Experts Say Carbon Border Adjustment Will Be Complex, and Hard to Make Fair Without Domestic Tax

A proposal to use a carbon border adjustment tax as a pay-for in legislation Congress hopes to pass this fall faces many obstacles, both political and technical. Politically, it must get support from all 50 Democrats in the Senate, including Sen. Joe Manchin, whose home state of West Virginia exports about a third of its coal; in some recent years, coal was about half of all exports from the state.

While what is likely under consideration is a tax on imports of fossil fuels, steel, aluminum, iron and cement, anything that raises the price of these goods is unlikely to be good for the coal business.

Gilbert Metcalf, an economics professor at Tufts University who researches how to design carbon taxes, said, "The Democrats have to thread a very narrow needle -- Manchin’s desire for pay-fors against his desire to protect the coal industry. So I could imagine that something happens, but I doubt it will collect much revenue."

In order to set a taxation level for imports, the U.S. will have to estimate what carbon content its products have in these high-carbon-intensity industries. That's not easy at all, because the sources of electricity vary by state; state regulation of greenhouse gas emissions varies; and many of these goods have international supply chains. For instance, members of Congress talk about how U.S.-produced steel is cleaner than the steel made in Europe (see 2108110042). The U.S. uses many electric arc furnaces, which are more efficient than traditional steel mills, but those cleaner mills often use imported steel slabs from Brazil. Brazil imports coal from the U.S. to make those slabs, and then finishing the product in the U.S. is cleaner.

Billy Pizer, a senior fellow at the Resources for the Future think tank in Washington, said, "Would the companies that claim to be really clean in the United States be really excited when their imported steel slabs are suddenly paying a tariff? And it’s particularly tricky when there’s no obvious domestic price."

Canada is also planning a carbon border adjustment tax, and it, like the U.S., has regional differences in carbon regulation. It has said explicitly it wants to coordinate with the EU and the U.S. in writing its legislation.

Economists believe that a national carbon tax is the most effective way to reduce greenhouse gas emissions and spur technical innovation that could make reducing those emissions less painful. The European Union is working toward such a system, though it does give free allowances to some producers in high-carbon industries. The EU also is planning a carbon border adjustment tax, which would be likely to hit U.S. exports unless the U.S. and Europe negotiate to avoid that outcome. Metcalf said it's clear that U.S. industry's costs in energy-intensive industries is well below the EU's industries, since they have to pay to pollute.

"That the U.S. can make its own calculation on its shadow price on carbon is based in regulation, and every country will obviously have an incentive to make that number as big as possible," Metcalf said. "The question is: How do we reconcile differences if the EU challenges Canada’s calculations or vice versa?"

Pizer said, "I think there’s a threshold question you have to start with, which is: Does a group of countries like in Europe that have a carbon tax want to deal with interpreting the regulations" that the U.S. has, and estimating how that compares with Europe's cap-and-trade approach? "Or are they uniquely fixated on the carbon price?"

He said if we want to coordinate with Europe and Canada on a carbon border adjustment approach, that would open ourselves up to their scrutiny of how our climate regulation is working.

Unless the carbon border adjustment pay-for legislation explicitly excluded Canada and the EU, there is not enough time for that kind of coordination to happen before the large spending bill gets a vote. The House is aiming to vote on the "soft infrastructure" bill, as some call it, in about a month.

Pizer said the Coons-Peters bill, which proposes a carbon border adjustment tax without a domestic carbon tax is so vague that it's hard to imagine how you could estimate what it could collect. The bill is also silent on whether there would be some kind of rebate for regulatory costs to exporters. "How do you calculate the basis for an import fee?" He said you could perhaps observe the domestic emissions rates for the targeted industries, but that still leaves you with the problem that there is no observable price for those emissions. The Coons bill suggests that EPA and the Commerce Department would have a year to do analyses on what a fair tax would be. But if that's the case, how could the amount of revenue it would bring in be modeled in time for the vote, so that it could be a pay-for?

"In the Coons bill there was a lot that was left to further work," he said. But the legislation under consideration requires that spending not exceed a certain amount, which means that revenue measures and spending measures have to be able to be estimated. Pizer said he doesn't know how that fits with the process. "How much can you say we’re going to have an analysis by EPA of what the carbon is of those products, and that is TBD? It would be different if we’re just going to say we’re going to tax steel at 3%."

