used to be easy to dismiss out of fear they would upend the delicate balances of trade, but that’s changing, say trade and climate policy experts. Credit: Matt Cardy/Getty Images

Companies that want to do business in the European Union will soon have to pay extra if the carbon footprints of their products are too high.

The EU on Sunday officially began phase one of its carbon tariff.

The EU on Sunday officially began phase one of its carbon tariff. The first-of-its-kind tax scheme could help reduce the climate-warming emissions of industries that are notoriously hard to decarbonize, including cement and steel manufacturing.

Under the EU’s new policy, foreign companies must now report all the greenhouse gas emissions associated with certain imported goods: cement, steel, iron, aluminum, fertilizers, hydrogen fuel and electricity. Starting in 2026, any of those imports that don’t meet the bloc’s emissions standards will face an additional fee when crossing the border. Other goods will be considered for the tax in the coming years, the European Commission said.

foreign companies must now report all the greenhouse gas emissions associated with certain imported goods: cement, steel, iron, aluminum, fertilizers, hydrogen fuel and electricity

The tax policy has drawn criticism from countries like China and Russia, which argue it undermines the principles of free trade and worsens geopolitical tensions. Supporters say the program is necessary to put EU companies on an even playing field with nations that have lower environmental standards. They also say it will incentivize industries to more quickly reduce their carbon emissions and encourage other countries to follow suit by adopting their own carbon tariffs.

The EU’s carbon tariff “is not about trade protection,” Paolo Gentiloni, the European economy commissioner, told Reuters. “It is about protecting the EU’s climate ambition and seeking to raise the level of climate ambition worldwide.”

By law, the EU must reduce its emissions 55 percent below 1990 levels by 2030.

The way a carbon tariff works is relatively simple. A company in China, for example, might sell relatively cheap cement, but with a high carbon footprint because the product is made in factories that run on electricity from coal-fired power plants. That puts EU cement makers, which are required to have lower emissions, at a cost disadvantage.

The EU company has had to invest extra money to switch to cleaner energy sources, buy carbon offsets and install more energy efficient equipment—meaning that, for now at least, it must sell its cement at a higher price. A carbon tariff essentially reduces the price differences between the domestic products and the more carbon-intensive foreign imports, incentivizing companies sending goods to the EU to reduce their emissions to avoid the additional fee.

Climate activists have long called on nations to adopt carbon tariffs, saying they’re a crucial tool in the fight to curb global warming. If enough nations adopt similar tax schemes, they say, even the companies and governments most resistant to calls for climate action could be forced to play ball.

In the United States, where climate policy has been highly politicized, the concept of a carbon tariff has recently emerged as a rare opportunity for bipartisan support.

While Republicans have generally opposed any new domestic taxes, some have now jumped on board with the idea of taxing the carbon emissions of foreign imports, seeing it as a way to give the U.S. a leg up on rivals like China.

Earlier this year, U.S. Sen. Bill Cassidy, a Republican from Louisiana, introduced a bill in Congress proposing a carbon tariff. Called the “Foreign Pollution Fee,” Cassidy said the legislation “would curtail China‘s ability to undercut U.S. manufacturers by penalizing China for not meeting the same reasonable environmental standards to which domestic manufacturers are held” and “level the playing field for American workers, making it less likely that jobs migrate to China.”

bill in Congress … called the “Foreign Pollution Fee”

Democrats proposed a similar bill last year, called the “Clean Competition Act,” championed by U.S. Sen. Sheldon Whitehouse of Rhode Island. The Whitehouse bill, however, would also charge domestic companies a fee if their emissions exceeded the average for their industry, E&E News reported.

With the two parties still fighting over budget issues, including efforts by GOP lawmakers to cut climate related funding made available under the Inflation Reduction Act, it’s unclear how either of the carbon tariff proposals will shake out this year.

Still, there are signs that the idea is gaining support. In August, a group of bipartisan lawmakers introduced the “PROVE IT Act,” which would require the Department of Energy to study the carbon intensity of U.S. industries with the intention of informing a future carbon tariff.

“The United States manufactures and produces domestic goods and resources with some of the highest environmental standards in the world—far cleaner than many of our global competitors,” U.S. Sen. Lisa Murkowski, a Republican from Alaska, said in a statement announcing the bill. “I’m glad to join this commonsense legislation that will demonstrate to the world our environmental standards and promote the continuation of clean production.”

 

Explanation of graph from Learn Economics

Carbon taxes

Carbon taxes and carbon trading

A carbon tax is a tax on carbon emissions. The term ‘carbon’ is now generally used as a shorter alternative to ‘greenhouse gases’, with C02 making up around 65% of global greenhouse gases [1].

Carbon is generated as a result of economic activity from both production and consumption. Most carbon emissions arise directly from the generation of energy from fossil fuels (coal, gas, and oil). In terms of sources of carbon, energy use if the single largest source, at 75% – comprising energy used in industry at 24.5%, energy used in buildings at 17.5%, and energy for transport at 16.2%. Agriculture and land use makes up a further 18.4% of emissions. [2].

Carbon taxes and carbon permits [3] are two methods which try to put a price on carbon emissions, and reduce the market failure [iii] arising from unregulated carbon emissions. Both carbon taxes and carbon permits use market mechanisms to help establish a price for carbon.

Classifying carbon taxes

There are several ways to classify carbon taxes depending at which stage in the supply-chain the tax is levied.

