Innovating the European Border: an Impact assesment of a transformed ETS in the Netherlands

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INNOVATING THE EUROPEAN BORDER

An impact assessment of a transformed ETS in the Netherlands.

Keywords: Environmental policy, EU, Environmental taxation, Emission Trading Scheme, Dutch Steel Sector. Abstract: A special report released in 2018 by the IPCC has warned that there is only twelve years to limit global warming in order to stay below 1.5C of warming. This limit of 1.5C is necessary to avoid catastrophic events and total eradication of certain species and countries (IPCC, 2018). The main instrument of the EU to tackle global warming has been the EU Emission Trading Scheme (ETS). However this instrument has been considered insufficient due to several reasons such as free-riding and carbon leakage outside of the European borders. In the academic field the issue of carbon leakage has been linked with the possible solution of a carbon border tax (CBT), which limits leakage by taxing greenhouse gas externalities from imported and exported products at the European border. This research reviews the challenges of the ETS and whether a CBT can be applied in light of limiting GHGs. Due to space limitations and feasibility the focus is on the Dutch Steel sector.

Britt Stenberg

Master of Arts: European Policy Dr. D.A. Hollanders

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Abbreviations

ETS Emission Trading Scheme

EU European Union

EEX European Energy Exchange

CO2 Carbon Dioxide

CBT Carbon Border Tax

CBTA Carbon Border Tax Adjustment

FDI Foreign Direct Investment

FME Federatie voor de Metaal- en Elektrotechnische

industrie

GDP Gross Domestic product

GHG Green House Gas

ICE ICE Futures Europe

IMF International Monetary Fund

IPCC Intergovernmental Panel on Climate Change

MPP Mandated Participatory Planning

NEA Nederlandse Emissie Autoriteit

NAPs National Allocation Plans

R&D Research and Development

OECD Organisation for Economic Cooperation and

Development

UNEP United Nations Environment Programme

VNMI Vereniging Nederlandse Metallurgische Industrie

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List of tables, figures and boxes

Box 1. Tragedy of the commons versus Prisoner’s dilemma ... - 4 -

Box 2. Illustration of the adjustment ... - 12 -

Box 3. Environmental Policy Instruments ... - 13 -

Figure 1. Outward FDI postiions in oil and gas extraction in 2014 from selected OECD countries, compared with ODA level ... - 16 -

Figure 2. Prisoner's dilemma ... - 22 -

Figure 3. Tax effects of ETS and CBT ... - 28 -

Figure 4. Changes in EU production compared to no-policy scenario ... - 32 -

Figure 5. Changes in price index in the EU compared to no-policy scenario .. - 34 -

Figure 6. Netherlands’ steel exports, top 10 markets in 2017………...- 41

- Figure 7. Netherlands's trade in steel mill products by quarter ... - 46 -

Figure 8. Netherlands’ steel imports, top 10 markets 2017 ... - 51 -

Figure 9. The European Steel Industry Vision... - 51 -

Table 1. PESTLE Template ... - 51 -

Table 2. PESTLE Analysis Scheme ... - 55 -

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Introduction

“The EU steel sector requires level playing field conditions in trade,

environmental and energy policies” -

EuroFer, 2016; 19.

The usual country-by-country approach to tackle Greenhouse gases has become less applicable in environmental policy making due to globalization1_{(Transport &}

Environment and the Trade Justice Movement, 2017). This because globalization has led to a rising number of trade agreements that have reduced trade barriers. Whether these agreements are on Global, European, regional or bilateral scale, the general reduction of barriers has made taxation unpopular and increasingly difficult to tax. This reduction of taxation and administration has also made it more problematic to track and isolate greenhouse gases which restrict the ability to tax them in the first place. The tendency of trade agreements to focus on removing barriers has led to huge unregistered activities and untaxed investments in various sectors, among which energy intensive activities that continue to flow across borders without externalities being considered2_{. This is}

especially problematic for the European Emission Trading Scheme (ETS), where the major challenge according to the European Commission (2018) is to prevent carbon leakage. This carbon leakage results from the behaviour of energy intensive companies trying to avoid taxation costs imposed by the ETS system by using moving their production, goods and capital outside of the EU, using the advantages given by trade agreements.

This relocation sustains the release of Green House Gases (GHG’s) into the air since this is only relocated. Even though several studies have found no significant examples of carbon leakage, due to the low price and generous admittance of free allowances, the general perception is that this behavior will

1_{Defined by the Director general of the WTO, Pascal Lamy as: “Globalization can be defined as a historical} stage of accelerated expansion of market capitalism, like the one experienced in the 19th century with the industrial revolution. It is a fundamental transformation in societies because of the recent technological revolution which has led to a recombining of the economic and social forces on a new territorial dimension” (Lamy, 2006).

2_{Note that Free trade is note the same as free trade agreements, according to Rodrik (2018; 3-8) trade} agreements have shifted towards increasingly including topics such as intellectual property rights, power of companies, vis-à-vis states and labor standards.

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occur more and more. One study found that under current conditions, the carbon leakage rate for the period 2015-2050 will be around 28%, decrease to 25% when the United States undertakes emission reductions and falls to an impressive 3% if China participates as well. This due to China’s market size and the energy intensity of its production (Paroussos et al., 2015).

