Inflation Reduction Act, CBAM, and Trade Protectionism?

The Inflation Reduction Act (IRA), signed into law by President Biden on August 16, 2022, is a significant piece of legislation aimed at addressing various economic and environmental issues in the United States.

Given the comprehensive approach of the Biden administration, driven by the Inflation Reduction Act (IRA), the United States is poised to expand its product and sectoral coverage and the scope of emissions. For instance, the IRA provides funding to the EPA for supporting innovation in developing climate-friendly construction materials and measuring emissions covering the life cycle of construction materials.

As the world’s largest crude oil producer and liquefied natural gas exporter and the second-largest emitter of greenhouse gases (GHGs), the United States bears a substantial responsibility to address global carbon dioxide (CO2) emissions.

A future U.S. Carbon Border Adjustment Mechanism (CBAM) could serve as a vital instrument in the nation’s transition toward a net-zero economy, encouraging domestic carbon footprint reduction and driving trading partners to adopt cleaner practices.

For both EU and US, a Carbon Border Adjustment Mechanism (CBAM) is a critical policy instrument that levels the playing field for domestic industries by imposing a fee on imported goods commensurate with the GHG emissions associated with their production. This fee is inextricably linked to an explicit carbon price, such as an emissions trading system (ETS) or carbon tax. The European Union’s bold CBAM underscores the urgency of addressing carbon leakage and catalyzing a global transition toward clean industrial processes. Under this pioneering mechanism, imports of emissions-intensive products like cement, iron and steel, aluminum, fertilizers, electricity, and hydrogen will be subject to a carbon price aligned with the European Union’s Emissions Trading Systems (ETS).

The Cost of Protectionism?

Donald Trump has promised to institute tariffs of 10 percent to 20 percent on almost all imports into the United States and a 60 percent tariff on all Chinese goods. Among Democrats, the anti-trade fervour is more muted, but hardly absent. Far from fully reversing the previous Trump tariffs on steel and aluminium, the Biden administration has recently added to them. And while its signature Inflation Reduction Act has laudable goals, it is laden with requirements penalising the buying of goods from abroad, even if they are less expensive and better than the domestic equivalent. Around the world, trade restrictions have risen explosively, with the number of protectionist measures imposed in 2022 more than 10 times as large as those imposed a decade earlier.

The IRA, while some may argue is making US turn increasingly protectionist. On both sides of the Atlantic, and both sides of the aisle in Congress, the idea has gained currency that trade with less affluent countries costs jobs and lowers wages. This kind of zero-sum thinking would sharply curtail development opportunities for countries with living standards far below those in the West.

The IRA’s subsidies and incentives for domestic clean energy production and advanced technologies could lead to trade imbalances and technological gap between developed and developing nations.

Through its powerful link to economic growth, international trade has long been a scourge of global poverty. Developing countries that liberalised their trade regimes and integrated with the world economy — call them “globalisers” — have vastly outperformed the non-globalisers over the past four decades. The globalisers have also grown much faster than rich countries, allowing them to gradually reduce the still yawning per capita income gap with the West.

China and India have been among the world’s fastest-growing economies since the 1980s, together lifting an astonishing 1.1 billion people out of absolute poverty.

U.S. Carbon Border Adjustment Mechanism (CBAM)

The introduction of a carbon border adjustment mechanism (CBAM) in the United States presents an intricate policy challenge at the intersection of climate action and international trade. With countries around the world integrating climate considerations into their trade policies, the United States is under growing pressure to develop and implement its own CBAM. This policy tool, already adopted by the European Union, is geared toward levelling the playing field for domestic industries while promoting global climate action and accountability. A future U.S. CBAM could serve as a vital instrument in the nation’s transition toward a net-zero economy, encouraging domestic carbon footprint reduction and driving trading partners to adopt cleaner practices.

However, in March 2024, the U.S. House of Representatives passed a resolution expressing opposition to a federal carbon tax, citing its potential detrimental impact on the U.S. economy. The resolution raised concerns about a possible increase in goods and energy prices, which could place an increased burden on U.S. households and industries. It also highlighted the potential decline in the country’s global trade competitiveness. Despite this stance, legislative proposals advocating for both implicit and explicit carbon pricing continue to emerge.

GHG Emissions Measurement, Reporting, and Verification Systems:

One of the key technological considerations for a CBAM is the adoption of a robust carbon accounting methodology. The measurement and accounting for carbon emissions is a complex and multifaceted process. With over 100 accounting methods currently in use, each employing different factors for emissions measurement, it becomes essential to establish consistent and standardized methodologies. In the United States, the EPA requires around 8,000 facilities to report their annual GHG emissions from different processes, including stationary combustion and electricity generation under the Greenhouse Gas Reporting Program, while multiple states have issued their own reporting requirements on carbon accounting, measurement, and disclosure.

The Greenhouse Gas Protocol, developed by the World Resources Institute, has garnered widespread attention by offering a comprehensive framework for categorizing emissions as Scope 1 (directly related to production), Scope 2 (indirect emissions from energy consumption), and Scope 3 (indirect emissions throughout the supply chain) and providing a structured approach for emissions accounting.

Notably, the state of California took proactive steps in October 2023 by enacting the Climate Corporate Data Accountability Act and the Climate-Related Financial Risk Act, which mandate U.S. public and private companies to report Scope 1 and 2 emissions from 2026 and Scope 3 emissions in 2027.

Integration with Existing Trade and Customs Infrastructure:

The harmonized system for determining taxes and tariffs is a cornerstone of international trade, utilized by over 200 countries and covering more than 5,000 commodity groups traded globally. This system can play a pivotal role in assessing the GHG intensity of traded goods. However, a critical consideration arises when the product-level accounting and reporting standards do not align with the harmonized system. This misalignment poses a significant risk of inaccurate assessment of GHG intensity, potentially complicating border adjustment, rebates, and credits, and ultimately leading to suboptimal realization of tax revenue from a CBAM. Therefore, ensuring alignment between product-level accounting and reporting methods and the harmonized system is essential for accurate assessment of GHG intensity of traded goods and effective implementation of a CBAM.

Automation, Digital Platforms, and Artificial Intelligence:

The adoption of automation, digital platforms, and artificial intelligence (AI) represents the next phase in ensuring efficient and accurate compliance with CBAM regulations and standards. Importers and foreign manufacturers will need to make strategic investments in state-of-the-art information technology systems to ensure the successful implementation of a U.S. CBAM. These systems will serve as the backbone for collecting and disseminating crucial data related to carbon emissions, as well as tracking the product life cycle to estimate GHG intensity. The BCG survey revealed that 86 percent of respondents manually recorded emissions data on spreadsheets, highlighting the slow adoption of automated information processing. Manual recordkeeping and reporting of GHG emissions present inherent risks of data manipulation and omission, potentially leading to compliance issues and compromising climate change action.

Capacity Building and Technology Transfer to Developing Countries:

In the absence of adequate capacity building and technology transfers to trading partners in developing countries, the fairness of a CBAM will be called into question. This mechanism is fundamentally designed to foster equitable competition between domestic and foreign manufacturers while advancing climate change objectives. Imposing penalties on developing countries due to their limited investments in clean technologies could potentially divert them away from U.S. or EU markets, leading to the persistence of carbon leakage in other parts of the world.

Impact on Trade Flows:

The implementation of a CBAM has the potential to significantly influence trade patterns and flows. In the case of the EU CBAM, the gradual phaseout of free allowances will increase the cost for EU manufacturers and may compromise their export competitiveness abroad as a result. Likewise, major EU trading partners will attempt to circumvent the higher cost of EU border adjustment by creating a “two-tier system,” with clean goods routed to the European Union and goods with higher carbon content sent to countries with lax climate regulations, thereby altering the region’s inbound trade flows. For instance, one study examined the impact of the EU CBAM on Chinese exports to the region using different scenarios related to the measurement of carbon emissions—direct or embedded—at different carbon prices ($50, $80, and $120 per ton of CO2) and found that the covered carbon-intensive sectors will take a significant hit, seeing declines in both export volume and traded value. Another study suggested that the EU CBAM will result in a 10 percent decline in both imports and exports in covered sectors.

Conclusion

Being connected to supply chains helps local businesses prosper. Not only do they get access to cutting-edge technology, but they also develop valuable long-term relationships and learn how to navigate international markets. Their demand for inputs and raw materials helps create a vibrant local ecosystem. The World Bank estimates that a 1 percent increase in participation in international supply chains is accompanied by a more than 1 percent increase in per capita income.

Although the IRA aims to reduce global greenhouse gas emissions, the focus on domestic production might lead to environmental degradation in developing countries if they increase their own fossil fuel production to compensate for reduced exports to the U.S.

The introduction and implementation of a CBAM in the United States would represent a significant step toward addressing the challenges of carbon leakage, maintaining industrial competitiveness, and promoting global climate action. On the international stage, the establishment of a harmonized and globally accepted framework for carbon accounting, emissions measurement, and border adjustments will necessitate extensive negotiations and consensus building among trading partners. This process is expected to be time consuming and challenging due to nations’ diverse interests and priorities. It is crucial to acknowledge that the successful implementation of the CBAM hinges on international cooperation and coordination.