Upstream taxation puts a tax on the primary source of the carbon emission, including the industries that extract and process fossil fuels, such as oil, gas and coal producers. The tax is then passed downstream towards final users [1],  eventually resulting in increases in the downstream prices of goods (and services).

The effect of a carbon tax - costs are increased, pushing up prices.

In theory, a carbon tax could be imposed at any point in the supply chain of a particular good (or service). However, those responsible for designing carbon tax systems prefer the tax to be imposed as far upstream as possible as there are fewer ‘entities’ involved [5]. The initial tax is then passed down through the supply chain, finally arriving at the end-user – hence there are fewer administration costs for the tax authorities.

How do carbon taxes work?

Like all indirect taxes, a carbon tax is imposed on producers, rather than consumers, although the incidence of tax may fall more on consumers than producers – this depends on the price elasticity of demand for the goods or services on which the tax is levied.

The rate of tax should, in theory, equate to the external cost of carbon to society. Most countries that have a carbon tax set a rate per metric ton of CO2 produced.

A carbon tax is, in effect, an additional production cost. How much costs increase depends partly on whether the tax is a percentage tax – known as an ‘ad valorem’ tax – or a specific amount.

Globally, carbon taxes are typically set at a fixed amount per metric ton produced, with annual increases to take into account each country’s target for reduced emissions. For example, Norway’s current €60 per ton tax is set to rise to €200 by 2030. [6]Graphically, the effect of a tax is to shift the supply (cost) curve vertically upwards.

The incidence of a carbon tax

The incidence of a carbon tax (or, indeed, any indirect tax) refers to ‘who’ pays the tax. In the above case, the incidence is split relatively evenly between the producer of the taxable output – in this case, the steel producer – and the consumer or user of the output – in this case, the downstream firms, such as motor vehicle producers. Motor manufacturers will, in turn, pass this on to the next stage – fleet car companies, or private car purchasers. Of course, governments can add additional taxes down the supply chain, such as introducing an additional carbon charge on new vehicles, or on petrol (gasoline) or diesel.

More countries introduce carbon pricing

As can be seen below, since 2005 carbon pricing has increased so that by 2021 nearly 25% of all carbon emissions were covered by some form of carbon pricing initiative. The single biggest impact on this growth was the introduction of China’s national Emissions Trading System in 2021. Of course, critics would point to the 75% of global emissions that remain untouched by carbon pricing.

Chart to show which countries use carbon trading systems.

The global carbon tax map

The map below shows which countries currently use a carbon tax. This does not include countries who participate in an Emissions Trade System (ETS). It should also be noted that not all countries refer to these taxes as carbon taxes. For example, in the UK the relevant tax is called the Climate Change Levy.

A global map to show carbon tax take-up.
Go to the World Bank dashboard.

Advantages and disadvantages of using carbon taxes

Advantages

Carbon taxes provide a number of benefits, including:

  1. Helping achieve the socially desirable and sustainable quantity of carbon emissions.

  2. Taxes are widely ‘understood‘ and accepted as a means of altering behaviour.

  3. Carbon taxes are relatively cheap to collect, with a small administrative cost.

  4. Global take-up is increasing.

  5. Carbon taxes generate tax revenue.

  6. Rates can be increased each year to help governments meet their carbon reduction targets.

  7. Rates can be adjusted for different energy sources – different rates for gas, oil and coal.

  8. Jobs cab be created in the emerging ‘carbon economy‘.

  9. Taxes exploit the market mechanism to ‘internalise the externality‘ – despite their failures, market forces are a powerful and efficient means of allocating resources and changing behaviour.

Disadvantages

Carbon taxes also have several disadvantages, including:

  1. While carbon taxes will affect the price of carbon they do not set a cap on emissions – unlike ‘cap-and-trade’ systems.

  2. Setting tax rates is subject to information failure.

  3. There may be unintended consequences, such as ‘carbon leakage’ where producers outsource production to territories which are not part of any carbon scheme.

  4. Reductions in carbon may not be guaranteed as consumers/users continue to undertake carbon emitting activities, and are willing to pay the tax [there is no cap on emissions].

  5. Indirect taxes tend to be regressive, with the heaviest burden on the poor (or poorest nations).

Sources and endnotes

[1] United States Environmental Protection Agency, 2019, viewed April 5, 2020, https://www.epa.gov/ghgemissions/sources-greenhouse-gas-emissions

[2] Options and Considerations for a Federal Carbon Tax, February 2013, Center for Climate and Energy Solutions, Viewed May 8th 2021, https://www.c2es.org/site/assets/uploads/2013/02/options-considerations-federal-carbon-tax.pdf

[3] Our World in Data, 2016, https://ourworldindata.org/emissions-by-sector, viewed May 1 2021

[4] UN Climate Change Report, viewed May 6th,2021, https://unfccc.int/kyoto_protocol

[5] Options and Considerations for a Federal Carbon Tax, February 2013, Center for Climate and Energy Solutions, Viewed May 8th 2021, https://www.c2es.org/site/assets/uploads/2013/02/options-considerations-federal-carbon-tax.pdf (p5).

[6] The Bellona Foundation – https://bellona.org/news/ccs/2021-02-norway-proposes-e200-per-ton-co2-tax-by-2030#:~:text=Norway%20was%20one%20of%20the,cubic%20metre%20natural%20gas%20emissions.

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