Credit: Stephen Sauer
There is an urgent need for businesses worldwide to reduce greenhouse gas emissions while remaining profitable.
In 2005, to address this challenge, the European Union launched its Emissions Trading System, a cap-and-trade program that requires companies in the most heavily polluting sectors to either reduce their emissions below a decreasing threshold or pay for them.
The system has worked relatively well over the past two decades, but it has given an unfair advantage to importers, since goods produced beyond EU borders may not be subject to a tax on their emissions.
The EU aims to address that imbalance with the implementation of its Carbon Border Adjustment Mechanism, or CBAM, starting in 2026; the United Kingdom plans to do the same in 2027.
“It’s a complicated topic with a kind of funny name, but this is something that could have pretty profound implications for carbon emissions around the world,” said a professor of energy economics at MIT Sloan and a former deputy assistant secretary for climate and energy economics at the U.S. Treasury. “I’ve been studying climate policy for about 20 years, and this is the thing that has made me most optimistic.”
In a recent Q&A, Wolfram, co-author of a report titled “How Carbon Border Adjustments Might Drive Global Climate Policy Momentum,” explained the mechanics of the CBAM, discussed why businesses outside the EU need to pay attention, and offered predictions on the future of carbon pricing. The conversation has been edited for length and clarity.
What do businesses need to understand about CBAMs? How do they help level the playing field?
Climate change is global problem. A ton of carbon emitted in one place affects the whole world, and so, in the language of economics, this creates a free-rider problem. If any individual country takes steps to reduce its carbon emissions, that country bears all the costs, but the whole world reaps the benefits.
The CBAM is the first climate policy that tackles this free-rider problem head-on.
If a country from outside the EU exports its products into the EU, then they’re going to be subjected to the same level of regulatory scrutiny that countries within the EU face, specifically when it comes to carbon emissions and the Emissions Trading System. Those imported goods are going to have an equivalent carbon price imposed on them.
At the same time, companies outside of the EU get credit for any carbon price that they’ve paid domestically, which basically reduces the incentive for any individual country to free-ride.
Without this adjustment, if you’re a German car manufacturer, then steel manufactured in Malaysia, with no carbon pricing factored in, is going to be a lot more economically attractive than German steel.
How is a CBAM different from a tariff?
A CBAM adjusts for domestic policy, whereas a carbon tariff does not.
As we said, the U.K. and EU have carbon prices domestically, which means [that], under a CBAM, if you’re a Malaysian steel manufacturer and you send steel to the EU, then you have to pay as though your steel factory were located in the same regulatory jurisdiction. You have to pay the carbon price — unless you’ve already paid for your carbon emissions in Malaysia.
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Carbon tariffs don’t adjust for carbon prices charged domestically. A country just makes the tariff proportional to the carbon emitted.
The CBAM is fundamentally designed to level the playing field and push for broader carbon markets.
What sectors will be affected first?
In the beginning, the EU CBAM only applies to a few pretty carbon-intensive sectors: cement, iron, steel, aluminum, fertilizer, electricity, and hydrogen. The U.K. CBAM won’t cover electricity, but it does include glass and ceramics. There’s no specific schedule to bring in other sectors, but that’s the plan over time.
How are other countries responding to the prospect of the CBAM?
It’s been successful beyond what any economic theory would predict. Since the EU started talking about this in 2019, 44 other jurisdictions around the world have either implemented or are in the process of debating, at a formal level, carbon prices.
China, which is a big deal in the climate world, previously had a carbon price that only applied to the power sector, but it has expanded this carbon price to cover CBAM sectors such as iron, steel, and cement. To me, that seems like a pretty impressive impact.
In other countries, like Pakistan, Thailand, and Taiwan, we’ve also seen a real run-up in the use of words like “decarbonization,” “green energy,” “clean energy,” and so on in the English language press. It has not been ignored. I would say this has started global conversation about decarbonization and carbon pricing, which is one of the things it’s designed to do.
What should businesses be paying attention to as the EU and U.K. CBAMs get underway?
All businesses should be paying attention to this. It seems, for one, to be an effective way to make some headway on confronting climate change. If the momentum behind carbon pricing and CBAMs really gets going, U.S. businesses will need to pay for their emissions when they export to [other] countries in addition to the EU and U.K.
It’s worth emphasizing that the CBAM is mainly trying to address the issue of competitiveness. The EU has this emissions trading system. If a domestic carbon-intensive industry just leaves a market like Europe, then the world doesn’t get the emissions benefits — and we might even get an increase in emissions if production moves to a place with less regulation. The EU also loses the economic benefits of the company.
This is where we can really see the value of the CBAM: It [disincentivizes] companies from leaving countries that are taking on climate change, and it generates policy spillovers, where other jurisdictions adopt prices themselves. It’s something businesses will need to start thinking about, depending on their export markets.
Are there big questions that remain unanswered about implementation or efficacy?
There are lots and lots of details that people are fighting over, and it remains to be seen how these fights get resolved and whether they delay implementation. I’ve certainly painted the rosy picture; that’s easy to do before you have to deal with messy details on the ground.
Questions remain about how other countries will report emissions, at what level reporting takes place, what exactly that means, and so on. There are also big questions about what, precisely, it means for other countries to have a carbon price and what kinds of activities will and won’t be credited by the EU and U.K. This needs to be worked out.
Finally, there’s some concern that countries will object to the CBAM as a whole and bring complaints to the World Trade Organization. I don’t think that would actually delay the policy. But, in general, the broad question remains about how much other countries will go along with this or how much they might put up a fight. All that is to be decided this year, before the policy takes hold in 2026.
Where does the U.S. sit in all of this, and what does the new administration imply?
There are two ways to think about that. In terms of exports, I don’t see this as an issue between the U.S. and the EU, as we export so little to the EU in the specific sectors covered by the CBAM. This protection is likely temporary as the EU and U.K. expand coverage to new sectors and as other countries around the world start to enact their own CBAMs, but for now, there are bigger fish to fry in U.S.-EU trade debates.
At the same time, some Republicans are talking about imposing a carbon tariff on U.S. imports. A bill has already been introduced on this last Congress, and it’s part of the conversation with the current Congress. Where that goes remains to be seen. Some think it’ll die; others think it has legs. But this would not have any direct effect on the CBAM, which ultimately remains an elegant solution to a tricky problem.
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