The EU is serious about decarbonization. Over the next twelve months, Brussels will finalize a massive energy and climate package, “Fit for 55,” that aims to accelerate progress towards net zero carbon emissions over the next decade. It is the EU’s most ambitious green effort yet. Though it will apply only within the bloc, its consequences will be felt globally — and, of the world’s major economies, China has the most to lose. 

At the heart of the proposals is carbon pricing. The idea is to internalize the cost of pollution by forcing producers to pay for each ton of CO₂ they emit. The EU has long had a carbon pricing mechanism in place — the Emissions Trading System (ETS). ETS allocates a fixed number of pollution permits to certain industries and allows firms to trade them at a market-determined price. Strengthening the ETS mechanism further is a cornerstone of “Fit for 55.” 

However, ETS currently provides a much weaker incentive for firms to decarbonize than it potentially could. The reason is simple. Brussels is cognizant that imposing a carbon price on EU producers allows their foreign competitors, who do not face pollution costs, to undercut them. This means that, without a correcting mechanism, EU firms in industries subject to a carbon price could simply offshore carbon-intensive production to jurisdictions without a carbon price (“carbon leakage”). To skirt the problem, the EU gives firms in industries at risk of carbon leakage — i.e., makers of physical goods with large, fixed production plants — a certain number of free ETS emissions credits per year. Yet such “free allocation” lets firms off the hook in terms of their decarbonization efforts, beyond a certain extent. 

To resolve the problems associated with free allocation, “Fit for 55” contains a proposal for a Carbon Border Adjustment Mechanism (CBAM). This would levy a tax on imports of goods in sectors that face an EU carbon price, equivalent to the prevailing level. It would mean that, if a producer were to relocate production plants abroad, it would still face a carbon price upon reimporting its goods into the EU. It would also mean that the EU’s external trade partners would face incentives to reduce their carbon intensity, if they want to preserve access to this major export market.

Brussels wants to phase in CBAM gradually from 2026 to 2035, applying it first to iron and steel, aluminum, fertilizers, cement, and electricity. CBAM will phase in as free allocations to European industry phase out, a necessary step for the EU to stay WTO-compliant. Importers would be able to deduct carbon taxes paid elsewhere from their CBAM liability. This incentivizes countries that sell finished goods to Europe to create their own CBAM equivalents or carbon-pricing schemes. 

An EU CBAM is bad news for large Asian countries that export to the EU. Because Asian industry is much more emissions-intensive than Europe’s, these countries have limited means to retaliate. China is directly in CBAM’s firing line. It is heavily exposed to CBAM’s targets, and as is well-known, China’s energy mix is very dirty, with almost 60 percent coming from coal, far higher than the EU (14 percent) and the global average (27 percent). True, China has made decarbonization pledges too: it aims to peak carbon emissions before 2030. Yet the country has a long way to go. China’s CO₂ price is multiples below the EU’s, which is today hovering around €80 per ton.

According to a recent study by He Jianwu, a research fellow in the State Council’s Development Research Center in Beijing, a full and comprehensive EU CBAM could reduce Chinese GDP by up to 0.64 percent, costing 2.3 million manufacturing jobs in the short-run. Under such a scenario, export costs would rise by an average of 3 percent and exports of manufactured goods to the EU could fall by around 13 percent. 

He argues that a CBAM would make China’s labour-intensive manufacturing industries such as textiles even less competitive than those of other developing countries (i.e., Thailand, Vietnam), given China’s higher carbon emissions intensity. Chinese exports of labour-intensive manufactured products could decline by 10–20 percent. Chinese electronics companies would also be hit. They are two to seven times more carbon-intensive than those of Europe and the U.S., and their exports to the EU could decrease by 8 to 15 percent, He estimates.

An EU CBAM is good news for the world, but terrible news for China. It will force Beijing to double down on its efforts to re-engineer its industrial production for a world in which carbon-intensive goods face structurally weaker international demand. 

True enough, the EU is unlikely to introduce a full and comprehensive CBAM on complex imports such as textiles and electronics, at least over the next decade. In fact, the products which “Fit for 55” covers may even be reduced over the course of negotiations between EU leaders. Yet, unsurprisingly, even a very limited carbon border tax is extremely concerning for the Chinese government. Beijing has claimed that CBAM violates “WTO principles,” though China, a notorious and blatant user of trade sanctions for political ends, is not likely to win a WTO challenge. 

Instead, Chinese producers are more likely to try “resource reshuffling,” exporting cleaner products to the EU while redirecting their carbon-intensive production to the rest of the world. Still, the risk of CBAM proliferation poses a major risk to this strategy. In theory, as Yale economist William Nordhaus and others have argued, if even one or two major economies adopt CBAM, they could force the entire global economy to adopt a de facto carbon price. Chinese producers of carbon-intensive goods could thus very quickly find themselves out of international customers altogether. The fear of a global “Brussels effect” on carbon tariffs surely strikes deep in Beijing. 

In the medium-term, the threat of a European CBAM will likely force Beijing to ramp up its national ETS and energy efficiency measures more aggressively than expected. Chinese manufacturers will take a hit and will export the higher prices to the rest of the world. Alternative paths of action — such as seeking a “CBAM truce” with the EU — will be far harder. 

Although the EU wants to rekindle its diplomatic dialogue with China after this year’s sanctions spat, the bloc still has a serious case of “promise fatigue” when it comes to dealing with Beijing on climate pledges. Most recently, China’s successful effort to tamper the COP26 communique on coal was not well received in Brussels. With premises like these, trust and goodwill is very hard to establish. 

By contrast, U.S.–EU climate cooperation is gaining ground. Recently, both sides have floated the idea of a “carbon club” on steel, which would see Brussels and Washington agree on common carbon standards for imports of the good. The scope for further U.S.–EU alignment is even deeper. Superficially, a U.S. CBAM looks like a political non-starter. In reality, there is scope for it to get bipartisan support: from Democrats who care about decarbonization, and from Republicans who view it as a geopolitical instrument against China. This year, GOP Senators Mitt Romney, Susan Collins, Lisa Murkowski, and Mike Braun formed a group to explore the issue. Granted, it will probably not happen before the mid-term elections in 2022, or even beyond then if inflation stays high. Yet with U.S.-China relations at historic lows, threatening a CBAM is also Biden’s last remaining lever to motivate China to cut emissions. 

An EU CBAM is good news for the world, but terrible news for China. It will force Beijing to double down on its efforts to re-engineer its industrial production for a world in which carbon-intensive goods face structurally weaker international demand. As the country is still heavily reliant on coal, this will be a Herculean task for the Beijing leadership. And as China attempts to engineer other major economic and social transitions — from real estate investment to advanced technologies, from growth-at-all-costs to common prosperity — the task will be all the harder, and CBAM all the more of a headache. 

---