Predicted implications of the 2027 carbon border adjustment mechanism (CBAM) in the United Kingdom

Introduction

The United Kingdom plans on implementing a carbon border adjustment mechanism (CBAM) from the 1st of January, 2027, which will involve levies on imported products whose production results in carbon emissions. This carbon tax is aimed at preventing ‘carbon leakage’, supporting domestic firms while driving global climate action, contributing to decarbonisation and, therefore, the transition to net zero emissions, in order to achieve the UK’s climate goals. In 2023 the average carbon tax levied on firms was EUR 28.58 per tonne of CO2 equivalent emissions in the UK, whereas in China, the country from which the UK imports the majority of its products from, the average carbon tax levied on firms was EUR 6.77 per tonne of CO2 equivalent emissions. This example of a 76.3% tax difference between the two countries showcases the cause of ‘carbon leakage’ and why domestic firms in the UK struggle to compete with imported products. This as well as the UK’s goal to reach net zero by 2050 justifies the need for the CBAM.

This research article will explore the predicted implications of the implementation of the CBAM in the UK on ‘carbon leakage’, global climate action and the transition to net zero emissions, specifically focusing on the period between 2026 and 2030. This time frame has been chosen as the EU plans on implementing a similar mechanism in 2026, a year earlier than when the UK plans on doing the same. This article will include an analysis of the implications of the CBAM on ‘carbon leakage’, domestic producers, total carbon emissions, consumers and the government budget as well as issues with the implementation timetable through the use of economic concepts and real world secondary data.

Theoretical Framework

Negative production externality models can showcase the implications of the CBAM on the domestic market and the external costs that arise from the production of goods, which involve carbon emissions as well as the market in the UK for similar imported products. The change in the area between the MSB and MSC curves in the diagrams can be calculated to understand the change in external costs once the carbon taxes are levied on the respective markets. Demand and supply models can showcase the implications of the carbon tax on imports on the demand for domestic goods and the supply of foreign imported products. The change in quantity demanded and supplied in the respective markets can be used to quantify the impact of the carbon taxes on market prices, quantities, and producer revenues. A carbon tax model can showcase how the levy will encourage the innovation of less polluting production methods and technologies as well as how it creates a new source of government tax revenue, which can be quantified using the difference between the price received by firms and the price paid by consumers with the quantity of the products sold.

The next section of this article utilises technical terminology that will be defined here in order to improve the understandability of the article. ‘Carbon leakage’ refers to a situation where firms switch production to another country with less strict climate change mitigation policies (Ex. lower rates of carbon tax) in order to reduce their total costs of production. This results in an increase in carbon emissions in one country owing to a decrease in carbon emissions in another country which has more strict climate change mitigation policies. Negative production externalities refer to external costs that arise from the production of certain goods which result in negative spill-over effects that are experienced by third parties, who aren’t involved in the process of consumption or production, and for which no compensation is paid. A carbon tax is a form of indirect tax levied on each unit of carbon emissions (the unit used to quantify carbon emissions is CO2 equivalent emissions in tonnes).

Analysis :

Impact on achieving climate goals and on domestic producers

In 2023 the UK imported $194.15 billion worth of goods and services from the US and China, its two main trading partners for imports. The carbon taxes in the respective countries were EUR 14.45 per tonne of CO2 equivalent emissions and EUR 6.77 per tonne of CO2 equivalent emissions at the time, which translates to 49.4% and 76.3% tax difference respectively in comparison to the carbon tax levied on producers in the UK. This leads to firms operating and producing in these countries benefiting from significantly lower costs of production which allow them to undercut prices charged by UK manufacturers for various goods and services, whose production/provision involves carbon emissions, as they have to pay larger sums of carbon tax for the same amount of emissions. This results in domestic firms being unable to compete with foreign imports. Therefore, this causes ‘carbon leakage’ as firms are encouraged by the lower carbon pricing in these other countries to shift production in order to benefit from similar competitive advantages.