An interesting case study for this is the Netherlands, a self-declared climate leader with one of the most progressive and highest tax rates (74 euros per ton Carbon Dioxide on energy and fuels of the European Union (Beckmans, 2017). However, the country remains oil-oriented when compared to oil-import and use from its European neighbors. This is important to take into context because if foreign investment and carbon intensive development overseas would be considered, the Dutch emission rates would be over 50 times higher than originally perceived. The claims of the Dutch government that the country is sustainable thus fall apart when taking the GHG emissions from foreign trade and investment into account. Both are crucial to the economy of a trading dependent country (Transport & Environment and the Trade Justice Movement, 2017). Another problem on international scale is the negative effect of environmental taxation inconsistency on competitiveness due to the interruption on market working. This leads to a situation where national governments provide subsidies in order to compete with markets that have less legal boundaries and are able to produce cheaper. So, even though the intention of the environmental taxation may have been good, the capitalist market pressure weakens the functioning of the taxation by creating competitive disadvantages. In that case, the measure that does not promote clean energy incentives but rather answers to market pressure (Beckmans, 2017). This is relevant to keep in mind when proposing adjustments to correct these inefficiencies.

Due to space limitations and feasibility to conduct interviews, only one of the most energy-intensive sectors of the Netherlands is included; the Dutch steel sector. There are several reasons for choosing the steel industry. First of all, it is an energy intensive sector which accounts for 7-10% of the world emissions in which the transport is not included, as should be noted, steel alone accounts for 20% of world sea trade (Mathiesen and Maestad, 2004). Secondly, the sector is highly prone to carbon leakage. Thirdly, the Netherlands is the 6th biggest producer in the European Union (Global steel trade monitor, 2018). Finally, the

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production process is easier to untangle than for example aluminum, which is also prone to carbon leakage and a big producer in the Netherlands. Also, I found the company TATA steel interesting since they operate in the Netherlands and in the UK, which might be traded with as a non EU-country soon.

Academic research has led to a possible solution for carbon leakage and competitive disadvantages; the Carbon Border Tax Adjustment (CBTA). This border adjustment to tax carbon can be implemented in two ways; tax-based or allowance based. The first one works rather simple, just like the excise tax on cigarettes, there is a general tax, like a VAT. Carbon is here directly taxed and this results in a constant incentive for producers and consumers to buy and produce less carbon- and energy intensive products by making renewable energy more attractive and competitive. The second option is allowance-based. This means that the border adjustment does not tax directly, but through allowances. Just like the current system of the EU ETS, companies will have to buy allowances or permits as one could call it, to emit GHG’s. How these taxes exactly work will be explained further in chapter two. Most important is that the objective of both taxes is to internalize the externalities on the environment, which in the case of the EU ETS could decrease the risk for carbon leakage since the tax advantage of producing outside of the EU is eliminated (Transport & Environment and the Trade Justice Movement, 2017). The simple economic understanding of this logic is best described by Joseph Stiglitz, chair of president Clinton’s Council of Economic Advisers (1995-97) and Chief Economist and Senior Vice President of the World Bank; “Not paying the cost of damage to the environment is a subsidy, just as not paying the full costs of workers would be” (Stiglitz, 2006; 2).

Even though this could be seen as a trade barrier in the sense of bringing extra trading costs into account instead of less, proposed border adjustments to include a carbon tax in the EU has been supported. In 2017 the idea was public supported at the World Trade Organization Public Forum (WTO, 2017) by economists like Paul Krugman and IMF managing director Christine Lagarde, who earlier also called carbon pricing the “crown jewel” of efforts to mitigate climate change, as well as support from politicians like the French President Macron who stated that “a border tax […] will […] protect our economic sectors against imports from countries that do not respect the same objectives and decide not to

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engage in this environmental transition” (New York Times, 2016; Transport and Environment, 2017; Simon, 2018).

This support is also seen as a response to the Trump administration’s withdrawal from the Paris Agreement, done officially on the 1st_{of June 2017 to which}

Macron responded with a three-minute-long speech named “Make the planet great again” (Schreurs, 2017). The withdrawal is argued to have led to certain sense of responsibility in the EU and support for further policy-making since it was made clear that the United States would not take responsibility. The reaction of the EU parallels that of 2001 when the Bush administration pulled out of Kyoto protocol and the European Union did not follow, but rather developed the EU ETS system. Today this system is the largest emission reduction system in the world and includes the highest emission reductions targets (Schreurs, 2017).

The methodology for this case study is theoretical research through a PESTLE (Political, Economic, Social, Technological, Legal, and Environmental) impact assessment and a SWOT (Strengths, Weaknesses, Opportunities and Threats) analysis. The reason for choosing a combination of the PESTLE and SWOT assessment is due to the approachable nature of PESTLE since it includes a broad scope of factors, like “government type” in the political section. The reason for choosing to complement this with a SWOT analysis is to give a brief overview of the PESTLE outcome (Zalengera et al., 2014; 347).

The methodology will be a combination of literature review and interviews with the three biggest companies of the Dutch steel sector as well as other relevant political actors that are explained further on in this paper. These face-to-face and telephone interviews are crucial since the aim is to review what the sector perceives versus what other sources claim to be the effect. The literature will provide the comparison of the two and will not only consist of scientific research on the matter but also secondary literature. This combination of sources is crucial to understand what the challenges and views are on the sectoral and Dutch political level and how they relate to scientific support or opposition. My research question will be; what are the perceived effects of the addition of a border tax and how can they be related to the market and political position of the Dutch steel sector?

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This paper starts by laying out the current challenges of the ETS. This section will mainly focus on carbon leakage since this is the biggest argument in favor of a CBT. The first chapter will also explain the practical workings of a CBTA and an adjustment is proposed that could complement the current ETS.

The second chapter proposes a solution, a border adjustment, based on the findings of the first chapter. This proposal complements the current EU ETS system and is used for the case-study application in the fourth chapter.

