THE CASE for an ECONOMY-WIDE CARBON FEE Carbon Pricing Policies Across the World Are Riddled with Exemptions That Undermine Climate Progress

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THE CASE FOR AN ECONOMY-WIDE CARBON FEE Carbon pricing policies across the world are riddled with exemptions that undermine climate progress. The answer is a uniform carbon price across the whole economy paired with a border carbon adjustment.

White Paper Climate Leadership Council October 2019

David Bailey Geoffroy Dolphin Ryan Rafaty ABOUT THE AUTHORS

DAVID BAILEY is Research Director RYAN RAFATY is a Postdoctoral at the Climate Leadership Council Research Fellow with the Climate and an Associate Professor at the Econometrics project at University of Walsh School of Foreign Service at Oxford, Senior Research Officer at the Georgetown University. An Oxford Institute for New Economic Thinking University graduate, he has been at Oxford, and consultant working on involved in worldwide policy debates climate and low-carbon technologies on climate issues since 1998 and at the World Bank. He completed his previously served as head of climate PhD at University of Cambridge. policy at ExxonMobil.

GEOFFROY DOLPHIN is a final year PhD student at the Judge Business School, University of Cambridge. His research focuses on the political, economic and institutional factors affecting the implementation of carbon pricing policies. Previously he studied at the Université Catholique de Louvain in Belgium and the London School of Economics.

THE CASE FOR AN ECONOMY-WIDE CARBON FEE

1. The Carbon Price Gap ...... 2

2. Why the Carbon Price Gap is Far Larger than Assumed ...... 4

3. Why the Gap Occurs & Why It Matters ...... 9

4. Solving the Problem with Border Carbon Adjustments ...... 14

5. Conclusion ...... 17

ABOUT THE CLIMATE LEADERSHIP COUNCIL

The Climate Leadership Council is an international research and advocacy organization founded in collaboration with a who’s who of business, opinion and environmental leaders to promote a carbon dividends framework as the most cost-effective, equitable and politically-viable climate solution.

Findi2 out more at www.clcouncil.org. THE SWISS CHEESE PROBLEM EXECUTIVE SUMMARY

An economy-wide price on carbon dioxide on page three, these gaps reach as high as (CO2) and/or other greenhouse gas (GHG) 80-90% percent in some jurisdictions. emissions has long been recommended as These policy holes mute carbon price signals the most cost-effective climate solution. and weaken incentives to reduce emissions in But at present, most of the carbon prices in nearly every jurisdiction that prices CO2 70 national and sub-national jurisdictions emissions. Plugging them is essential for around the world are riddled with exemptions achieving the emissions reductions potential of and partial rebates given to high-emitting carbon pricing. industries due to competitiveness and leakage concerns. Many policymakers and An economy-wide carbon fee researchers tend to overlook this problem, partly because there has thus far been a lack paired with a border carbon of standardized data. adjustment would not only close the carbon price gap but This report assesses the persistent gaps pave the way for far greater between “nominal” and “effective” carbon prices cross-nationally and describes the global climate ambition extent to which they are weakening climate policy. While the nominal carbon price takes To make carbon pricing more effective, a jurisdiction’s CO2 fee rate (or CO2 allowance governments should implement a truly price) at face value, the effective carbon price economy-wide price on CO2 emissions by is weighted to account for the percentage of eliminating sectoral omissions and special emissions actually covered by the nominal treatment of high-emitting industries. But price across each fossil fuel and each sector governments will only do so if they are of the economy. able to overcome legitimate concerns about competitiveness and carbon leakage. The This report sheds new empirical best policy mechanism to accomplish this is a border carbon adjustment (BCA) that levels light on the striking gaps the economic playing field and encourages between nominal and effective other jurisdictions to adopt similar carbon carbon prices, which reach pricing approaches. as high as 80-90% in some Although a meaningful carbon price can jurisdictions be set by either a carbon fee or a cap-and- trade system, the former is better suited to a Utilizing new data on emissions-weighted uniform and transparent carbon price without carbon prices developed at the University of exemptions and is more compatible with a Cambridge by one of the authors (Dolphin) BCA. An economy-wide carbon fee paired and updated for this purpose, this report sheds with a border carbon adjustment would new empirical light on these striking gaps not only close the carbon price gap but between nominal and effective carbon prices. pave the way for far greater global As can be seen in Tables 1 and 2 appearing climate ambition.

