Carbon border adjustment 

Downing Street is running a consultation on its carbon border adjustment mechanism (CBAM), to be introduced in 2027. CBAM is designed to level the playing field for emissions costs between foreign and domestic goods, and follows the EU’s carbon mechanism introduced last year.

It is a key pillar of the UK and EU’s broader climate goals. Most Western policymakers believe these goals are best achieved through price incentives rather than bans, so they try to make it expensive to emit. This was traditionally done through taxes or levies.

Enter the EU Emissions Trading System (ETS). ETS works on a ‘cap-and-trade’ principle, whereby the regulator sets a limit on the total emissions, and companies can buy or sell the rights to emit within this limit. Businesses have to buy these ‘carbon credits’ on the open market, though some are given out for free by the EU (a giveaway that will eventually be phased out).

The UK officially broke away from the EU ETS in 2021, but quickly introduced a similar system. Both try to let the ‘invisible hand’ of the market allocate emission rights to companies that most need them, while giving policymakers the power to control overall emissions.

The problem – as so often with climate change initiatives – is that ETS only covers a small part of the world. This creates ‘carbon leakage’, whereby emissions from one part of the world are just replaced with emissions from somewhere with looser regulations.

Not only does this negate the overall climate benefits of the policy, but it also means foreign producers have an unfair price advantage. US companies, for example, are not currently subject to a national cap-and-trade policy, meaning their carbon-intensive production is cheaper than in the UK or Europe.

CBAM is supposed to tackle this problem. The EU says it will put a “fair price on the carbon emitted” by companies selling into Europe. Importers can buy CBAM certificates from national authorities – where the price of these certificates is set by carbon credit markets. Companies will have to declare the emissions that went into their imports, and hand over the corresponding number of certificates each year.

It comes into full effect in 2026, but the EU’s CBAM has been in a “transitional phase” since October. During this transition, importers have to report on the emissions that went into goods production, but don’t have to pay for certificates. Even these reporting requirements will only apply to a few select industries: cement, iron and steel, aluminium based fertilisers, electricity and hydrogen.

The EU calls it “a learning period for all stakeholders”. The UK government is fortunate that this learning period coincides with their own consultation on CBAM. Teething issues are likely to include how to make sure that reporting is accurate and avoids double counting, especially when regulation can differ greatly from source to sale.

A deeper issue is the policy’s sole focus on imports. This is a feature rather than a bug, but it means UK and European exports might be disadvantaged in global markets. It is currently more expensive for Europeans to emit than it is for Americans, making European exports less competitive in American markets. This will probably get worse if Donald Trump becomes president again, considering his promotion of emission-heavy industries.

Yet again, the problem is a lack of international cohesion. The CBAM will likely have a positive impact in terms of reducing emissions – as indeed the ETS seems to have already had – but coordination remains a barrier. For investors, this could mean another competitive disadvantage for Europeans. We will watch the transition closely.

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