The drive for net zero is increasing the role of governments in their economy through the implementation of new regulations, subsidies and taxes. For now, subsidies are centre stage. The Biden administration’s Inflation Reduction Act (IRA) fired the starting gun with the announcement of a mammoth $369bn in green subsidies. The EU has pledged $270bn in green subsidies as part of its “Green Deal” and, in response to the IRA, plans to ease its state aids policy to boost funding for green projects. The UK Labour Party’s “Green Prosperity Plan” looks like a British version of Bidenomics with major new funding for energy infrastructure and renewables.

The cost of subsidies is largely hidden from the public in government borrowing or general taxation. Taxing energy at a household level is a different proposition. Energy costs are hugely politically sensitive, as demonstrated by the “gilets jaunes” protest movement in France and the energy crisis in Europe last year.

The most widespread climate-related carbon tax is levied on corporates, not households, and its costs are therefore largely hidden from consumers. Carbon pricing charges businesses for emissions. The EU has led the charge on carbon pricing and a growing number of other countries have followed. Many countries don’t levy carbon taxes and, even those that do, exempt many types of emissions. Just 30 per cent of global emissions are covered by a carbon price which, in most cases, is far too low to meet net zero targets. The IMF estimates that to limit climate change to even 2°C (above the 1.5°C Paris target) the average global price of carbon needs to rise from $6 per ton of CO2 to $75 by 2030 with coverage expanding to cover every sector and country.

Unless all countries have a carbon tax those that do put themselves at a potential disadvantage relative to those that don’t. Domestically produced goods and services lose out to imports that do not face the levy, creating an incentive for producers to relocate to lower-tax jurisdictions. Without global coordination carbon taxes could create a situation in which efforts to decarbonise are thwarted by the relocation of polluting industries to such countries.   

To counter carbon leakage the EU is implementing a Carbon Border Adjustment Mechanism (CBAM) that will levy a carbon price on imports into the EU. The details are complex, but make no mistake, this is an important measure, one that is getting attention from policymakers around the world. Europe’s CBAM will be phased in from this October, initially affecting carbon-intensive sectors at greatest risk of carbon leakage – cement, iron and steel, aluminium, fertilisers, electricity and hydrogen. The scope will expand reaching full planned coverage, which will account for half of all sectors covered by the EU’s carbon tax, in October 2026.

The CBAM represents a logical way of reducing carbon emissions, albeit one that creates risks, as well as opportunities, for European producers. Although the CBAM aims to level the playing field between domestic production and imports, some EU producers will see their costs rise immediately. These companies are heavy emitters and are currently exempt from the EU’s domestic carbon pricing scheme to keep them competitive against imports. With the carbon content of imports now being taxed, the EU plans, quite reasonably, to levy the carbon tax on these domestic producers, pushing up their costs. While in the home market, domestic production and imports will face the same charge, the CBAM will affect the competitiveness of some EU exports which, directly or indirectly, are subject to the levy. 

There will be second-round effects too. Input costs for many industries will rise, including autos, home appliances, and construction, as industries and importers affected by the CBAM pass on higher costs. The European Central Bank has said that the CBAM, like the carbon price before it, will raise inflation. We expect to hear a lot about so-called “greenflation” in the next few years as the costs of the energy transition feed into the general price level.

While the EU regards the CBAM as an environmental measure, other countries may see it as a form of protectionism, leading to retaliatory tariffs and restrictions on trade. The current trade dispute between the EU and US over steel and aluminium underscores the challenge with universal adoption of carbon pricing.

The hope is that Europe’s CBAM could create a different type of bandwagon effect, encouraging other countries to adopt domestic carbon pricing and border taxes. Countries that export to the EU can avoid paying the CBAM by taxing carbon domestically. Canada and Australia are considering the introduction of their own CBAM and the UK has recently held a consultation on the idea.

Reaching net zero is a herculean task of vast complexity. It will require innovation and experimentation across the economy and government policy. With carbon pricing and border taxes the ultimate prize is huge – a common way of measuring and charging for carbon across the world. If the EU’s CBAM prompts widespread adoption of effective carbon pricing it takes us a long way to that goal.

A personal view from Ian Stewart, Deloitte’s Chief Economist in the UK. You can subscribe and/or view previous editions here.

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