EU carbon border tax
In July 2021, the EU revealed its intention to implement a new tax on emissions for goods imported into the EU from outside. The Carbon Border Adjustment Mechanism is designed to address the problem of "carbon leakage" caused by emissions-intensive activities being shifted outside of the EU to avoid the costs associated with the EU's cap and trade scheme. As will be seen below, this is going to have a drastic impact on the economics of many sectors and disproportionately affect individual companies within those sectors.
Before we move onto the new import tax, let's take a look at the existing cap and trade scheme.
The EU Emissions Trading Scheme (ETS)
The EU Emissions Trading Scheme which is often referred to as the "cap and trade" scheme works by allocating permits to companies in the high-emitting sectors. Each permit enables the holder to emit 1 tonne of CO2-equivalent. At present there are roughly 1.57 billion permits in circulation but a key feature of the scheme is that the number of permits will be reduced linearly at a rate of 2.2% a year bringing the number down to zero by 2050.
The ETS has been successful in helping to reduce emissions within the EU borders but there is a recognition that this has led to companies shifting high-emitting activities to offshore locations (particularly Asia) where there is currently little-to-no price placed on emissions.
EU Carbon Border Adjustment Mechanism
To address the issue of carbon leakage, the EU has introduced a new mechanism to tax goods imported into the EU based on their "embedded emissions". The initial scope will include aluminium, iron & steel, fertilizer, cement and electricity. The scheme will become active in 2026 with a phasing in of disclosure requirements by 2023. In my view this scheme is going to have major economic ramifications for pretty much every company globally. The simple example below should illustrate why.
A worked example - Aluminium import/exports
The production of Aluminium works broadly as follows:
Bauxite is mined out of the ground and then refined into Alumina (Aluminium Oxide) before being smelted to created molten Aluminium.
Below is my cradle-to-grave emissions analysis for the production of 1 tonne of Aluminium:
As can be seen, the largest driver of emissions is the electricity used in the smelting process. On average, this generates about 5.6 tonnes of CO2 per tonne of aluminium but this number varies dramatically based on the type of electricity being used. As a result, a tonne of aluminium produced using hydroelectric power in Norway has a carbon footprint of about 4 tonnes whereas a tonne of aluminium produced using coal power in China and India has a footprint in the range of 16-20 tonnes.
At the time of writing, the price of a tonne of aluminium was roughly $2600. When it comes into effect in 2026, the EU import tax will be Euros 75 (or roughly $85) per tonne of emissions so the extra 16 tonnes of CO2 created during Asian production would lead to an extra charge of $1356 adding 52% to the price aluminium imported from Asia. That's a big increase.
One European metal producer's gain is another European car manufacturer's loss
US and European steel and aluminium producers have been complaining for some time that an over-abundance of cheap Chinese steel and aluminium has been driving them out of business. There is no question that above tariff would go a long way to helping those companies rebuild production particular in places like Scandinavia with their access to large amounts of clean power. In parallel it would incentivize the Asian producers to switch from coal-powered electricity sources to something lower carbon. In fact, there is already a lot of hydro power available in China but it is often inconveniently located far from the smelting operations.
Whereas the European metals producers might stand to gain from the EU import tax, European car manufacturers would stand to suffer. The average car contains roughly a tonne of steel and 200 kg of aluminium. These tariffs on cheaper foreign imports will naturally push up prices on these key input materials possibly knocking a point or two from the profit margins on each vehicle.
So as can be seen, the imposition of a carbon import tax on aluminium doesn't just create winners and loser in the aluminium sector, it also incentives nations to clean up their power grid as well as affecting the procurement choices and profit margins of manufacturers.
Does the scheme go far enough?
I'm a big fan of this EU carbon import tax since I think it is the policy tool we have been waiting for to align economic incentives with carbon-reducing activities but I have a couple of big questions. The first one is: Why wait until 2026? I realize that creating a new tax system is difficult but I already have access to pretty good estimates of the emissions for all the items in scope of the new scheme and there is already a tax system set up for collecting import duties. The second question is: Why have carbon taxes on imports of oil and gas been omitted?
But perhaps an even bigger question is for all the policymakers outside the EU: Why aren't you already making similar plans to implement your own ETS and carbon import tax schemes? When posed this question recently, a UK policymaker recently said something along the lines of "we are first going to work on getting commitments from other countries and if that doesn't work we might try imposing a carbon import tax". Because of the whack-a-mole nature of emissions, these international commitments are going to be highly ineffective unless they are backed up by a system of taxes and tariffs similar to those put forward by the EU.