1 1. THE CARBON PRICE GAP

The rapid growth of carbon pricing initiatives too low to elicit substantial emission reductions, – from just a handful in the early 1990s to but the very few that do reach considerable 51 initiatives today across 70 jurisdictions levels are implemented in countries and sectors producing 20 percent of global greenhouse (mainly electricity) that are already relatively gas emissions – has not been accompanied by low-carbon.5 At the same time, approximately 1 a comparable increase in carbon price levels. 80 percent of global greenhouse gas emissions There remains a substantial gap between still remain officially unpriced. current carbon prices and those compatible with achieving the goals of the Paris Agreement, which itself is just a starting point. This represents the first comprehensive effort to Model-based estimates of the carbon price reliably ascertain the actual levels needed to limit warming to well below 2°C vary widely, largely due to divergent stringency of carbon prices assumptions, especially regarding future in a standardized and cross- energy technology costs and structural nationally comparable format trends in GDP and population in different 2 economies. One widely referenced example, That is not to say that these emissions may the Stern-Stiglitz Report of the High-Level not in some way be regulated under the more Commission on Carbon Prices, recommends than 1,500 climate-related laws worldwide, that carbon prices should reach at least $40–80/tCO2 by 2020 and $50–100/tCO2 which include mostly non-pricing policies by 2030, when paired appropriately with such as product design and energy efficiency 6 complementary policies.3 standards. But regulatory approaches, while appropriate in some cases – for example, where When considering the global marginal abatement costs exceed politically viable carbon price levels, where market economy as a whole, the world's failures cannot be better addressed by carbon effective carbon price was only pricing or where measurement of emission about $2.30/tCO2 in 2018 levels is difficult – can be as much as three times more expensive than carbon pricing per This illustrates the extent of the sociopolitical ton of CO2 avoided.7 challenge. At present, less than 10 percent of existing carbon prices across 70 jurisdictions Climate policymakers have learned both from are at or above $40/tCO2.4 When carbon prices basic economic theory and more complex are weighted to account for the percentage of domestic CO2 emissions they actually cover, as Integrated Assessment Models (IAMs) that we describe in the next section, that number when it comes to effectively reducing emissions, falls to less than five percent. Although the different carbon price levels can yield very momentum is moving in the right direction, different outcomes. But what is far less noticed the majority of carbon prices currently remain or candidly discussed is that not all ostensibly below $15/tCO2. Not only are these carbon prices equivalent carbon prices are “created equal.”

2 THE SWISS CHEESE PROBLEM Table 1: Nominal vs. Effective Carbon Prices (US$/tCO2e) in Selected Jurisdictions, 2018

Table 1: Data for nominal carbon prices are from World Bank and Ecofys (2018) and based on the highest carbon price levied within the jurisdiction in 2018, without accounting for any sectoral, industry-specific or fuel-specific exemptions. Data for effective, emissions-weighted carbon prices are updated from Dolphin et al. (2016) – see References for full citation.

Table 2: Nominal vs. Effective Carbon Prices (US$/tCO2e) in U.S. States, 2018

3 2. WHY THE CARBON PRICE GAP IS FAR LARGER THAN ASSUMED

Various sectoral omissions, industry applied, specific exemptions, and different exemptions and partial rebates have reduced compensation methods.”9 Following standard the coverage of carbon prices and made them practice, the World Bank report presents a lot less effective in practice than in theory. data on “nominal” carbon prices, which do Following theoretical recommendations about not take into account these cross-national “first-best” policy design, the Integrated differences.10 Assessment Models (IAMs) used by the Intergovernmental Panel on Climate Change In order to compare carbon pricing initiatives (IPCC) generally assume in their simulations across countries, we use effective, “emissions- that implemented carbon prices are more weighted” carbon prices, developed at or less economy-wide. But actual carbon University of Cambridge by one of the authors prices have varied starkly in coverage – from, and updated for the benefit of this report. for example, 34 percent of CO2 emissions Effective carbon prices are novel in that they in Switzerland to 91 percent in Norway in are not only weighted to discount unpriced 2018.8 To understand their actual stringency emissions in omitted sectors of the economy, and to make them truly comparable, carbon but also carefully account, with the greatest prices need to be assessed in relation to their possible precision, for various industry coverage. exemptions and partial rebates that further reduce coverage and/or price. The series exist Sectoral omissions, industry for nearly all initiatives implemented at the national level as well as in North American exemptions and partial rebates subnational jurisdictions over the period have reduced the coverage of 1990-2018. carbon prices and made them far less effective Given that carbon price exemptions, rebates and subsidies are sometimes opaquely specified or buried deep in large legislative In France, for example, emissions-intensive texts, this computation exercise is bound to industries participating in the EU cap-and- be imperfect. But to the best of our knowledge trade system – chemicals, iron and steel, it represents the first comprehensive effort cement, oil refineries, electric utilities and to reliably ascertain the actual stringency of others – are exempt from the €55/tCO2 tax that carbon prices in a standardized and cross- French consumers pay. What these industries nationally comparable format. do pay under the EU emissions trading system (ranging from €7-25/tCO2 in 2018) is less than As shown in Table 1, there is a large chasm half the carbon price for the rest of the country. between nominal and effective carbon prices. The difference between the two metrics As the 2018 World Bank report on the State and is greater than 50 percent in numerous Trends of Carbon Pricing emphasizes: “Prices jurisdictions, including Chile, Colombia, are not necessarily comparable between France, Spain and Switzerland. In some other carbon pricing initiatives because of differences jurisdictions, such as Sweden and Finland, in the sectors covered and allocation methods the difference in percentage terms is relatively

4 THE SWISS CHEESE PROBLEM small but much larger in absolute terms. their various pilot cap-and-trade systems at Moving from nominal to emissions-weighted the provincial level – but these, too, would carbon price data reduces Sweden’s carbon register low coverage and prices, largely since rate in 2018 from $139/tCO2 to $119/tCO2, they are restricted to the electricity sector. while Finland’s decreases from $77/tCO2 to about $56/tCO2. As Table 2 shows, the carbon price chasm is even larger when assessing the nine U.S. states Other key emitters, such as India, Russia and participating in the Regional Greenhouse Gas Brazil are omitted since they have no carbon Initiative (RGGI). The difference between the price at all – effectively pricing emissions nominal and effective carbon price is greater at $0/tCO2. China is also omitted from our than 65 percent in all nine states. This is analysis, due to a lack of adequate data on unsurprising given that RGGI’s cap-and-trade

