Person:

Sandler, Ely

Article 6 of the Paris Agreement, finalized at COP26 in 2021, was meant as a key tool for financing the energy transition. Through Article 6, emissions reductions in one country count for the climate targets of another. Developed countries receive credit for emission reductions they finance outside their borders, allowing these states to reach ambitious targets they would otherwise miss. Creating avenues for developed states to achieve cost-effective net emissions reductions, wherever in the world, is especially important in light of growing fears around energy security and affordability. On the other side of Article 6, developing nations host infrastructure projects and receive low-cost funding. As access to capital becomes more constrained globally, Article 6 offers a win-win: lowered net emissions for developed states alongside new capital for sustainable development in emerging markets.

This white paper offers a policy proposal for how border carbon adjustments can increase global climate finance, with a focus on the EU Carbon Border Adjustment Mechanism (CBAM). This proposal is designed to offer a “carrot” to developing countries in the form of new funding for decarbonization, to complement the “stick” of carbon pricing introduced by CBAM. By offering a practical way forward for the CBAM to increase finance for clean energy and other carbon mitigation projects in developing countries, we hope to catalyze large volumes of new investment in the Global South, and also to re-energize support for the CBAM as a vital measure in the energy transition.

At its core, CBAM is designed to preserve the level playing field of European firms subject to the EU ETS by imposing an equivalent carbon price on foreign imports. At the same time, CBAM also has core environmental goals, aiming to encourage more countries around the world to adopt carbon pricing measures, and therefore to incentivize decarbonization.

While the positive impacts of CBAM have already begun, with several countries announcing domestic carbon pricing schemes in response to the policy, the EU has also faced significant backlash from its trading partners. Specifically, CBAM has been criticized for disproportionately affecting low- and middle-income countries, which often depend on carbon-intensive exports and may lack the financial resources to decarbonize in response to CBAM. In addition, the lack of domestic carbon pricing systems in most developing nations has left them unable to safeguard CBAM revenues through their own effective carbon price (ECPs), which firms can deduct from their CBAM dues. Critics therefore argue that CBAM risks exacerbating global inequalities, conflicting with principles such as Common but Differentiated Responsibilities.

To address these criticisms, this paper proposes expanding CBAM’s definition of an effective carbon price to account for investment in decarbonization. We suggest this could be enacted by recognizing the retirement of certified “carbon tax assets” representing emissions reductions from carbon mitigation projects such as clean energy. These “carbon tax assets” could be used by firms to match “carbon tax liabilities” arising from CBAM. Exporters to the EU could therefore reduce their CBAM bills by purchasing carbon tax assets, generating investment for decarbonization projects in the Global South.

It is crucial to note that our proposal preserves CBAM’s core objective of maintaining a competitive level playing field by denominating carbon asset deductions in monetary terms, rather than directly offsetting tons of carbon emissions. By linking CBAM deductions to the price paid for carbon assets, exporters face equivalent economic pressures to reduce emissions, avoiding risks of carbon leakage and perverse incentives towards low-quality assets. In other words, unlike previous links between carbon assets and carbon tax liabilities, for example the use of Clean Development Mechanism (CDM) credits in the EU ETS, our proposal does not simply allow a ton to offset a ton, but rather recognizes that the price paid for an offset can be considered a tax, and thus deducted as an ECP.

Mechanically, our proposal operates through two channels to support developing countries burdened by CBAM. First, the “external channel”, where exporters in developed nations purchase carbon assets from developing countries to pay their CBAM liabilities. This might be, for instance, a Japanese steel company exporting to the EU investing in a clean energy project in Mozambique. In this way, the external channel creates a new flow of external carbon finance from Global North to Global South by generating demand for carbon assets.

Second, we propose an “internal channel,” where developing nations can use our flexible definition of an ECP to retain carbon revenues and encourage green investment at home. This would allow domestic firms to offset CBAM obligations through investments in local decarbonization initiatives, for example a steel producer in Azerbaijan funding clean manufacturing and deducting its investment from its CBAM dues.

This proposal comes at a critical time both for border carbon adjustments and for climate finance. At the international level, the recent agreement on Article 6.4 methodologies at COP29 could provide a starting point to define robust eligibility standards for carbon assets. At the same time, the inclusion of border carbon adjustments as part of the COP29 agenda for the first time, within a Presidency’s Consultation to report by COP30, offers a multilateral forum to discuss how this proposal might be enacted.

For the EU, while the Article 6 methodologies establish a foundational framework for international carbon markets, there is the opportunity to “gold-plate” international standards with additional criteria on which carbon assets would count as an ECP. This gold-plating could include metrics such as additionality, permanence, transparency, social impact, and governance. This could enhance carbon market integrity and reinforce the EU’s leadership in global climate governance.

To operationalize our proposal, this white paper contains an appraisal of the next steps that will be necessary from both the EU and its trading partners. For the EU, these include issuing delegated or implementing acts under the CBAM regulation to explicitly recognize carbon mitigation assets as ECPs. As we discuss, it is also possible to directly amend the CBAM regulation via changes to Articles 2 and 9. Simultaneously, EU trading partners will need to enact national legislation governing the use of carbon assets, ensuring alignment with EU criteria. This could involve establishing registries for carbon asset certification and leveraging international standards like those defined at COP29.

Border carbon adjustments, starting with the EU CBAM, represent a huge opportunity for the energy transition, creating incentives for decarbonization and revenue for governments. But for these policies to reach their potential, equity concerns amongst developing country exporters must be addressed. Our hope is to link two great challenges for the energy transition – the need for carbon pricing and the need for climate finance – letting one create a solution for the other. Allowing carbon assets to match carbon liabilities could turn CBAM into both a carrot and a stick. This aims to present a practical and just way forward.