The implementation of the CBAM from 2027 will involve levies on all imports whose production involves carbon emissions in order to create a level playing field for all firms in terms of carbon pricing. This will allow UK producers to compete more effectively and thereby benefit from increased revenues and profits as customers will switch to purchasing domestic goods from them owing to the lower prices offered. Additionally, this will decrease the UK’s reliance on imports and allow it to run a trade surplus rather than the deficit it currently runs. Essentially, the quantity demanded of domestic goods will increase and the quantity supplied and demanded of imported goods will decrease owing to the change in carbon pricing.

The levies will be calculated on the basis of the difference between the carbon tax applied in the countries where they are respectively produced and the equivalent paid by UK manufacturers for the same amount of emissions. This can be showcased by a shift of the supply curve of imported foreign products from S1 to S2 , which is the supply curve of similar domestic products, thereby internalising some of the negative production externality. This ensures that the mechanism is as equitable as possible and prevents ‘carbon leakage’ as firms will no longer be able to export their products to the UK at lower prices, therefore no longer incentivising firms to switch production while continuing to sell their products in the UK.

Instead the mechanism will incentivise firms globally to invest in and switch to more sustainable production methods and technologies in order to decrease the carbon emissions they generate, thereby paying lower sums of carbon tax which will allow them to benefit from lower costs of production and, therefore, enable them to be more competitive by decreasing their prices. This can be showcased by a rightward shift of the MSC curve as the external costs involved in the production of these goods decreases owing to the use of less polluting resources. This increased investment in decarbonisation efforts will help aid the global transition to net zero and directly work towards achieving UN Sustainable Development Goals 12 and 13, “Responsible consumption and production” and “Climate action”.

An unintended effect the CBAM will have on domestic firms is rising costs of imported raw materials whose extraction/production involves carbon emissions. This will result in increased costs of production for domestic firms and, therefore, cause cost-push inflation which will decrease the purchasing power of consumers and make various carbon-products less affordable as the market equilibrium price will increase. This can be showcased by a leftward shift of the supply curve of domestic products.

Impact on consumers

Currently, consumers in the UK benefit from increased choice as a large number of firms, both domestic and foreign, sell their products to them. Additionally, the lower prices offered by foreign firms, who benefit from lower rates of carbon tax, increases the purchasing power of consumers and, therefore, the number of goods and services they can purchase with their income. However, the implementation of the CBAM will make foreign imports more expensive and result in fewer foreign suppliers as some of them might generate too much carbon emissions, to the point at which supplying to the UK will only result in losses owing to the levies imposed. This will both decrease consumers’ purchasing power and decrease the choices they have when purchasing various products.

Moreover, as previously mentioned this will have the effect of also causing cost-push inflation. As some goods and services will become unaffordable, consumers will suffer from lower standards of living. In order to maintain their real income, workers in the economy might push for wage raises which could result in a wage spiral, further increasing the rate of cost-push inflation. Additionally, the carbon tax will be regressive as the increase in prices of goods and services will disproportionately affect lower income consumers as they will have to pay a larger proportion of their income for the same goods. This is considered inequitable and will worsen the income inequality in the UK which currently stands at 33.1% as of FYE 2023. On the other hand a positive effect this will have is the fact that consumers spending and consumption patterns will change to be more focused on low-carbon alternatives as they are cheaper, causing an increase in demand for these goods.

In order to mitigate the negative impacts the higher market prices have on consumers as a result of the CBAM, the government could subsidise domestic firms who utilise sustainable production practices and technologies in order to decrease their costs of production, thereby encouraging and enabling them to increase supply at lower prices for consumers. Additionally, this will also have the effect of incentivising other firms to make a similar transition to less polluting production in order to benefit from these subsidies. The regressive nature of the carbon tax can be mitigated by the government through reductions in the rate of income taxes in tandem with the imposition of the carbon taxes, similar to British Columbia’s revenue-neutral carbon tax.