Figure 1: Heat Map of CO2 Emissions Coverage Across Selected Carbon Pricing Systems Over Time

Australia 100 Austria Belgium British Columbia Bulgaria 90 Chile Colombia Croatia Cyprus 80 Czech Republic Denmark Estonia Finland 70 France Germany Greece Hungary Iceland 60 Emissions

Ireland 2 Italy Japan Kazakhstan 50 Latvia Lithuania Luxembourg Malta 40 Mexico Netherlands New Zealand Norway 30 Poland of CO % Coverage Portugal Quebec Romania 20 Slovak Republic Slovenia South Korea Spain Sweden 10 Switzerland United Kingdom World 0 2004 2006 2008 2010 2012 2014 2016 2018

5 system applies exclusively to the electricity is computed based on a fuel-specific and sector- sector and is primarily operating as a specific disaggregation of the percentage of revenue-generating policy to fund renewable emissions covered by both carbon fees and energy initiatives and assist families with cap-and-trade systems, one may dive deeper electricity bills. RGGI’s effective carbon price into the data to compare varying coverage. is consistently below $2/tCO2 across the nine states and only about one cent per ton in As shown in Figure 1, the percentage of total Vermont, where the electricity mix is already CO2 emissions covered varies substantially almost entirely decarbonized. California’s cap- cross-jurisdictionally and over time. Very few and-trade system boasts far wider emissions countries, mainly in northern Europe, have coverage and is nearly economy-wide, but its managed to implement carbon prices that are persistently low carbon price has contributed nearly economy-wide. to very little of the state’s emission reductions. Since each jurisdiction’s effective carbon price Figure 2 provides a similar heat map

Figure 2: Heat Map of CO2 Emissions Coverage Across U.S. State-Level Carbon Pricing Systems Over Time

California 90 Connecticut 80 Delaware 70 Maine 60 Maryland Emissions 2 50 Massachusetts

New Hampshire 40

New Jersey 30 % Coverage of CO % Coverage New York 20 Rhode Island 10 Vermont 0 2009 2011 2013 2015 2017

6 THE SWISS CHEESE PROBLEM Figure 3: Choropleth Map of CO2 Emissions Coverage Across Carbon Pricing Systems, 2018

100%

80%

60%

40%

20%

Figure 3: Based on data updated from Dolphin et al. (2016). Note that China’s pilot, provincial emissions trading programs are not included due to missing data.

visualization of carbon price coverage in are CO2 emissions in the majority (65 percent) California and the ten U.S. states that have of the world’s countries exempted from any participated in RGGI (nine after New Jersey carbon price, but even in Europe, where pulled out in 2012). Coverage at the U.S. state carbon pricing has a firm basis, coverage often level has ranged from less than one percent of hovers below 50 percent. When considering CO2 emissions in Vermont to about 95 percent the global economy as a whole, the world’s in California. effective carbon price was only about $2.30/ tCO2 in 2018. There is a striking paucity of jurisdictions whose policies As a final consideration, Figure 4 plots the statistical distributions of effective, emissions- have been commensurate with weighted carbon prices in each jurisdiction the goal of limiting warming to over time, from 1990 to 2015. The box plots below 2°C follow the standard interpretation, with each horizontal line indicating (from bottom to top) Focusing only on the most recently available the minimum, first quartile, median, third coverage data for the world as a whole in 2018, quartile and maximum values of all carbon a similar picture emerges in Figure 3. Not only prices in each country during the time period.

7 The distributions for each country include Taken together, the data on carbon prices show only values for which the carbon price was that there is a striking paucity of jurisdictions greater than zero. The data clearly show that whose policies have been commensurate the only countries that have had an effective with the widely-agreed upon goal of limiting carbon price consistently above $40/tCO2 are warming to below 2°C. Effective carbon Sweden and Norway. More strikingly, Sweden prices, when standardized on an economy- is also a stark outlier with a median effective wide basis, are even lower and laxer than carbon price of $100/tCO2. Norway’s median generally assumed by climate researchers and carbon price is just above $40/tCO2. All other policymakers. countries have had a median effective carbon price below $20/tCO2.

Figure 4: Box Plot Distributions of Emissions-Weighted Carbon Prices in Selected Jurisdictions, 1990-2018

120

100

2 80

60 US$/tCO 40

AustraliaAustriaBelgiumBulgariaChile ColombiaDenmarkFinlandFranceGermanyGreeceIcelandIrelandItaly JapanMexicoNetherlandsNew ZealandNorwayPolandPortugalSouthSpain KoreaSwedenSwitzerlandUnitedUnited KingdomWorld States

Figure 4: Based on data updated from Dolphin et al. (2016). Effective carbon prices are weighted according to coverage of CO2 emissions only, rather than coverage of all GHG emissions on a CO2-equivalent basis. Were effective carbon prices weighted according to total GHG coverage, prices would be considerably lower in most jurisdictions.

8 THE SWISS CHEESE PROBLEM 3. WHY THE GAP OCCURS & WHY IT MATTERS

There are four main reasons that carbon prices There are exceptions (such as California and have been perforated and weakened relative Québec), but generally, cap-and-trade systems to their theoretical potential: policy design have not covered road transport emissions (one choices (omitted sectors), competitiveness of the most important and growing emission concerns (industry exemptions and rebates), sources globally). The EU Emissions Trading the outsourcing of emissions (exemptions for System (ETS), for example, includes domestic internationally traded products) and practical aviation but excludes road transportation; limitations on policy. to expand coverage, some countries such as Switzerland and Sweden have complemented Policy Design Choices: Omitted Sectors the ETS with national carbon taxes applied to fossil fuels (and thus road transport), while The first source of the carbon price gap – limited avoiding double taxation by exempting the sectoral coverage – has been a persistent issue fossil fuel used in energy production already across nearly all jurisdictions. covered under the ETS.

