5 November 2023

The Rise of International Carbon Taxation

Introduction

Since 1988, scientists have been sounding the alarm on climate change and its potentially catastrophic consequences. Yet, international political efforts have largely failed to bend our emission trajectory. Multilateral agreements such as the UNFCCC, the Kyoto Protocol and the Paris Agreement were important steps forward, but mostly only created a rising awareness of a problem that was yet to be tackled.

 

New hope rose in July 2021, when the EU mandated the European Climate Law, making its 2050 net zero target and a 55% decrease by 2030 legally binding. In response, businesses also set their net zero targets. The only problem was that 2050 was still very far away.

 

There had to be a stronger incentive for the world to decarbonise, and since money is king, policy makers could only see one solution: a carbon tax. There remained one issue though: greenhouse gas emissions resulting from imports. If those were not included, businesses would simply outsource their emissions (carbon leakage).

 

To grasp the immense importance of this seemingly minor factor, this article dives into the intricate interplay of climate science, international politics, and economics over the past three decades in the context of climate action. It also elaborates on how the recently introduced Carbon Border Adjustment Mechanism (CBAM) has the potential to overshadow all prior international accords, including the European Climate Law.

Indeed, the CBAM’s unique design has the potential to catalyse global carbon pricing, which, as per climate scientists, stands out as the singular, most effective policy instrument to keep us below 2°C.

The CBAM really is our last but also strongest hope.

The Scientific efforts to Measure our Damage

Yet, using integrated assessment models to estimate the SCC presents numerous technical challenges such as, for instance, the difficulty of estimating the exponential nature of climate damages. Nevertheless, the biggest uncertainty simply remained the unpredictability of our future emission path. To answer this question, Swiss Re , a major reinsurance firm, has projected global damage estimates by 2050 in the following scenarios:

  • 18% SCC to GDP ratio with no mitigation actions (3.2°C increase) 
  • 14% SCC to GDP ratio with moderate mitigation actions (2.6°C increase) 
  • 11% SCC to GDP ratio with further mitigation actions (2°C increase) 
  • 4% SCC to GDP ratio if the Paris Agreement targets are achieved (below 2°C increase)

If a carbon tax is the solution, how high should we set it? Scientists came up with something called the Social Cost of Carbon (SCC) to help answer that. It is a way to put a price on the economic and environmental damage caused by each extra unit of greenhouse gas we release. Right now, there are mainly two ways to measure that: they either estimate how much it will cost to pull those emissions back out of the air, using natural methods or technology, or they sum and predict the damages from climate-related disasters.

 

The first approach derives its figure from the costs of solutions such as planting trees, transitioning from industrial to regenerative agriculture, or scaling up carbon-negative technologies like Direct Air Carbon Capture and Storage (DACCS) and Bioenergy with Carbon Capture and Storage (BECCS). Natural methods range in cost from 0.20 to 50 EUR/tCO2e, while technological solutions can run up to 600 EUR/tCO2e in the carbon credits market.

 

The second technique for computing the SCC employs integrated assessment models. These models predict the future repercussions of CO2 emissions, factoring in concerns like infrastructure damage, agricultural shortages, our escalating emissions and climate feedback loops. Recent research has broadened the scope of these models to weigh long-term impacts, resulting in a SCC estimate of $307 per ton of CO2, significantly surpassing current emission trading market prices.
Notably, this increased cost stems largely from damages arising from the Global South (Kikstra et al., 2021).

 

Robert S. Pindyck, an MIT professor, opted for a different approach. He favoured grounding SCC estimates in the insights of experts across diverse fields, as opposed to models that could be affected by subjective calibrations. His research revealed that the 2021 US and EU carbon pricing estimates were undercutting the expert consensus, which reached up to $300 per ton of CO2e. Intriguingly, these expert evaluations were often influenced by the possibility of an extreme damage scenario, seen by many as plausible. Once extreme outliers were excluded, the average estimate settled closer to $80. Notably, the experts’ fields also played a role: climate scientists generally offered higher valuations ($316) compared to economists ($174).  

In 2022, the world’s SCC to GDP ratio was 0.27%, and our emission trajectory… , and our emission trajectory currently envisages a 3°C temperature increase. This means that over the next 30 years the Social Cost of Carbon is likely to become about 70 times higher. Quite terrifying.



In essence, the SCC is a scientific effort to quantify the environmental and economic impact of our actions and should offer guidance for policymakers crafting carbon tax legislation and Emission Trading System rules. Because of the exponential nature of climate catastrophes, its figure must also incorporate the worst-case scenario, meaning a 300 EUR carbon tax is not only likely but necessary due to our current emission trajectory.

Climate Politics: 30 Years of Illusive Global Agreements

In 1896, a Swedish scientist, Svante Arrhenius, first theorised that burning coal in large quantities would emit enough CO2 to induce the globe to warm. It took us almost a century until in 1988, Dr. James Hansen, a NASA director, gave the first ever political call to action by testifying to the US Senate that, according to NASA simulations, not only climate change was real and underway, but also that it would be already large enough to cause major weather changes and that it was caused by humans with a 99% certainty.