To make the import tax fair, it needs to reflect the costs to domestic manufacturers of containing carbon emissions. Metcalf said, "How do you decide what is the cost of that [domestic] regulation? And what is it doing to the cost structure of that industry? We want to get both of those aspects correct."

He took the example of building aircraft, which is one of the top 10 goods exports for the U.S. Some aircraft are assembled in Washington state, where no-emission hydropower provides about two-thirds of electricity. Others are assembled in South Carolina, where no-emission nuclear power provides about half of the electricity. Airbus has a plant in Alabama, which has dirtier electricity. Aircraft engines are made in Connecticut, which is in a greenhouse gas reduction compact; in Ohio, where half of electricity comes from natural gas; and in Indiana, where coal makes up more than half of the electricity supply.

"The EPA could determine sort of an average shadow carbon price based on some sort of weighted average of the production costs," Metcalf said. He said it would be way too complicated to have a different price for each industry cluster state. "If you're a low-cost firm, then does the Coons bill allow for a rebate," he said. "That simply creates an incentive for the U.S. firms to create the documentation to prove they have lower emissions." He said carbon accounting is already taking place in firms, so he's not so worried about that. "I think this is going to end up being a jobs bill for trade lawyers," he said.

Pizer said, "Certainly a lot of people have felt like the idea of broad-based border measures where we were having to track both the carbon content of our domestic production but also the carbon content of our imports could be a rather daunting task. Certainly, my own view is sympathetic to that. In particular when you don’t have a carbon tax."

Is the carbon border adjustment tax aimed at changing industries' behavior, or is it to raise money, the economists asked.

Norwegian University of Science and Technology Industrial Ecology Professor Edgar Hertwich said in an email interview that the point of a carbon border adjustment is to prevent trade distortions caused by one country having a tax on emissions, or a cap-and-trade system that costs producers money, and another not having those policies. "For the US, I think talking about CBA is premature, I do not see that carbon tax or emissions trading system is on the horizon," he said.

"Another objective is to incentivize production companies to increase efficiency and shift to clean energy sources, as well as to incentivize consumers to shift their consumption activities away from those that cause high pollution," he said, which would also work when carbon carries a cost in both domestic goods and imported goods.

He said that the U.S. proposal, which would expand beyond commodities to tax imports that are more than 50% of those commodities by weight, such as cars, is more effective than just taxing the commodities. He said his research "shows that those manufactured goods are much more important contributors to the total amount of emissions contained in traded products. The energy intensity of these products does not vary by large amounts. Of course if you want an accurate assessment to two digits you would need to conduct a life-cycle assessment of the specific production process taking technology differences into account. If you are interested in a one-significant-digit result (+- 10%), you can employ assessments of proxies. Hence, you would just devise a tariff schedule, that has a specific tax rate for specific products. You can give importers the chance to provide their own, certified assessments that show they have in fact lower emissions, e.g. having a more efficient technology or low-carbon energy source for important production processes, and then you even create an incentive both to improve and to provide data."

The U.S. exports large quantities of fossil fuels to Europe, which would probably be taxed under the EU's carbon border adjustment, but Hertwich said that shouldn't hurt sales. "The tariffs will be small in the beginning and constitute costs that EU domestic producers also have, so it is not so much to worry about," he said.

Yale economics professor William Nordhaus, who won the Nobel Prize for his study of carbon and trade, said in an email interview that both the U.S. and the EU proposals will be ineffective. "These are unlikely to accomplish much except making countries angry," he wrote. "Aside from technical details, these should be part of an international agreement, not national fiats."

Metcalf said he believes the real reason for imposing a carbon border adjustment tax is to convince voters that you're doing something to protect local industry from foreign competitors. "It’s not going to change behavior very much. It’s going to be incredibly complicated to put anything into place to do anything effective," he said. But he said it's possible -- if not terribly likely -- that if a carbon border adjustment tax is passed in the U.S., the administrative burden of estimating how all the regulation translates into a carbon price will be so onerous that policymakers will decide that they need to establish a domestic carbon tax.