The omission of certain sectors and/or fuels from carbon pricing is often a product of the Expanding sectoral coverage choice between a carbon fee or cap-and-trade. with cap-and-trade is more By design, and by their nature (because of the administratively cumbersome inherent administrative requirements of the than with a simple and allowance market), cap-and-trade systems transparent economy-wide fee have often been limited to large emitters in the power sector and/or industry. Cap-and- trade systems typically price GHGs midstream Meanwhile, California’s cap-and-trade system at the point of emission – power plants and pioneered the inclusion of transport fuels by industrial facilities – regardless of the specific requiring that fuel suppliers provide lower- fuel from which the emissions originate. carbon fuels or purchase allowances in the Operators of power plants and industrial carbon market. The trading system in New facilities are thereby the parties responsible Zealand has even included forestry and waste for reducing their emissions or paying the sectors, while South Korea’s includes waste, carbon price by surrendering “allowances,” buildings and domestic aviation. Expanding which can be purchased through auctions. sectoral coverage with cap-and-trade is Part or all of the higher energy prices are in possible, but it is more administratively practice passed on to end-consumers, such cumbersome than with a simple and as households and other businesses, but transparent economy-wide fee. In addition, the point here is that a relatively smaller not all countries have governance standards number of companies directly participate in compatible with running an allowance market. the trading system. Under such a system, it is far simpler to focus on electric utilities and By contrast, carbon fees apply directly to fossil large industrial emitters, rather than tens of fuels and are calculated using appropriate thousands of smaller producers or millions of conversion factors based on the carbon content end consumers. of each fuel. The sectors exposed to the fee are

9 then specified in a second step. In principle, a on its past emissions or product-specific carbon fee may apply straightforwardly to benchmarks. Some analysts argue that freely 100 percent of energy-related emissions from allocated permits pose no problem, since as the combustion of fossil fuels, comprising the long as the carbon price is strictly positive, largest source (about 95 percent) of global firms receiving free allowances are still CO2 emissions, covering electricity and heat incentivized to reduce their emissions in order production, industrial plants, transportation to sell any surplus allowances for a profit in the and buildings. As we discuss later, the carbon market. However, when an excessive remaining five percent of global CO2 quantity of permits is freely allocated and the emissions is generally more difficult to price, carbon price is fairly low, many firms have no regardless of the policy choice. But overall, incentive to invest in low-carbon substitutes the sectoral coverage of carbon fees is far less – for example, switching steel production constrained than for cap-and-trade. For methods from blast furnaces to far more CO2- the majority of sectors, therefore, there is efficient electric arc furnaces.11 no technical justification for the persistently low levels of coverage. A carbon fee may apply Competitiveness Concerns: Industry straightforwardly to 100 percent Exemptions and Rebates of energy-related emissions from the combustion of fossil The second major source of the coverage fuels problem is special treatment of industry, particularly emissions-intensive, trade- exposed industries. There is a preponderance Empirical evidence based on interviews of full exemptions and partial rebates that with company managers has shown that effectively reduces the percentage of total EU firms receiving permits for free invest emissions covered by the carbon price in significantly less in low-carbon innovation a given industry and the industrial sector than firms without free allowances.12 Not only as a whole. For example, countries such has free allocation reduced decarbonization as Australia, Denmark, France, Ireland, incentives, but in some cases it has also Norway, Sweden, Switzerland and the UK resulted in billions of dollars in windfall have each at various points in time granted profits for a small number of large firms.13 A full or partial carbon tax exemptions to all or far more cost-efficient and environmentally most manufacturing industries, sometimes effective approach is to auction all permits, with specific conditions attached. These but policymakers have been slow to make the exemptions have been present since the transition.14 first carbon taxes were implemented in the early 1990s, although some countries have The primary rationale for these exemptions, gradually reduced them over time. rebates and free allowances relates to concerns about competitiveness and carbon “leakage.”

Meanwhile, governments operating cap-and- These concerns are powerful political trade systems have, to various degrees over motivators. In a world of unequal carbon time, freely allocated tradable permits to prices, a jurisdiction that unilaterally prices emissions-intensive industries. The quantity of emissions from domestic emissions-intensive free permits a firm receives is usually based industries such as steel or cement may put