The third chapter focuses on the theoretical scope of environmental policy and explains why impact assessments are crucial to our understanding of implementing new policies. For this paper, the PESTLE framework is chosen since it offers a broad understanding of the proposed policy change.

The fourth chapter will assess what impact the case study, the Dutch steel sector, perceives from the proposed adjustment and compares this to what literature and other sources claim to be the effect. This is done through the PESTLE impact assessment with a combination of literary research as well as interviews. Concluding, the effect is reviewed through a SWOT (Strengths, Weaknesses, Opportunities and Treats) analysis to determine whether there will be an expected positive or negative outcome.

The overall aim of this paper is not only to contribute to previous research done on the CBTA’s and how this would work at the European Union border, but more importantly to assess how the impact of such a tax is perceived by the Dutch steel sector and comparing this to literature research. So, the purpose is to show what (perceived) impact the policy change will have by placing literature research next to interviews with the Steel sector. The outcome of the research is hopefully relevant to the academic field, but more so as a call to action.

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1. The EU ETS

The European Energy Union is the overarching energy and climate body of the European ETS which globally has been the first and largest cap and trade scheme with over 11.000 companies, accounting for 50% of EU’s total emissions. The system caps an x amount of emission allowances so no more than the maximum amount of emissions can be emitted within the European Union. Most emissions are freely allocated to companies by the EU ETS system. The companies that are included in the EU ETS are energy-intensive producers that use power plants larger than 20MW. Such energy-intensive producers are for example: refineries, steel, aluminum, pulp and paper, cement, glass and ceramic products. For companies that utilize more or less allowances for their production process, there is the option to go physically of online to stock markets and buy or sell allowances.

The system is legally referred to as Directive 2003/87/EC for the first two phases (2005-2012) and was amended twice with Directive 2009/29/EC for the third phase (2012-2020) and Directive 2018/410 for the fourth phase (2021-2030). It started as free allocation but has evolved into auctioning where carbon allowances are financial permits subject to a prize mechanism of demand and supply. The auctioning takes place on two main emission trading exchanges; the EEX (European Energy Exchange) in Leipzig and the ICE (InterContinental Exchange Futures Europe) in London. Important to note is the fact that in 2017 80% of the emissions have been freely allocated but that the amount of free allocated allowances will decrease linearly to 30% until 2026 and to 0% by 2030.

Currently the prize of CO2 is very low due to several reasons that are set out in the next two sections. The main body is the European Commission that decides on the amount of allowances and the rationale of the system. According to the Commission (2014), the aim is to reduce emissions in an effective and efficient way and to achieve the environmental 2030 targets. These targets include a 40% cut in greenhouse gas emissions, 27% of EU energy from renewables and 27% improvement in energy efficiency, all measured from 1990s levels. The ETS

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offers loopholes in order to maintain competitiveness by giving free allowances to certain sectors and countries (Jensen, 2009; DG CLIMA 2016; Chaton et al. 2017).

The 450 companies in the Netherlands that are included in the EU ETS receive a monitoring protocol which helps them to calculate their annual emissions. This is annually reported to the Dutch Emissions Authority (NEa) before April first and is used to set up a proposal to the European Union. This proposal states how many emissions the Netherlands should receive from the European Union and which sectors should receive free emissions in order to protect their competitiveness. The European commission (2018) states that free emissions avoid high costs which ensure a competitive position and consequently prevents carbon leakage. This amount is usually concluded by a combination of data given by Dutch companies as well as the carbon leakage list from the European Union (NEa, 2018).

1.1 Main issue

Nonetheless, the system has some shortcomings. The first, and for this research the most relevant problem, is the issue of Carbon leakage, which is defined by the International Panel on Climate Change (IPCC, 2018; 12) as;

“The increase in CO2 emissions outside the countries taking domestic mitigation action divided by the reduction in the emissions of these countries”

Research done in 2011 showed that in the period from 1990-2008, one third of GHG reductions in developed countries are due to outsourcing of energy intensive industries towards developing countries or i.e. carbon leakage (Peters, G. et al., 2011). The problem of carbon leakage is confirmed by the EU and responded with a carbon leakage list which assessed the risk of carbon leakage for various sectors. The first list was adopted in 2013 and the second list was adopted in 2014 and applied for the years 2014 to 2019. More on this in 1.1.2 (DG Clima, 2016).

The problem of outsourcing is mainly a problem of specific sectors, which makes it more common not to view the amount of carbon leakage per country but

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rather per sector. The reason for this is that environmental policy affects certain sectors more than others, which increases the ratio of emissions and reduces environmental effectiveness (Reinaud, 2008). A special report by the Centre for European Policy Studies (2013) supports this and states that carbon leakage is caused by asymmetrical climate policies, meaning that one jurisdiction imposes a price for carbon while another jurisdiction has no, or less stringent, climate policies and/or prices.

The idea of asymmetrical climate policies is not accidental and originates from the political momentum when the Kyoto protocol was written. When Kyoto was signed, the principle of Common But Differentiated Responsibilities (CBDR) weighed heavily, meaning that developed countries were burdened most with the responsibility of reducing emissions. In the EU this CBDR principle led to the development of the ETS. Some articles suggest that this caused asymmetric relations and consequently carbon leakage since relocation or FDI became more profitable (Aicheley and Felbermayr, 2011; CEPS, 2013). This phenomenon has been described by Sinn (2008) as the Green Paradox, a situation where a policy that is designed to reduce emissions leads to an increase of emissions instead. Now one could say that the EU ETS was made with good intentions and rather other actors should be accountable. However, this research is based on the idea that the system does not actively tackle these asymmetric relations and thus is accountable by association.