The New York Times headline on Friday, June 24, 1988.

 

That same year the United Nations (UN) created the Intergovernmental Panel on Climate Change (IPCC). This initiative was composed of scientists from 195 countries, sought to collect all scientific papers on climate change and provide a singular and credible source of information to guide countries in their climate change strategies.

 

In 1992, the Rio Earth Summit led to the creation of the UNFCCC, the first international agreement which aimed to address global warming and receiving 166 signatures. With developed nations responsible for two thirds of global GHG emissions, the idea of climate justice emerged, expecting them to financially support developing nations. However, despite requiring annual emission reports, the UNFCCC had no legally binding reduction targets which meant no penalties for inaction.

 

The 1997 Kyoto Protocol emerged as the UNFCCC’s first revision, setting an ambitious goal of a 5% emissions reduction between 2008 and 2012 for developing countries only. Its impact, however, was limited. Key global emitters like the U.S. didn’t sign and developing countries, whose emissions grew fast were exempted. This resulted in the Protocol covering only 18% of worldwide emissions.

 

Yet, Kyoto brought innovative market tools: the International Emissions Trading (IET), incentivising the few signatories to create their own carbon pricing systems, and the Clean Development Mechanism (CDM) allowing developed nations to issue carbon credits from projects in developing countries. The Kyoto Protocol also marked the birth of Europe’s Emission Trading System (ETS) in 2006. Lamentably, the 2008 financial crisis shifted global attention, temporarily stalling climate initiatives.

 

Building upon the foundation set by the Kyoto Protocol, the 2016 Paris Agreement used a broader approach, focusing on keeping global temperature increases below 1.5°C to 2°C. What distinguished this Agreement was its all-inclusive nature, mandating countries, regardless of their development status, to commit to emissions reductions. Despite its rigorous legally binding financial and reporting commitments, the Agreement faced challenges in its execution, highlighted by the U.S. withdrawal in 2017.

 

Despite decades of scientific evidence and diplomatic efforts, international agreements were still at a dead end. Voluntary pledges sounded promising but didn’t guarantee much, while legally binding agreements would result in fewer signatories. As a consequence, the climate crisis remained an imminent challenge still requiring coherent action at the global level.

Europe’s Unilateral move: the worldwide first carbon tax and CBAM

In July 2021, the European Union announced the phase-out of the free allowances in its Emission Trading System as well as the Carbon Border Adjustment Mechanism (CBAM). While the first simply stands for a gradually increasing carbon price on its most polluting sectors, the CBAM plans to do the same for imports, thereby signalling that the EU would stop consuming energy derived from fossil fuels in a foreseeable future.

 

CBAM’s specific objective is to prevent carbon leakage, which occurs when developing countries outsource their emissions to nations where carbon taxes are lower. Carbon leakage would not only distort the EU greenhouse gas registry, by showing an illusory decrease in emissions, while in reality CO2 has just been relocated, but also increase total emissions due to switching to a more carbon intensive production facility.

 

The most important but hidden outcome of CBAM is that it indirectly stimulates developing countries to ramp up their carbon pricing mechanisms. In fact, according to the regulation, carbon taxes paid abroad are deductible. This implies that carbon-intensive commodity trading partners, like China, could lose potential tax revenues to Europe. This bold step sees the EU using its economic power to bypass unfruitful multilateral negotiations and drive real global climate action while proclaiming itself as a green ambassador.

 

The strategy has already had an impact: nations like Japan, the United Kingdom, and Canada are evaluating similar policies. Although the CBAM has elicited criticisms for potential risks of protectionism and trade tensions, the EU states that it has been designed to comply with the World Trade Organisation (WTO) rules. The move has been met with mixed feelings: for some, it represents an essential step towards a sustainable global economy, while others see potential dangers to international relations and diminished competitiveness of EU export products.

Conclusion

To conclude, the EU’s gradual carbon price and CBAM are the result of many failed multilateral efforts to agree on international climate policies and on the will of Europe to step up as a global climate leader. Countries involved in commodity trading are faced with a new type of financial risk jeopardising their competitiveness and forcing them to embark on a new decarbonisation journey.

 

CO2 has become a financial liability and raw material producers worldwide now have to look at decarbonisation not only as the only way to survive but as an opportunity to act fast and increase market share. It is worth remembering that the EU ETS’s price, to which CBAM allowances are also coupled, is driven by auctions, and it is quite likely that demand soon surpasses the supply of allowances, drastically increasing prices.

 

European import companies, not only face a severe financial risk but also the tasks of collecting and reporting all their supplier’s emission intensities: a stressful but essential task necessary to get the data transparency needed to strategically redesign their supply chains and eventually find cheaper trading partners.

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Nicolas Endress

Nicolas Endress

Founder of ClimEase