10 THE SWISS CHEESE PROBLEM its companies (and jobs) at a competitive production, have meant that there has disadvantage, relative to producers in foreign been limited empirical evidence of carbon countries without a carbon price. All else leakage.16,17 At low carbon price levels, leakage equal, domestically manufactured products impacts are typically less significant than they would lose ground competitively relative to are often painted. equivalent products produced abroad. If carbon prices rise to levels commensurate with the goals of the Paris Agreement, The primary rationale for these competitiveness and leakage will become exemptions, rebates and free more serious economic and environmental allowances relates to concerns concerns, particularly for highly-traded, about competitiveness and emissions-intensive commodities that would be hit hardest by a robust carbon price: carbon "leakage" cement, refined petroleum, aluminum, iron and steel, inorganic basic chemicals, paper Were the competitiveness losses large enough and some others.18 Reducing emissions in to threaten market shares, businesses could these industries will require additional R&D decide to close plants and move production and capital investments – but neither will – and more importantly, future investment occur if businesses are effectively incentivized – to countries with lower environmental to move jobs and investment dollars outside standards. The carbon price would thus fail the country pricing carbon. to reduce emissions, since they would “leak” to other countries while the home country Outsourcing of Emissions: Exemptions would lose valuable industrial capacity in the for Internationally Traded Products process. Despite these efforts to limit carbon Concerns about competitiveness and leakage leakage with sector omissions and industry are valid, but the scope of the likely impact exemptions, large quantities of emissions have nevertheless ‘transferred’ overseas is often misunderstood or exaggerated. Most with the outsourcing of emissions-intensive industries and companies, comprising the industry. This trend began before carbon majority of value added to GDP, face limited pricing and is related to the effect of relative impacts; they may simply adapt to a carbon prices (including exchange rates) on price through relatively minor improvements production location, but it has gathered steam in energy and material efficiency. In other since the Kyoto Protocol in 1997. The rapid cases, companies may over time adopt resource growth of industrial production in economies substitution and low-carbon innovation with low or no carbon pricing, such as China across supply chains. Such has been the case and India, has significantly reduced the in the UK, for example, where firms exposed coverage of carbon pricing worldwide. As a to a carbon price floor have seen gains in result, many developed economies that price productivity, without any evidence of losses carbon domestically now import a sizeable to employment or revenue.15 amount of CO2 emissions, making the carbon ‘embodied’ in internationally traded goods Meanwhile, persistently low carbon prices, one of the largest gaps in carbon pricing together with various factors favoring local globally.

11 The scale of this gap is revealed by a recent estimates that California’s carbon footprint study on embodied carbon in traded is over 25 percent larger when accounting products, entitled the “The Carbon Loophole for consumption of embodied emissions.21 in Climate Policy.”19 The study estimates California has taken important steps to price that approximately 25 percent of global CO2 emissions embodied in imported electricity emissions are embodied in internationally and transport fuels, but as an individual traded goods. It also estimates that since 1990, state, it has limited ability to prevent further even as wealthier economies such as Germany, carbon leakage as its carbon price increases France and the United Kingdom have cut over time. domestic emissions, they have increased the amount of embodied carbon they import from The fundamental reason for this trade- China and other economies. For example, in related carbon loophole is that carbon the case of the United Kingdom, if one includes pricing is applied directly to production and the carbon embodied in the goods it imports, only indirectly, if at all, to consumption. then the UK has actually increased its carbon In many cases, consumption of carbon footprint over time. embodied in traded goods escapes carbon pricing or comparable regulation altogether. If the amount of carbon This in turn reduces the effective global price on carbon, exacerbating the imported were taken into problem. If carbon pricing is to reduce account, U.S. CO2 emissions CO2 emissions globally and not just in the would be 14 percent greater than jurisdiction where a carbon price is applied, the reported number this design flaw will need to be addressed. Since applying carbon pricing to upstream production is more administratively The study found the U.S. to be the world’s feasible and cost-effective than downstream leading importer of embodied carbon. If consumption, trade-related measures the amount of carbon imported were taken into account to measure its actual carbon such as border carbon adjustments, which footprint, U.S. CO2 emissions would be 14 will be detailed in the next section, are best percent greater than the reported number, suited to close these gaps. which measures only domestic production of CO2 emissions.20 Practical Design Issues

A similar problem of importing embodied There are, however, exceptions that may carbon exists at the sub-national level in practice make 100 percent coverage in the United States. Among U.S. states, suboptimal. As mentioned earlier, a carbon California is recognized as having the most fee can straightforwardly apply to all energy- comprehensive set of policies designed to related emissions from fossil fuel combustion, curb GHG emissions, including an emissions which account for about 95 percent of trading system. Yet its success in reducing global CO2 emissions. About four percent emissions has coincided with growing of remaining CO2 emissions are caused by imports of embodied carbon. For example, chemical processes during cement production; California imports roughly one-third of its while both fee and cap-and-trade policies electricity from neighboring states with can also apply to these direct emissions from more carbon-intensive power. A recent study cement, doing so accurately requires detailed

12 THE SWISS CHEESE PROBLEM and regularly updated plant-level data.22 Most sectoral omissions, Less straightforward is the inclusion of the industry exemptions and rebates roughly one percent of global CO2 emissions from gas flaring and venting, referred to that have reduced coverage are as “fugitive emissions.” There are similar attributable to political choices measurement issues with applying a broader rather than practical problems CO2-equivalent fee to GHG emissions from agriculture and forestry, waste and landfills. coverage may be less than 100 percent.23 In But assuming it were administratively feasible such cases, emission reductions may be best and cost-efficient to accurately verify such achieved by policies other than a simple emissions, they could also be subject to the carbon price. Notwithstanding these caveats, carbon fee. most sectoral omissions, industry exemptions and rebates that have reduced coverage If the marginal cost of monitoring and (and free allocations that have reduced verifying each additional metric ton of decarbonization incentives) are attributable emissions exceeds the marginal benefit of to suboptimal design and political choices those additional reductions, then optimal rather than such practical problems.

13 4. SOLVING THE PROBLEM WITH BORDER CARBON ADJUSTMENTS

Fortunately, the primary source of the should be considered. There are policy design carbon price gap – the competitiveness decisions and administrative challenges to and leakage concerns that lead be made in addressing all four categories governments to exempt or freely allocate of information, but it is entirely feasible to permits to certain industries – are all design an effective system. solvable with well-designed policy. The practical effect of a BCA is to level the playing Eliminating the gap with a truly economy- field between domestic companies exposed to a wide carbon fee becomes politically carbon price and foreign companies in countries feasible and economically sound when that do not price carbon, while encouraging paired with a border carbon adjustment these trading partners to adopt a carbon price (BCA). BCAs address the issues of of their own.24 For U.S. industries that are less competitiveness and leakage by applying CO2-intensive than their counterparts overseas – the domestic carbon price on emissions- for example, U.S. steel relative to Chinese intensive imports and rebating the carbon steel – BCAs would shift relative prices such price on emissions-intensive exports. It that the most CO2-efficient products stand to also addresses the problem created by the benefit.25 Unlike the current system, which outsourcing of emissions and the gives special treatment to the most CO2- importation of embodied carbon by inefficient companies, BCAs would enhance subjecting imports to a carbon price. The climate action with a firm, legally defensible relevant trade authority in the importing environmental justification. country would administer the BCAs, while the relevant firms in the exporting country For these reasons, BCAs are a central pillar would be liable for paying the BCA of the Climate Leadership Council’s Carbon associated with their products at the border. Dividends plan, which would effectively cover 100 percent of energy-related CO2 emissions Eliminating the gap with a in the U.S. A BCA would thus help close the truly economy-wide carbon gap in carbon price coverage that has been fee becomes feasible when created by the outsourcing of emissions- paired with a border carbon intensive industrial activity as well as prevent further leakage. adjustment It is important to consider the global In practice, four key pieces of information implications of BCAs. Non-OECD economies are required to set the appropriate rates for (including China and India) export about BCAs: (1) the products to which the BCA 1.8 billion more metric tons of CO2 annually should apply; (2) the volume of carbon- than they import (as embodied in traded intensive material in the product; (3) the products).26 Meanwhile, OECD economies carbon intensity of the production process import about 1.8 billion more metric tons in the exporting country; and (4) the extent of CO2 than they export. Since 1990, for to which the exporting country’s carbon example, Switzerland reduced its domestic price (and potentially, other climate policies) CO2 emissions by 12 percent but increased its

14 THE SWISS CHEESE PROBLEM consumption-based emissions (accounting render them unnecessary. WTO rules permit for CO2 embodied in imports) by about 57 well-designed BCAs on environmental percent.27 Even Germany, with a trade surplus grounds under Article XX of GATT (General of nearly eight percent, imports more in Agreement on Tariffs and Trade), but only if CO2-intensive goods than it exports. The relevant imports are liable for a carbon price coverage gap therefore presents a double equivalent to the one levied on equivalent whammy of climate damages: from domestically produced goods.28 So, for emissions unpriced due to exemptions and example, BCAs on imports of steel products emissions unpriced due to neglect of could only be legally imposed once the international trade. carbon price exemptions for domestically produced steel were eliminated. Border Carbon Adjustments could trigger a positive feedback Carbon Fee vs. Cap-and-Trade: loop whereby an increasing Implications for BCAs number of countries join the Although carbon fee and cap-and-trade "club" of jurisdictions pricing systems each have their relative advantages carbon as the two main forms of carbon pricing, the former is better suited to overcoming the By putting a price on CO2 embodied in energy- coverage problem for two reasons. intensive imports, BCAs would not only strengthen carbon pricing policies by building the political support required to phase out Carbon fees, by their nature exemptions and rebates, but would also do and design, are simpler to far more to stimulate CO2 reductions globally. administer, more transparent Foreign countries and firms would have three options: (1) pay the BCAs associated with the and more easily applied without carbon-intensive products they export; (2) exemptions reduce their emissions in order to pay a lower rate; and/or (3) adopt a comparable carbon First, carbon fees, by their nature and price of their own and a parallel BCA system design, are simpler to administer, more in their own country. The third option would transparent and more easily applied without better adhere to their international climate exemptions to all energy-related CO2 commitments while retaining carbon price emissions. Cap-and-trade systems dominate revenues onshore. In this way, BCAs could current carbon pricing regimes, covering trigger a positive feedback loop whereby an about three quarters of all explicitly priced 29 increasing number of countries join the “club” emissions worldwide. Yet they are prone of jurisdictions pricing carbon. In any case, to exemptions, often for entire sectors foreign countries and firms would have every (due to the aforementioned administrative incentive to reduce emissions at home. requirements of emissions trading). Some

jurisdictions, such as California, South Korea Ironically, the same industry exemptions and and New Zealand, have expanded coverage rebates that are weakening carbon prices to additional sectors. But such modifications cross-nationally are also preventing countries have been exceedingly slow and the exception from adopting the sensible BCAs that would rather than the rule. Moreover, sub-national