Carbon leakage has been cited as an example of free riding, which happens when individuals have no incentive to pay for their own consumption of a good, they will take a free ride on anyone who does pay; a problem with goods that are non-excludable. For example; public parking spots, sewage system, scientific research etc. (Krugman, 2010; 280). In the ETS this is the case with excess global emissions but production shifting anyways to a place where they do not have to pay for polluting and thus taking a free ride. Essentially climate change and trade policy clash because countries differ in their commitments to reduce greenhouse gas emissions (Jensen, 2009).

Additionally, the ETS has also been cited as an example of both market failure and government failure (Andrew, 2008). Market failure is present when not all parties are better off. In this case when firms or other actors do not pay the full cost of their production when relocation. Here the EU ETS fails to prevent carbon

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leakage. This imposes significant costs from externalities like pollution on society in general. Government failure here is governmental intervention of the EU to correct a market failure as described above, that creates inefficiencies. So, trying to tackle “European” greenhouse gases but not preventing these companies and thus these gases from relocating, thus not tackling the GHG’s efficiently and misallocating resources (Andrew, 2008).

This has inexplicitly been mentioned by NASA and climate scientist James Hansen (2010), whom expressed severe opposition against the cap-and-trade system. He expresses that the cap-and-trade system does not incentivize acts of individual virtue to contribute to social goals but rather is a “path of corporate greed” which is not stopped by governmental action (2010; paragraph 1). Even if someone buys a hybrid car, all that happens is that that person frees up emissions for someone else to produce, an effect of the above-mentioned carbon leakage.

The pessimism over the efficiency of markets is contrary to more regular belief of the, as Krugman (2010; paragraph 16) calls it; “almost mystical confidence in the effectiveness of market incentives”. He views this as a technologically advanced capitalist system that can overcome limitations of supply, such as oil. A cap and trade system would be perceived as a limited form of supply; however, the “mystical” belief in dynamism of the market is not present in this situation. The reason for this is that government intervention often leads to a sense of aversion from the public, which negatively effects objectivity when looking at the economic functioning. For example, in the United States when the National Republican Congressional Committee, issued multiple press releases specifically citing a study as the basis for a claim that cap and trade would cost $3,100 per household. This led to opposition to the system and political paralysis to move forward with it, despite repeated attempts by the study’s authors to get out the word that the actual number was only about a quarter as much (Krugman, 2010). This shows the opposition of actors with market power that steers the government’s direction. The government is most likely to follow the course to avoid great opposition and loses leverage, e.g. policy instruments, over the actors with market power. This ultimately leads to a weak government that is unable to act efficiently and can contribute to inefficient policies where resources are misallocated, e.g. government failure.

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If we look at our case study, the Netherlands, the country is like the reversed National Republican Congressional Committee, claiming to be a climate leader but ignoring the emissions from foreign energy-intensive activities (Beckmans, 2017). When looking at Foreign Direct Investment (FDI) as an example, the negative effect of the ETS system can be recognized in figure 1. If this FDI would be accounted for, the Netherlands their emissions would rise to a number between 6.7 and 9.1 billion tons, almost fifty times more than the annual emissions as measured in 2014 (Transport & Environment and the Trade Justice Movement, 2017). The high rate of FDI here causes such externalities since the ETS system leaves a market-loophole, leading to a free-riding and a tragedy of the commons situation. This concept will be explained further down.

Figure 1. Outward FDI positions in oil and gas extraction in 2014 from selected OECD

countries, compared with ODA level.

Source: Transport & Environment and the Trade Justice Movement (2017).

1.1.1 Other issues

Another issue besides carbon leakage has been legal and economic uncertainty. Even though this is since phase 3, a problem of the past, it is still vital to show the structure and forming of the EU ETS. In 2004 (phase 1 of the ETS) and in 2006 (phase 2) countries had to issue how much emissions they would be needing, called their National Allocation Plans (NAPs) which was followed by approval or refusal from the Commission. Especially the second phase was

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problematic since the cap was significantly reduced and the Commission refusal was challenged by many Member States. Evidence by Entracte (2012; 2) has been found of substantial non-compliance to the system: “between 2005 and 2012, there were 4,496 instances of non-compliance among installation-years, accounting for 5.2% of total installation-years and 3.6% of overall emissions”. However, most of the uproar presented itself in court. Most applications from Member States to the court were to annul the refusal of NAPs by the Commission. This is considered as a property-rule remedy and caused strong disruptions in the expected amount of allowances. For example, when the court decided in favor of the Member State, allowances would be added to the country its reserve, which led to a price drop and create market uncertainty. In the case of Poland vs. Commission and Estonia vs. Commission, the court decided in favor to which the commission appealed. The court’s decision and the appeal both led to a state of legal uncertainty which subjected the price of allowances to speculation and uncertainty. This was made visible by a price decline of 2.9% rights after the court’s decision. This since the market reacted to a hypothetical rise of 4.2% in allowances (and 8.4% if other cases were also decided in favor of the Member States) which were not even in the market yet. The Netherlands responded by setting a certain amount of allowances aside, just in case of successful claims by individual installations. (Dari-Mattiacci & Zeben, 2010; Minister for Economic Affairs and the State Secretary for Housing, Spatial Planning and the Environment, 2006; European Commission, N.D.). After these issues the NAPs were replaced in 2013 with an EU wide cap, which led to the next issue. The EU wide cap thus replaced NAPs and made for a more flexible design, companies could buy and sell allowances as they please with no national restrictions.

The second issue is the result of this, where first the legal uncertainty led to economic uncertainty, here the inherent flexibility of the market design has also created uncertainty. The EU wide cap its flexibility works as a disadvantage by subjecting itself to companies auctioning their free allowances off for “windfall profit”. It has been estimated that 65% of the companies received 7% more

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allowances than they needed.3_{This has led} _{to speculation, instability and unfair}

competition (Chaton et al. 2017). However, a positive effect of this profit has been the fact that many energy intensive companies, such as the cement industry whom profited with an estimated 3.5 billion, would have been worse off in the 2008 crisis if it hadn’t been for these extra allowances (Branger, 2014). The main reason for this is that the system has too little financial regulation, implementation and impact is weak because companies are auctioning or saving their emissions (Hinterman et al., 2016; Chaton et al. 2017). Due to these failures the system has been described in the media as; Climate Casino.

Climate Camp protestors occupy the entrance to the European Climate Exchange in London on August 27, 2009. Source: The Guardian (2009).

As Hintermann et al., (2016) stated; “We cannot say with any degree of confidence whether the CO2 price is “right” ”. This was meant in the sense that it reflects marginal abatement costs, or whether there is a price wedge caused by transaction costs, price manipulation, or other sources of inefficiency. It is proven that the only measurable effect for the EU to directly impact the price effect is to restrict the allowances supply (Chaton et al. 2017).

3_{An unexpected rise in income due to sudden external factors like winning the lottery, a shortage of supply} (Economic times, n.d.). Or in this case companies with large reserve emissions that they were able to sell and generate profit from.

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A situation arose when on January 23rd_{2013, a circulating surplus of allowances}

led to the minimum price of 2.81 euros to which the European Commission was forced to respond by postponing over 900 million allowances until 2019-2020 (Chevalier 2012; Chaton et al. 2017; Financial Times, 2013). Today, the price is at 19,87 Euros a Ton as a result of the political market interference e.g. the visible hand in the perceived invisible market (Markets Insider, 2018). The instability of the market may improve in 2019 when the Commission implements the Market Stability Reserve (MSR).4

Thirdly, the ETS does not promote enough innovation towards less carbon-intensive production. Innovation is halted since companies fear that if they do take measures, it will lead to a disadvantage for them towards other companies that just buy extra allowances and sell their products at a lower more competitive price. This risk to lose competitiveness is somewhat financially softened by the fact that the ETS will let any company sell their extra allowances (or free allowances are given). However, when the price is low due to the disadvantages of market-working as stated above, this incentive is negligible. This creates on greater scale home industries that do not dare to innovate out of fear for losing competitiveness to industries that do not take such measures (Krugman, 2011).

Fourthly, the ETS used to include only three out of six GHG’s in its system, which have been determined as the “basket of GHGs” by the Kyoto protocol. Included were; carbon dioxide (CO2) nitrous oxide (N2O) and perfluorocarbons (PFCs)

while three other gases, methane (CH4) hydrofluorocarbons (HFCs) and sulfur hexafluoride (SF6) were excluded from being regulated (DG CLIMA, 2016; United

Nations Framework Convention on Climate Change, 1997). However, from the third phase in 2012 on, the gas was included as monitored gas. So, methane is only monitored while the IPCC’s Fifth Assessment Report (2013) has showed that it is a serious threat and estimated that “methane is the second largest contributor to total anthropogenic radiative forcing and is equivalent to 58% of the radiative forcing of CO2 [….] methane’s global warming potential is in the

4_{“A key notion for the functioning of the MSR is the total number of allowances in circulation (TNAC).} Allowances will be added to the reserve, if the TNAC is above a predefined upper threshold (833 million allowances) and will be released from the reserve, if the number is below a predefined lower threshold (below 400 million allowances) *. Thus, the MSR absorbs or releases allowances if the circulating ones are outside of a predefined range. Back-loaded and so-called unallocated** allowances will also be absorbed by the reserve.” (European Commission, 2017)

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range of 28–34 times that of CO2 on a 100-year timescale” (IPCC, 2013). Nevertheless, the word “methane” was 0 times mentioned in several documents like the report from the commission to the European Parliament and the Council on the functioning of the European carbon market (2017). The comparative study by Höglund-Isaksson (2012) concluded that this sector is evidently the biggest contributor of methane. If we look at total GHG emissions in European Union, the share of methane has increased from 36.87% in 1996 to 40.69% in 2008, even though the total methane emissions decreased in this period with 9.6% (World Bank, 2008; Eurostat 2018). However, it is likely that the reason for this rise could be due to decreased CO² emissions.

As a final remark, the price of allowances remains sensitive to supply and demand shocks as well as to energy and environmental policy measures from outside of the European Union. However, a more long-term reform is needed in order to develop a market stability mechanism and tackle this financial bubble (Chaton et al., 2015; Neuhoff et al., 2015). The European court of auditors (2015) has respectively tackled the issue of gaming and the risk of failing market integrity and irrational pricing as well as VAT fraud and hacker attacks that have proved to influence the system (Frunza et al., 2010). All in all, it is a complex system and argued here that there is a need for revision and improvement.

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Box 1.: Tragedy of the commons versus Prisoner’s dilemma

Two theories are here presented to show the challenges of decision making. This tragedy of the commons situation was introduced by the political economist Lloyd (1833) and claimed that self-interest of human beings can lead to a situation where common goods, in this case clean air, oil etc., are exploited until the good is ruined. Today this is seen as market failure since the 'invisible hand' of the free capitalist market fails to work and leads to a non-efficient result, in this case polluted air and exploited oil reserves. When this market failure is inefficiently tackled by the government, this government failure keeps the market failure at stand.

The prisoner’s dilemma was introduced by Drescher in 1962, the phenomenon states that if two persons are charged for a crime, both will confess in order to get a light sentence. The rationale is that there are two options. Confess; if the other confesses, they both get a sentence of 10 years. If the other does not confess, the sentence is 20 years for that person. Not confess; if the other does not confess either, both will only get a sentence of one year. If the other does confess, the person that confesses will be free and the one that does not confess have a sentence of 20 years. The best rationale is to confess in order to avoid the 20 years and the worst-case scenario will be 10 years. It is a non-cooperative game, which means that even if they can communicate, there is nothing that binds them to their statements. (Dresher, 1961).

These two ideas are used to illustrate the current situation where China and the European Union are used as an example. The dilemma is created by a tragedy of the commons situation, a common good like air is not owned by anyone. For example, clean air from which both China and the Europe Union would like to profit from and be able to produce and emit GHGs. However, when there is no regulation this tragedy of the commons becomes a prisoner’s dilemma, there are two options; cut emissions or not cut emissions. Cutting emissions comes with high costs and if both countries do it global warming will slow down, making everybody better off, leading to a win-win situation (2-2). However, if only the Europe Union will cut emissions and carry the financial burden and China decides not to cut emissions, then China both profits from cleaner air and from profits generated out of polluting activities (thus 0 for the European Union and 3 for China). Financially, the most sensible thing to do for both parties is not to cut emissions since it does not depend on what the other country does and profit for both remains (1-1), paradoxically this leads to the worst collective outcome, namely market failure where overproduction of GHGs remains. This is often the challenge of sustainable policy making, where the justification for implementing any tool often originates from the tendency that private benefits of pollution reduction do not outweigh the private costs.

Figure 2. Prisoners Dilemma

European Union

China

CUT NO CUT

CUT 2 2 0 3

NO CUT 3 0 1 1

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1.1.2 Sectors most prone to carbon leakage

The issue of carbon leakage has been responded with a carbon leakage list from the European Commission (2018). This list uses specific criteria to determine which sectors are most prone to carbon leakage. These are criteria such as: ability to pass on the costs for regulation to downstream economic agents and consumers, thresholds for the direct and indirect additional costs induced by the implementation of the ETS system and thresholds for the intensity of import and export competition. Even though the list is up to formal review every five years, the Commission has the legal option to initiate changes in the list each year (DG Clima 2016; Jensen, 2009). The Commission has often stressed the need for harmonizing Member State procedures for monitoring, reporting, and verification in the ETS. For example, small installations are excluded since the administrative burden is too high (Jensen, 2009). The list for 2021-2030 (2018/C162/01) has been published May 8th_{, 2018 and was prepared with two public consultations,}

between November 2017 and February 2018, with, according to the European Commission’s statement (2018), a “significant number” of meetings. This consultation took place from November 2017 to February 2018 and included 102 sector associations, 43 individual companies, 5 NGOs, 5 government institutions and 1 citizen. Also, quantitative assessment is done based on Eurostat’s indicator of high risk to carbon leakage. A sector is included if the threshold is above 0.2, which is mentioned in Article 10b, paragraph 1 of the EU ETS Directive 2009/29/EC.

It is stated by the European Commission (2017; 5) that the policy is the “cornerstone of the EU's strategy for reducing greenhouse gas (GHG) emissions from industry and the power sector since 2005”. The goal of the list is to inform Member States which sectors and companies are most eligible for free allocation. Besides advising the national governments, sectors that are categorized as category A, B or C are eligible to apply to the Commission for free allocation. These categories and sectors are set out in ANNEX 1 (European Commission, 2018).

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Unsurprisingly, the most-cited sectors to be at risk for carbon leakage are energy-intensive sectors, mainly at the manufacturing stage, and sectors that are sensitive to loss of “sectoral competitiveness”.5_{The highest risk for leakage}

occurs at energy-intensive sectors such as; cement, aluminum, iron and steel, food, pulp and paper, as well as refineries and chemicals (see ANNEX 1). A report by Paltsev (2000) estimates that the steel industry may account for nearly 20% of all carbon leakage in the wake of the Kyoto Protocol.

Besides energy-intensity, is competition a crucial factor for determining whether a sector is sensitive to leakage. Sectors sensitive to competition are subject to other criteria and factors that influence competitiveness like carbon pricing, labour and environmental regulation. These are factors that can be relatively controlled by the European Union. However, uncertainty arises in both the vertical (downstream products in the supply chain) as well as the vertical process of new products. But other aspects like the global cost of raw materials or energy also influences competitiveness but cannot be regulated by the EU (CEPS, 2013; Jensen, 2009).

The challenges of the EU ETS are due to internal struggles as well as external struggles. The first two phases were characterised by legal battles whereas windfall profit and fear of losing competitiveness characterised the third phase. However, to my opinion as well as concluded in many literature research these are not challenges that cannot be overcome, the EU’s flagship can still be corrected and refloated, to start with a price floor (Jensen, Paltsey). Now that the most important challenges of the EU ETS have been set out an alternative system should be considered to answer to any on these challenges.

5_{The European Commission provides two definitions; competitiveness of the economy refers to the capacity of} a nation or region to provide its citizens with a sustained increase in living standards with jobs available for those willing to work. Competitiveness of enterprises refers to the ability of firms to sustain and gain in market share through their cost and pricing policy, innovative use of production factors, and updates to product characteristics. It is often measured by the share of the products of one manufacturer in value terms in domestic and international market for those products. Accordingly, at sectorial level, EU industry’s

competitiveness refers to sales performance (market share and comparative advantage) of this industry in EU and world markets (European Commission, 2009). The WTO (2009) has defined sectoral competitiveness as its ability to maintain profits and market shares.

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1.2 Carbon Border Tax Adjustments

According to the WTO (2009; 100) the overall economic objective of carbon border tax measures is to; “level the playing field between taxed domestic industries and untaxed foreign competitors by ensuring that internal taxes on products are “trade neutral”. The research done by the Transport & Environment and the Trade Justice Movement (2017; 7) use the following definition “The adjustment is designed to level the playing field in international trade while internalizing the cost of climate damage into the prices of goods and services”. A somewhat simplified explanation would be that a carbon border tax is a tax levied on imported goods proportional to the carbon emitted in the manufacture of those goods (Krugman, 2010). There are two main versions of carbon border tax adjustments, tax-based and allowance-based (WTO, 2009; Monjon et al., 2011). As can be seen in figure 3, the price level change from tax-based carbon taxes or allowance-based pollution permits is essentially the same. Both change from p1 to the same price level to p2. However, this does not mean they are equal in feasibility, battling GHG emissions, revenue allocation or WTO compatibility.

Figure 3. Tax effects of ETS and CBT

Source: Monjon et al., 2011

The EU ETS is an example of allowance-based and thus could function as a border tax as well. The research by Monjon et al. (2011) shows several

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scenarios, both allowance-based and tax-based. The conclusion however states that allowance-based measures are preferential over tax-based. This since the allowance-based measures are more efficient in limiting leakage, are better in reducing world emissions and is likely to be compatible with WTO standards (Mathiesen and Maestad, 2004; 26; Monjon, 2011; 13). This vision was already shared as a possible option by the WTO & the United Nations Environment Programme (2009; 101) that stated:

“It has been envisaged to link an emission trading scheme to [...] requirements on imports from countries that do not impose similar emission reduction obligations on their industries. In such cases, importers would have to submit emission allowances or certified emission credits to cover the emissions created during the manufacturing process of the imported good; or they would be allowed to purchase allowances in the domestic emission trading markets on equal terms with domestic industries”

Most importantly, how would this work as a border measure? Firstly, allowance based would mean that the supply of allowances is recalculated and adjusted to the new group of emissions covered. These will have to be product specific benchmarks, so which products and companies are included in the system, determined by the European Commission. Based on these benchmarks it is decided by the European Commission which companies receive free allocation and which will have to buy allowances on an auction.

Now, after this has been decided the question remains whether the border measure applies to imports alone or imports and exports. The first one means that foreign importers will have to buy allowances, but European exporters don’t. The reason that European exporters don’t have to buy emissions for exporting is due to the expected rise in electricity price. However, the second one, including exports is preferential according to Monjon et al. (2011), since it would likely be more in line with WTO standards of equal treatment. Including exports means here that European exporters will still have to pay for their emissions when exporting to non-EU countries.

Thirdly, the allowance will have to be handed in directly at the border and not yearly, as is the case for European emitters. Monjon et al. (2011) finally

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concludes that the adjustment will apply to basic products and not to consumer products, creating a horizontal line of products included.

Next to review is the other measure, which is tax-based. Here products are directly taxed, like a VAT and it has two basic principles according to Monjon (2011); first, the profits generated have to be given back by the government to the citizens, so the consumer spending will not decrease. This can be done for example with tax cuts for non-carbon intensive products. The second principle in order to prevent carbon leakage is to implement the Border Carbon Adjustment (BCA) mechanism. The principle is simple; when importing as an EU country from a non-EU country, one looks at how much taxation would have been paid here, and then this amount will have to be paid. However, when an EU country exports to a non-EU country the exporter (polluted product export) will receive the tax paid product back. This sustains an equal level playing field and prevents unfair competition since developing countries will not able to pay such high rates.

The first principle, which here is called principle A, has the result to lessen carbon leakage by taking away the incentive to relocate or invest outside of the European Union. As shown in figure 1, there is an issue in the Netherlands with carbon leakage in terms of overseas economic activity, or more concrete; their FDI, for which externalities are unaccounted for. The CBT could be a solution for this by bringing in a tax on profit derived from FDI as well as implementing the Carbon Border Tax Adjustment (CBTA) mechanism. The CBTA follows an understandable logic; when importing as an EU country from a non-EU country, one looks at how much taxation would have been paid in the EU and then this amount will have to be paid. Carbon is taxed directly, and the price will rise exponentially over time, forming a constant incentive for producers and consumers to shift to less carbon-intensive products. The report (2017) concludes thus that a CBTA will make renewable energy more attractive and competitive. The result is thus that foreign exporters will have increased costs, depending on the energy intensity of the product but this is not the case for European exporters. When an EU country exports to a non-EU country the exporter will receive the tax back for the number of products they export. This sustains the WTO concept of an equal level playing field and prevents unfair competition since developing countries will not be able to pay such high rates

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and are typically importing countries with a positive trade balance whereas developed countries typically export and have a negative trade balance. The “invisible” hand ensures that the financial burden will automatically be carried by developed export countries and polluting sectors. However, this will be discussed further in the next chapter.

Hypothetically speaking: during the ETS system China would not reduce emissions out of ETS legal or economic obligations.6_{Though with the CBTA, the}

Chinese importers that trade to the EU are charged with allowances. Since the Chinese producer will not like this, they will either look for a more sustainable solution themselves or pressure the Chinese government to invest in green technology in order to maintain their trading position. This CBTA is argued by the Transport & Environment and the Trade Justice report to be a good replacement for the classic CBT where imported goods are taxed proportional to the carbon emitted in the manufacture of the goods as mentioned by Krugman (Transport and Environment, 2017; Krugman, 2010). Several reasons to prefer the CBTA over a classic CBT plus a more detailed description of the CBTA will be discussed in section 1.2.1 and 1.3. Concluding, principle A thus expands the costs of internalizing externalities on the environment outside of the EU.

The second principle, here called principle B, derives from Principle A. As one would expect, the price of energy intensive products will rise since foreign exporters have increased costs and must pay a higher fee as they produce higher externalities. These exporters are most likely to be producing in the same sectors mentioned in the carbon leakage list. This tax measure will logically lead to higher consumption in less-carbon intensive products and decreased consumption in carbon intensive products. However, this is totally depending on the elasticity of a product, in other words; how the consumer responds to a price change. So, when taking steel as an example, it has been proven inelastic, meaning that consumers have been relatively unresponsive to price changes (Mathiesen and Maestad, 2004). This seems like a simple enough effect but the issue is that consumers may not have the financial freedom to shift to other products. When taking for example oil prices, there are consumers that can barely pay their bills, let alone shift to an electric car of more a more economical

6_{Clarifying that it is not implied here that China does not decrease emissions out of other motives like the} Paris agreement or Kyoto protocol.

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car when oil prices rise. The recent protest in France about a sudden raise in fuel prices provides evidence that a shift needs to happen gradually to avoid shocking citizens and prevent opening them up to sudden price changes (New York Times, 2018).

These increased costs should not lead to unbearable costs for consumers and affect their consumer spending, not only to avoid a widening economic gap but mainly to avoid decreased economic activity or recession. The profits generated by the CBT therefore have to be given back by the government to the citizens to prevent this decrease in consumer spending. One way that this can be done is for example by giving tax cuts for non-carbon intensive products and subsidies to lower-income households. This consequently will lead on the production side to a higher trust to produce in a more environmentally sustainable way and will thus tackle the issue of fear of decreased competition which is mentioned as the third failure of the ETS in 1.1. Supporters of the tax argue that a CBT(A) will level the playing field across countries as well as it being simpler, more transparent and easier to administer (Jensen, 2009). Others state that the expected effect of the tax is curbed emissions and improved energy productivity (Andersen, 2010).

Also, Friends of the Earth (The guardian, 2011) has described carbon trading as a "distraction" and states that direct carbon taxes would be more effective and less susceptible to abuse.

1.2.1 Main issues CBT

Even though the CBT(A) is more focused on tackling GHG emissions outside of the EU than the ETS, there are also some costs to be considered. First and foremost is the feasibility of carbon calculation (Monjon, 2011). In order to tax at the right price, a life-cycle analysis (LCA) must be done which results in the carbon footprint of a product. However, consensus on import agricultural products from developing countries lacks due to non-complete data. This was pointed out by a report of the World Bank, as well as showing diversity in commonly used databases over simplistic things such as the carbon footprint of

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the most-commonly used 16-ton truck. The report also showed that carbon data was mainly available to OECD countries (World Bank, 2009; Jensen, 2009). For example, when looking at aluminum, commonly estimated at 15 to 20 CO2 per kilogram, due to green energy sources has been produced at 5.2 CO2 per kilogram in Greenland. When recycling is taken into account, aluminum as well as steel has been found very sustainable as it only costs 5 to 10 percent compared to the production of virgin aluminum which should be taken into account when calculating (Schmidt and Thrane 2009, EuroFer 2016). Although these are fair concerns, a common analysis used in LCA is the sensitivity analysis, which gives an initial indication of estimates with a certain degree of uncertainty. This analysis provides a range since it is only logical that a certain degree of uncertainty exists and is impossible to avoid. Factors of uncertainty are mainly energy source of production and recycling possibilities. Information on energy sources is difficult since suppliers shift frequently, and information gets lost with the trade since no efficient system to keep track of the input is operational.

Even though all EU ETS companies have to register their carbon use, there is no requirement yet for foreign importers to do so. That does not mean however that this does not exist or is unconventional. The Boxer Substitute Amendment of the Lieberman-Warner Climate Security Act in the United States is a requirement for foreign importers to track embedded carbon in the production (van Asselt et al., 2009).

The second main burden of costs are the administrative costs. Even though these costs can be manageable, they can vary and function as important political arguments against carbon border adjustments. The costs arise from two things; WTO compatibility and rent seeking behavior. Costs of WTO compatibility however, will only arise if another country decided to challenge the decision and start a case against the EU. This could happen and lead to high administrative and legal costs. However, if no case is started, the WTO will not pose much cost besides the administrative costs of reviewing and complying with the WTO jurisdiction when creating the policy change.

The other administrative burden arises from rent-seeking behavior that may occur, which will lead to protectionist policies. This rent-seeking behavior arises

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in regulated markets as opposed to profit seeking behavior in free markets and is the cost of an actor trying to increase its wealth, not by creating new wealth but through political input. For example, a company decides to lobby or increase its market share in order to influence policy making in their favor and financial advantage (Krueger, 1974; 302). In this case, protection is expanded horizontally in order to manipulate the “calculation of carbon footprints through methodology choices and through provision of favorable datasets” (Jensen, 2009; 8)

Thirdly, it has been argued by some scientist that carbon leakage is not as concerning as it seems and that no harm is done to the economy. