Designing Border Carbon Adjustments for Enhanced Climate Action DECEMBER 2017 Michael Mehling Harro van Asselt Kasturi Das Susanne Droege Cleo Verkuijl Acknowledgements Michael Mehling – Deputy Director, MIT Center for Energy and Environmental Policy Research (MIT CEEPR), and Professor of Practice, University of Strathclyde Law School Harro van Asselt – Senior Research Fellow, Stockholm Environment Institute (SEI), and Professor of Climate Law and Policy, University of Eastern Finland (UEF) Law School Kasturi Das – Associate Professor Economics and International Business, Institute of Management Technology (IMT), Ghaziabad, India Susanne Droege – Senior Fellow, Global Issues Research Division at the German Institute for International and Security Affairs (SWP), Berlin, Germany Cleo Verkuijl – Research Fellow, Stockholm Environment Institute (SEI) We gratefully acknowledge funding from the KR Foundation for this report under the project ‘Making the Trading System Work for Climate Change’ (2016-2017). Our sincere appreciation also extends to James Bacchus, Henry Derwent, Gary C. Hufbauer, Joost H.B. Pauwelyn, Rodrigo Polanco, Joel P. Trachtman, and Jacob Werksman for thoughtful comments at various stages of the project. Also thanks to participants in the workshops ‘Border Carbon Adjustments: A Renewed Role after Paris?’ on 25 May 2016 in Bonn, Germany, and ‘Making the International Trading System Work for Climate Change: Assessing the Options’ on 19 October 2017 in Crozet, France, for their valuable input. Project Manager: Alexandra Carr Editor: Claudia Delpero Design and typeset: Margherita Gagliardi The research for this working paper was completed in December 2017. This report is part of the Climate Strategies project “Making the International Trading System Work for Climate Change”, funded by the KR Foundation. About Climate Strategies Climate Strategies is an international organisation that convenes networks of leading academic experts around specific climate change policy challenges. It offers rigorous, independent research to governments and the full range of stakeholders, in Europe and beyond. We provide a bridge between research and international policy challenges. Our aim is to help government decision makers manage the complexities both of assessing the options, and of securing stakeholder and public consensus around them. Our reports and publications have a record of major impact with policy-makers and business. Copyright © 2017 Climate Strategies Climate Strategies encourage reproduction and communication of their copyrighted materials to the public, with proper credit (bibliographical reference and/or corresponding URL), for personal, corporate or public policy research, or educational purposes. However, Climate Strategies copyrighted materials are not for commercial use or dissemination (print or electronic). Unless expressly stated otherwise, the findings, interpretations, and conclusions expressed in the materials are those of the various authors and are not necessarily those of the Climate Strategies Board/Secretariat. Cite this report as: Michael Mehling, Harro van Asselt, Kasturi Das, Susanne Droege, and Cleo Verkuijl (2017), Designing Border Carbon Adjustments for Enhanced Climate Action, Climate Strategies. Table of Contents LIST OF ABBREVIATIONS 6 EXECUTIVE SUMMARY 7 1. INTRODUCTION 14 2. EVOLVING CONTEXT OF CLIMATE COOPERATION AND INTERNATIONAL TRADE 17 2.1 A More Bottom-up Climate Regime 17 2.2 A Changing Outlook on Trade Policy and Liberalisation 20 2.3 Interim Conclusions 21 3. CONCEPT AND RATIONALE 22 3.1 Definition and Conceptual Boundaries 22 3.2 Rationale and Purpose 23 4. PAST PROPOSALS AND EXISTING APPLICATION 25 4.1 Europe 25 4.1.1 The 2007 FAIR Proposal 26 4.1.2 The 2009 Carbon Inclusion Mechanism 27 4.1.3 The 2016 Border Adjustment Proposal for the Cement Sector 28 4.2 United States 29 4.2.1 International Reserve Allowance Program 30 4.2.2 Californian Emissions Trading System 33 4.2.3 Climate Leadership Council (CLC) 34 4.3 Interim Conclusions 35 36 5. DESIGNING A BCA: LEGAL AND ECONOMIC CONSIDERATIONS 36 5.1 Relevant Design Considerations from the Perspective of WTO Law 36 5.1.1 Border Tax Adjustments (BTAs) and Broader Legal Context 38 5.1.2 Trade Law Implications for BCA Design 40 5.2 Relevant Design Considerations from an Economic Perspective 42 5.3 Interim Conclusions 2 6. DESIGN PRINCIPLES AND RECOMMENDATIONS 44 6.1 Overview 44 6.1 Scope and Coverage 44 6.2.1 Product Coverage 44 6.2.2 Sectoral Coverage 45 6.2.3 Geographic Scope 45 6.2.4 Policy Coverage 45 6.3 Carbon Content 46 6.3.1 Emissions Scope and Benchmarks 46 6.3.2 Data Sources 46 6.4 Adjustment Level 47 6.5 Revenue Use 48 6.6 Expiration 48 6.7 Process 48 7. CONCLUSIONS 49 REFERENCES 50 LIST OF TABLES, FIGURES AND TEXT BOXES Table ES-1: Selected Case Studies 10 Text Box ES-1: Legal Aspects of BCAs 11 Figure ES-1: Design Steps and Related Process 13 Table 1: (I)NDCs of the World’s Top Five Emitters 18 Table 2: Summary of the FAIR Proposal (2007) 26 Table 3: Summary of the Carbon Inclusion Mechanism (2009) 28 Table 4: Summary of the Border Adjustment Proposal for the Cement Sector (2016) 29 Table 5: Border Adjustment Provisions Legislative Proposals 31 Text Box 1: Relevant GATT Text on Border Tax Adjustment 37 Figure 1: Pathways to BCA Compliance 43 Text Box 2: Calculation of the Adjustment Level 47 Text Box 3: Measures in the Trade Regime 49 Figure 2: Design Steps and Related Process 50 List of Abbreviations AB Assembly Bill AEP American Electric Power ASEAN Association of South East Asian Nations BAU Business-as-usual BCA Border carbon adjustment BTA Border tax adjustment CDM Clean Development Mechanism CER Certified Emission Reduction CIM Carbon Inclusion Mechanism CLC Climate Leadership Council DDA Doha Development Agenda ERU Emission Reduction Unit ETS Emissions Trading System EU European Union EXIOBASE Externality Data and Input–Output Database G7 Group of Seven G20 Group of 20 GATT General Agreement on Tariffs and Trade GDP Gross domestic product GHG Greenhouse gas GRAM Global Resource Accounting Model GTAP Global Trade Analysis Project HS Harmonized System IBEW International Brotherhood of Electric Workers ICIO Inter-Country Input-Output INDC Intended Nationally Determined Contribution ICTSD International Centre for Trade and Sustainable Development LCA Life Cycle Assessment LCSA Life Cycle Sustainability Assessment MC Ministerial Conference NAFTA North American Free Trade Agreement NDC Nationally Determined Contribution NGO Non-governmental Organisation OECD Organisation for Economic Co-operation and Development 6 Climate Strategies PPM Process and Production Method RCEP Regional Comprehensive Economic Partnership RTA Regional Trade Agreement SB Senate Bill SCM Agreement Agreement on Subsidies and Countervailing Measures TPP Trans-Pacific Partnership TTIP Trans-Atlantic Trade and Investment Partnership UK United Kingdom UNFCCC United Nations Framework Convention on Climate Change US United States USTR United States Trade Representative VAT Value Added Taxation WIOD World Input-Output Database WTO World Trade Organization Designing Border Carbon Adjustments for Enhanced Climate Action 7 Executive Summary The Evolving Context of Climate Cooperation With the entry into force of the Paris Agreement, Such effects – collectively referred to as leakage heterogeneity of domestic action has become an – have been discussed in the context of climate accepted feature of the climate regime. Whereas the policies, such as the Emissions Trading System in earlier Kyoto Protocol formalised a binary asymmetry the European Union, the proposed federal climate of effort between developed and developing states, legislation in the United States, and the forthcoming the new architecture now requires all parties to national carbon market in China. So far, existing contribute towards common climate objectives, policy frameworks have mostly addressed the risk albeit in accordance with vastly divergent national of leakage with measures behind the border, from circumstances. output-based rebates and free allocation of emission rights to full exemption of affected emitters. Given this flexibility, levels of climate ambition differ widely across countries, and may grow larger as A growing body of evidence suggests that these countries chart their individual paths towards ever- approaches have not performed as intended, deeper decarbonisation. Universal participation in however, causing regulatory capture, perverse this collective effort is not guaranteed, however, as incentives, and windfall profits. Although often the withdrawal of the United States from the Paris designed to be temporary, these measures have also Agreement has shown. Even among participants proven resilient to change, and will likely remain in in the new regime, the achievement of mitigation place given the observed context of persistent policy pledges may be imperfect, with limited chances to heterogeneity. As parties to the Paris Agreement address compliance shortfalls. engage in progressively more ambitious climate action, this situation may become increasingly untenable, generating pressure for more suitable Concerns about the impacts of uneven climate approaches to counter leakage. action, reinforced by concurrent nationalism and protectionism trends in many countries, will sustain or increase pressure to apply some form of corrective measure or safeguard. Whereas political discourses about climate action tend to be dominated by preoccupation with competitiveness of domestic