Carbon border adjustment mechanisms

Effective carbon pricing is crucial to decarbonisation, but cannot be achieved without effective anti-carbon leakage policies in place. The Government’s current approach to addressing the risks of carbon leakage, including free allocation of Emissions Trading Scheme (ETS) allowances, is insufficient on its own to incentivise industrial decarbonisation effectively. A clear policy response is needed to address this; we consider that a UK carbon border approach is the most appropriate response.

Multilateral and global approaches to carbon pricing represent the most appropriate way to support global decarbonisation. Since the process to negotiate and agree these is lengthy, they cannot provide the urgent action necessary in the short term. Pursuing a unilateral carbon border approach does not preclude continuing to push for global action; rather, unilateral action may support these efforts by encouraging other jurisdictions to strengthen their own decarbonisation policies and spurring co-operation on multilateral solutions, while delivering the action needed to address emissions in the meantime. It is important that unilateral action is aligned with the UK’s international obligations and commitments.

While net zero policies address the UK’s territorial production emissions, 43% of the UK’s consumption emissions arise from imports. The UK’s principal carbon pricing mechanism, the ETS, applies to domestic production, but no carbon price is currently applied to imports of the same products. A CBAM could address this, enabling a carbon price to be applied to consumption emissions arising from both domestic production and imports of products covered by the ETS. In particular, CBAM has the potential to help build support for green policies in historic manufacturing areas where opportunities for a renaissance in low-carbon UK-based manufacturing are likely to be greatest.

Alongside CBAM, the UK’s carbon border approach needs to comprise a set of complementary policies, including product standards, to tackle consumption emissions beyond those covered by explicit carbon pricing, and support decarbonisation across the economy. Careful design is needed to ensure the carbon border approach is successful in achieving its environmental objectives while mitigating the risks of adverse impacts.

We recommend that the Government commence work immediately on developing a comprehensive UK carbon border approach, in order that this might be implemented during the 2020s. We recommend that this include a CBAM as part of a co-ordinated set of policies including product standards, alongside work to build consensus with trading partners, industry and consumers on the need for this policy response. The Chancellor of the Exchequer should provide an initial report to the House on progress on a CBAM not later than Budget 2023. We recommend that the Government build on its COP26 climate leadership internationally through pursuing long-term multilateral solutions alongside this ambitious UK approach. (Paragraph 34) Greening imports: a UK carbon border approach 47 Geopolitical considerations

The UK is an open, trading economy, and trade can be a powerful lever to drive environmental outcomes. Careful design, alongside inclusive engagement with trading partners, is needed to ensure that any CBAM and wider carbon border approach are aligned with the UK’s international obligations and commitments, including the principle of common but differentiated responsibilities and respective capabilities in respect of low- and middle-income country trading partners, as set out in the Paris Agreement and Glasgow Climate Pact.

As the UK continues to negotiate its own trade agreements following exit from the European Union, there is an opportunity to align trade policy with the UK’s role as a leader in climate change action; further analysis is required to understand how the UK’s carbon border approach might interact with these negotiations.

Our recommendations to Government on the design of the carbon border approach are as follows: a) to ensure, from the outset, that the carbon border approach is designed to adhere to the principles of common but differentiated responsibilities and respective capabilities set out in the Paris Agreement and Glasgow Climate Pact in respect of low- and middle-income country trading partners. This might be through the CBAM design itself, or through a complementary policy in parallel to the CBAM; b) to ensure that the UK CBAM is designed in accordance with WTO rules; c) to establish forums to enable inclusive engagement with trading partners on the design and implementation of the carbon border approach. These should include forums specifically for engagement with low- and middle-income country trading partners; and d) to conduct analysis to understand how the carbon border approach might interact with free trade agreements.

In our view, the Government’s commitment to work with stakeholders to understand the potential impact of an EU CBAM on UK industry and ensure no unreasonable barriers to trade is welcome. Given the potential UK impacts, clarity is needed on how the Government intends to do this, and urgently, given that the proposed EU CBAM is intended to be fully in effect from the mid-2020s.

It is at present unclear how the proposed EU CBAM might impact the UK, particularly Northern Ireland, where electricity generators are currently under the scope of the EU’s ETS. We understand that this is a dynamic discussion which depends on wider continuing negotiation between the UK and EU, as well as developments in the proposed EU CBAM. It is nevertheless important that UK stakeholders are kept informed.

The Government has committed to ensuring businesses do not face any unreasonable barriers to trade; further detail would be welcome on how it plans to work with stakeholders in the EU and UK to achieve this. Given that electricity generators in 48 Greening imports: a UK carbon border approach Northern Ireland are under the scope of the EU ETS, it will be important to work with stakeholders to understand how this might interact with the UK CBAM and wider carbon border approach.

The UK and EU have agreed to consider linking the UK and EU ETS systems, which would exempt UK producers from the EU’s CBAM (and vice versa), simplifying administrative processes for UK-EU trade; as linking can be a lengthy process, it is important for exploratory work to commence on this now. This may also be a welcome sign that there is a political recognition on both sides that linkage of CBAM schemes in due course could be achievable.

We recommend that the Government: a) Set out in its response to this report: b) how it intends to work with stakeholders in the EU and UK to understand how the proposed EU CBAM, would affect the UK, including in Northern Ireland; and c) how it intends to ensure open and transparent communication on progress on its actions to ensure businesses do not face any unreasonable barriers to trade, to provide greater clarity to UK industry; d) Engage directly with affected stakeholders in Northern Ireland and the EU during the design stage of any UK carbon border approach, and e) Before the end of 2022, launch a consultation on measures to link the UK and EU emissions trading schemes. (Paragraph 72) Further design considerations

As the report of the Treasury’s Net Zero Review notes, there can be no one-size-fits- all mechanism to address carbon leakage risks. The UK’s carbon border approach needs to comprise a set of complementary policies, designed to drive industrial decarbonisation in the UK and globally. A CBAM will be an important lever to support decarbonisation in key foundational sectors; complementary mechanisms such as standards, regulation and support for low-carbon technologies are also required to drive this change across the economy.

To navigate the design options available and ensure a policy response that is effective in achieving its objectives, it is important that the Government articulate from the outset the objectives of the UK’s carbon border approach, so that the design is led by these, and understand the potential impacts to industries across all sectors of the economy and at all stages of the value chain, to ensure effective policy responses and implementation. This should include assessment of the impact on SMEs.

We recommend that the Government: a) clearly define its objectives for any carbon border approach at the outset, and ensure the choice of policy options and design consideration at each stage is led by these objectives. These should encompass the need to drive decarbonisation across Greening imports: a UK carbon border approach 49 the economy to address climate change, whilst ensuring low- and middle-income countries, vulnerable households and wider environmental goals, such as nature, are not adversely impacted; b) During the design stage of the carbon border approach, engage with industrial stakeholders and conduct impact analysis across sectors, so as to understand the most effective policy instruments and implementation timescales for each sector and ensure industries at all stages of the value chain, including end users, are involved in the design of the carbon border approach. This engagement should be conducted through specific forums which bring stakeholders, including industry, academics, the environmental community and consumer groups, together alongside representatives from all relevant Government departments. c) Carry out a specific assessment of the impact on SMEs during the design phase of the carbon border approach, and set up a forum for engagement with SMEs. The UK’s carbon border approach should also include a plan for communicating changes with SMEs and should ensure that ease of administration is built into design.

Pricing the carbon element, so low-carbon products become less expensive than high-carbon ones, is a powerful lever to reduce consumption emissions, to support the development of low-carbon products and increase access to such products. Currently, high energy prices and rises in inflation are contributing to stark rises in living costs; it is important that the design of any carbon border approach include a strategy for public engagement to build consensus around the importance of the policy response as a measure to combat climate change, alongside assessments to understand any potential impact on consumers, including vulnerable and low- income households, to ensure any supporting policies which might be required can be incorporated into the approach.

We recommend that the Government, at the design stage: a) Include a strategy to engage with the public in the design of the carbon border approach to develop and maintain public support and keep the public informed of the changes that would occur, the rationale and methodology supporting the changes, and their impact and timescales; and b) Conduct analysis to understand any potential impact on consumers, including vulnerable and low-income households, and ensure the carbon border approach includes any measures needed to address this.

The UK’s carbon border approach needs to be aligned with the Government’s wider environmental policies, and integrated into trade, development and fiscal policy. The context for carbon border measures is not fixed, and CBAM in particular represents a new policy lever. It is important that the UK’s design for a carbon border approach include a strategy for ongoing monitoring of its impact, to ensure its objectives are being achieved. (Paragraph 106) 50 Greening imports: a UK carbon border approach

We recommend that the Government: a) Ensure, through the oversight of both Cabinet Committees on Climate Action, that the UK’s carbon border approach is aligned with existing environmental, trade, development and fiscal policy, through both its design and implementation stages. This should include setting out how the carbon border approach would interact with the tax and customs arrangements in Freeports; and b) During the design stage, establish methods for monitoring and understanding the impacts of the carbon border approach once implemented. This should include mechanisms for periodic consultation with stakeholders, including those in industry, academics, the environmental community and consumer groups. We expect any statement of policy on the UK’s carbon border approach to be presented to Parliament. (Paragraph 107) Greening imports: a UK carbon border approach 51