Impact on the government budget

In 2023 the UK imported EUR 1.077 trillion worth of goods and services. Although this number will decrease post the implementation of the CBAM owing to the increase in import prices it will bring about, this number will still remain pretty high from the start of 2027 onwards. The carbon taxes levied on the imports of products whose production involves carbon emissions will significantly boost government tax revenue from the EUR 63.16 billion generated in 2023 from carbon taxes. This increase in planned revenues can be used to finance the policies and bills that need to be passed in order to comply with UK’s fifth carbon budget which covers the 2028-2032 period and is aimed at decreasing carbon emissions from the 1990 level by 57%, which equates to 1,725 million tonnes of CO2 equivalent emissions, as part of its Nationally Determined Contribution towards the Paris Agreement.

Additionally, the government can use this increased tax revenue to finance the expansion of Great British Energy in order to increase the accessibility and utilisation of renewable sources of energy in order to decrease the UK’s reliance on fossil fuels, which generate carbon emissions (GHGs), and thereby work towards its goal of reaching net zero by 2030.

Moreover, the government could utilise the tax revenue to provide subsidies to GE Vernova, bp and Technip to finance their EUR 4.81 billion venture Net Zero Teesside which involves the creation of a natural gas-fired power plant with integrated carbon capture. This venture is vital to the UK’s goal of achieving net zero by 2050 and, therefore, will be in the government’s best interests to pursue this course of action.

Issues with the implementation timetable

The EU plans on implementing a similar mechanism in 2026, a year earlier than when the UK plans on doing so. Multiple organisations and trade bodies in the UK such as UK Steel have expressed concerns about the UK not mirroring the EU implementation timetable. These concerns are justified as there are numerous downsides to this delay in implementation in comparison to the EU. Since, the mechanism will be set in place by member nations of the EU in 2026, the prices of imports in those countries will significantly rise and they will become uncompetitive from then on. Therefore, the one year gap between the UK’s implementation of the CBAM allows all firms globally who generate large amounts of carbon emissions to dump their products in the UK without incurring the high rates of carbon tax they would if they continued to export to EU countries.

Therefore, the dumping of high-carbon goods for an entire year will result in price wars in almost every market for every good or service owing to the skyrocketing new competition. This will lead to many domestic firms being unable to compete with the extremely low prices owing to the limited financial resources they might have and, therefore, they might shut down. This as well as decreased profits and individual firm revenues will cause large numbers of layoffs and redundancies. The UK’s unemployment rate will therefore increase significantly from the current 4.3% as of September, 2024. This increase in unemployment will negatively impact short-term and long-term economic growth and living standards. Additionally, dumped products often aren’t of acceptable quality and their consumption may involve health and safety risks.

Evaluation

The sources used for this article include scholarly articles and government reports on the purpose, design and implementation of the CBAM with detailed real world statistics. I’ve also used research reports published by consulting firms and international organisations such as PwC and OECD for reasoned, data-based insights with empirical evidence attached. Additionally, I’ve utilised articles from reputable and reliable news outlets such as The Guardian for a different, more concise analysis of the mechanism. However, it may include some media bias which could decrease the reliability of the information it presents.

In a longer, more detailed version of this article, increased quantitative and qualitative analysis of various more complicated economic theories, models and concepts will be required. Although most of the data used will still be collected second-hand, interviews with experts in economic policy making in the field of climate change and the environment can be used to gather a more accurate and cohesive understanding of the answer to the research question.

Conclusion

The UK plans on implementing the CBAM in 2027 to prevent ‘carbon leakage’, support domestic firms and incentivise global decarbonisation efforts. Imposing carbon taxes on imports, the mechanism allows UK firms to compete more effectively, decrease negative production externalities, and encourage sustainable development globally, which is consistent with the UK’s net zero target for 2050 and the UN’s SDGs 12 and 13.

However, there are challenges in the form of cost-push inflation, decreased consumer purchasing power and regressive impacts on lower-income households that would need to be mitigated through subsidies and changes in income tax policies. The one-year delay in comparison to the EU’s implementation opens the door to dumping of high-carbon goods by international firms worldwide, which will only negatively impact domestic industries and drive up unemployment.

Additionally, the CBAM promises significant government revenue for climate programs, its success will depend on careful execution, supportive policies, and alignment with broader economic objectives. If implemented effectively, the CBAM could catalyse the global transition to more sustainable production and, therefore, net zero emissions.

– By Sanjay Ramakrishnan R

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