What Is a Carbon Tariff and Why Is the EU Imposing One?

Pierre Coster, Julian di Giovanni, and Isabelle Mejean

The European Union has been an early adopter of carbon policies, with the introduction of the EU Emissions Trading System (ETS) in 2005. This scheme sets a common price for carbon and is applied to the most polluting manufacturing sectors. By increasing the cost of emissions-intensive production, the system incentivizes firms to decrease their use of fossil fuels. However, as we show in a companion post, the policy’s impact was moderated by firms increasing their reliance on high-emissions imports. To eliminate this workaround, the EU will expand the ETS to imports in 2026, through the Carbon Border Adjustment Mechanism (CBAM). The CBAM will essentially put a tariff on imported goods based on their carbon content. Our recent work provides a quantitative analysis of how the ETS and CBAM affect firms’ supply choice decisions, and the resulting changes in domestic prices and emissions.

A Quantitative Framework

Our companion post showed that French firms adapted to the ETS by increasing their imports of ETS-regulated products from outside the EU. Here, we highlight findings from a model that allows firms to choose between unregulated and regulated inputs, based on the relative costs of these inputs. The distinction between unregulated and regulated inputs makes it possible to mimic the two ETS policy regimes: (1) a carbon tax on all inputs produced by regulated sectors in ETS member states, and (2) the ETS + CBAM system, in which the same inputs imported from outside the EU are also taxed. These simulations thus allow us to study how adding the CBAM impacts firms’ supply chain adjustments across types of inputs and countries, along with the resulting changes in emissions and in prices faced by French households in their consumption of final goods.

Model Estimation

Before running the model-based policy simulations, we estimate several parameters that drive the sourcing decisions of French firms. One key statistic is a country’s sourcing potential, which captures the comparative advantage that firms in another country have in producing an input relative to those produced by French firms. We use French firms’ product-level import data to estimate these sourcing potentials for pre-ETS data for the year 2004. This estimation provides intuitive results—for example, that non-ETS countries like Russia and Australia and the ETS member Norway, all of which are major exporters of petroleum products and high-emissions raw materials, have a comparative advantage in producing such goods relative to firms operating in France. The estimated model is able to generate data that match the share of French imports of regulated and unregulated goods observed in the actual data.

Policy Scenario Analysis

Under the ETS-only scenario and applying a carbon tax that matches the price of carbon in the ETS market, global emissions fall by 0.7 million tons of CO2, but at the cost of a modest increase in the price of French manufacturing products (0.87 percent). The impact on emissions is small due to French firms switching input sourcing away from regulated countries—the carbon leakage we documented in our companion post. Indeed, the model replicates 80 percent of the carbon leakage estimated in the data.

When we extend the ETS system to include imported products, thus mimicking the future CBAM, the global reduction in emissions increases sevenfold while the manufacturing price level nearly doubles (1.42 percent). The combined ETS + CBAM tax is far more powerful than ETS alone, as the CBAM eliminates the incentive to import regulated goods. Firms shift sourcing away from countries like Russia and China that are outside the regulated area and toward less polluting countries, such as France. According to the model’s simulation, the resulting cut in emissions comes with a cost, however, as prices faced by French consumers rise quite a bit given the higher cost of inputs.

Conclusion

The results in our two posts underscore the importance of considering the indirect impacts of carbon policy through supply chain linkages. Firms can adapt along multiple dimensions to minimize the cost of carbon policies. These adaptation strategies can be welfare-improving when incentivizing clean technology investment, but they can also induce undesirable carbon leakage effects when firms adapt their sourcing strategy. While firms in our model reshore regulated inputs locally under the ETS + CBAM policy, thus reducing emissions generated by French production, firms’ international competitiveness is also reduced, which leads to higher prices faced by domestic households.

Pierre Coster is an economics Ph.D. student at the University of Southern California.

Julian di Giovanni is an economic research advisor in the Federal Reserve Bank of New York’s Research and Statistics Group.  

Isabelle Mejean is a professor of economics at Sciences Po.