15 cap-and-trade policies such as California’s, is to adopt an economy-wide carbon fee on RGGI’s or the Canadian provincial systems the carbon content of fossil fuels. Exemptions cannot be accompanied by BCAs since and rebates for emissions-intensive industry domestic laws prohibit internal trade should be phased out in parallel with restrictions. This is a significant constraint expanding the fee and implementing BCAs. on their ultimate ability to cover all emissions (both territorial and trade-related) and a The time to get serious about strong argument for national policy. practically implementing Border Second, it is undoubtedly easier to pair BCAs Carbon Adjustments is long with a carbon fee (where prices are fixed on overdue an annual basis and known in advance) rather than with a cap-and-trade system For countries currently committed to a cap- where prices can and do vary daily. In 2018, and-trade system, policymakers can switch to for example, allowance prices in the EU ETS full auctioning of allowances and introduce a ranged from $7.78/tCO2 in January to $24.81/ carbon price floor, thereby creating a hybrid tCO2 in December. Given such volatility in the system that incorporates some of the advantages allowance price, it would be difficult to adopt of a carbon fee within a cap-and-trade model. a BCA under cap-and-trade. Ensuring that This would create more investment certainty domestic and foreign companies are exposed around carbon price levels, make it easier to an equivalent carbon price throughout a to cover more sectors of the economy and given year would require constantly updating make it simpler to adopt a BCA. It would also the border adjustment rate. reduce more emissions: the United Kingdom, a participant in the EU ETS, introduced its own The other option, more commonly advocated, carbon price floor in 2013, which contributed is to require foreign companies to surrender to its per capita CO2 emissions falling to levels allowances for their emissions-intensive below what they were in 1860, at the height of products at the border, similar to requirements Britain’s industrial renaissance.31 for domestic companies participating in emissions trading.30 But while this would The essential point that applies to both carbon ensure a level playing field, it would also fee and cap-and-trade policies is that they flood the cap-and-trade system with tens should be paired with BCAs in order to better of thousands of additional carbon market incentivize decarbonization in high-emitting, participants, many of which may resist the trade-exposed industrial sectors. added administrative burden. Since emissions trading systems were originally designed to cap territorial emissions, incorporating BCAs through the allowance option would introduce substantial administrative complexity.

The path towards sensible, economy- wide carbon pricing is clear. For countries currently without any carbon price and for those that levy a carbon fee with exemptions, the simplest and most transparent approach

16 THE SWISS CHEESE PROBLEM 5. CONCLUSION

The world’s most difficult challenges when assemble the political support required to do so, tackling climate change – cutting emissions appropriate measures must be taken to address from cement, chemicals, iron and steel, concerns about industrial competitiveness and aluminum, refined petroleum, plastics and carbon leakage – concerns that will only grow other industries at the center of the global stronger and more valid if carbon prices are to economy – are likely to be impossible without reach levels commensurate with the world’s a robust, economy-wide price on carbon. But it climate objectives. is in these same industries that carbon prices have long been muted by exemptions, rebates, Pairing an economy-wide omitted sectors and suboptimal policy design. carbon price with Border Carbon As this report has shown, the gap between Adjustments is the most viable nominal and effective carbon prices is way to overcome climate substantial and larger than assumed, with few gridlock signs that countries are taking the necessary steps to close it. The problem is The proposal we outline – pairing an economy- stifling climate efforts around the world. wide carbon price with well-designed BCAs – is the most viable way to expand carbon price The problem will only be solved coverage and overcome the climate gridlock if policymakers resolve to posed by international trade competition. Its increase effective carbon price effectiveness will ultimately depend on how levels well BCAs are designed, to which products they apply and how trade relations are managed in The problem will only be solved if policymakers the process. For these reasons, the time to get resolve to close the gaps in coverage and serious about practically implementing BCAs is increase effective carbon price levels. But to long overdue.

17 ENDNOTES

1. These figures include not only implemented carbon prices but 14. Hepburn, C., Grubb, M., Neuhoff, K., Matthes, F. and Tse, M., also several scheduled for implementation up to 2020, most 2006. Auctioning of EU ETS Phase II Allowances: How and notably China’s national emissions trading system. For further Why?. Climate Policy, 6(1), pp.137-160. details, see: World Bank and Ecofys. 2018. State and Trends of 15. Martin, R., De Preux, L.B. and Wagner, U.J. 2014. The Impact Carbon Pricing 2018. Washington, DC: World Bank. Available at: of a Carbon Tax on Manufacturing: Evidence from Microdata. https://openknowledge.worldbank.org/handle/10986/29687 Journal of Public Economics, 117, pp. 1-14. 2. Barron, A.R., Fawcett, A.A., Hafstead, M.A., McFarland, J.R. 16. Barker, T., Junankar, S., Pollitt, H. and Summerton, P. 2007. and Morris, A.C. 2018. Policy insights from the EMF 32 study on Carbon Leakage from Unilateral Environmental Tax Reforms in U.S. carbon tax scenarios. Climate Change Economics, 9(01), Europe, 1995–2005. Energy Policy, 35(12), pp. 6281-6292. p.1840003. 17. Branger, F., Quirion, P., and Chevallier, J. 2016. Carbon Leakage 3. Stiglitz, J. and Stern, N. 2017. Report of the High-Level and Competitiveness of Cement and Steel Industries Under Commission on Carbon Prices. Washington, DC: Carbon the EU ETS: Much Ado About Nothing. The Energy Journal, Pricing Leadership Coalition. 37(3). 4. World Bank and Ecofys. 2018. State and Trends of Carbon 18. Grubb, M., Hourcade, J.C., and Neuhoff, K. 2014. Planetary Pricing 2018. Washington, DC: World Bank. Available at: Economics: Energy, Climate Change and the Three Domains https://openknowledge.worldbank.org/handle/10986/29687 of Sustainable Development. Routledge. 5. OECD. 2018. Effective Carbon Rates 2018: Pricing Carbon 19. Moran D., Hasanbeigi A., and Springer, C. 2018. The Carbon Emissions Through Taxes and Emissions Trading. Loophole in Climate Policy: Quantifying the Embodied Carbon OECD Publishing, Paris. Available at: https://doi. in Traded Products. KGM & Associates Pty Ltd. and Global org/10.1787/9789264305304-en Efficiency, LLC. 6. Climate Change Laws of the World database, Grantham 20. Ibid, Moran et al. (2018). Research Institute on Climate Change and the Environment and Sabin Center for Climate Change Law. Available at: http:// 21. Caron, J., Metcalf, G.E., and Reilly, J. 2017. The CO2 Content of www.lse.ac.uk/GranthamInstitute/legislation/ Consumption Across U.S. Regions: A Multi-Regional Input- Output (MRIO) Approach. The Energy Journal, 38(1), pp. 1-22. 7. Parry, I.W., Evans, D. and Oates, W.E., 2014. Are Energy

Efficiency Standards Justified? Journal of Environmental 22. Andrew, R.M. 2018. Global CO2 emissions from cement Economics and Management, 67(2), pp. 104-125. production. Earth System Science Data, 10(1), pp. 195-217. 8. Dolphin, G.G., Pollitt, M.G., and Newbery, D.G. 2016. The 23. Ibid, Dolphin et al. (2016). Political Economy of Carbon Pricing: A Panel Analysis. 24. Helm, D., Hepburn, C. and Ruta, G. 2012. Trade, Climate Cambridge Working Paper in Economics 1663. https://www. Change, and the Political Game Theory of Border Carbon eprg.group.cam.ac.uk/wp-content/uploads/2016/11/1627-Text. Adjustments. Oxford Review of Economic Policy, 28(2), pp. pdf 368-394. 9. Ibid, Stiglitz and Stern (2017). 25. Erickson, P., Kemp-Benedict, E., Lazarus, M. and van Asselt, 10. The OECD (2018) has recently published data that attempts to H. 2013. International Trade and Global Greenhouse Gas account for these differences (see Endnote 5 for reference), Emissions: Could Shifting the Location of Production Bring but they cover only a short time period, and they also merge GHG benefits? Stockholm Environment Institute. carbon price information with non-carbon energy taxes 26. Le Quéré, Corinne, et al. 2018. Global Carbon Budget 2017. (which in nearly all cases were implemented for reasons Earth System Science Data, 10, pp. 405-448. http://www. other than climate). Hence, the OECD data doesn’t provide globalcarbonproject.org/carbonbudget/17/data.htm perspective on long-term trends and doesn’t isolate policy differences that are specific to carbon prices. 27. Ibid, Le Quéré et al. (2018). 11. Flues, F. and van Dender, K. 2017. Permit Allocation Rules 28. van Asselt, H., Brewer, T., Mehling, M. 2009. Addressing and Investment Incentives in Emissions Trading Systems. Leakage and Competitiveness in U.S. Climate Policy: Issues OECD Taxation Working Papers. Available at: https://doi. Concerning Border Adjustment Measures. Climate Strategies org/10.1787/22235558 Working Paper, March 5, 2009. 12. Martin, R., Muûls, M., and Wagner, U.J., 2013. Carbon Markets, 29. Ibid, World Bank and Ecofys (2018). Carbon Prices, and Innovation: Evidence from Interviews with 30. Monjon, S. and Quirion, P. 2010. How to Design a Border Managers. Paper presented at the Annual Meetings of the Adjustment for the European Union Emissions Trading American Economic Association, San Diego. System? Energy Policy, 38(9), pp. 5199-5207. 13. Martin, R., Muûls, M., De Preux, L.B. and Wagner, U.J., 2014. 31. Hendry, D. 2018. First-in, First-out: Driving the UK's Per Capita Industry Compensation under Relocation Risk: A Firm-level Carbon Dioxide Emissions Below 1860 Levels. Vox EU, CEPR Analysis of the EU Emissions Trading Scheme. American Policy Portal. https://voxeu.org/article/driving-uks-capita- Economic Review, 104(8), pp. 2482-2508. carbon-dioxide-emissions-below-1860-levels

18 THE SWISS CHEESE PROBLEM APPENDIX

The analysis in this report covers carbon prices Massachusetts, Mexico, Netherlands, New across 51 jurisdictions worldwide, for which Hampshire, New Jersey, New York, New Zealand, detailed policy data could be obtained. They Norway, Poland, Portugal, Quebec, Rhode include: Austria, Belgium, British Colombia, Island, Romania, Slovak Republic, Slovenia, Bulgaria, California, Chile, Colombia, South Korea, Spain, Sweden, Switzerland, Connecticut, Croatia, Cyprus, Czech Republic, United Kingdom and Vermont. Due to missing Delaware, Denmark, Estonia, Finland, France, data, carbon prices in Alberta, Lichtenstein, Germany, Greece, Hungary, Iceland, Ireland, Saitama, Ukraine, Tokyo’s municipal cap-and- Italy, Japan, Kazakhstan, Latvia, Lithuania, trade system and China’s pilot provincial cap- Luxembourg, Maine, Malta, Maryland, and-trade systems could not be computed.

Appendix Table: Nominal vs. Effective Carbon Prices (US$/tCO2e) Across Jurisdictions Globally, 2018

19 Notes: Data for nominal carbon prices are from World Bank and Ecofys (2018) and are based on the highest carbon price levied within the jurisdiction as of April 2018, without accounting for any sectoral, industry-specific, or fuel-specific exemptions. Data for effective, emissions-weighted carbon prices are updated from Dolphinet al. (2016).

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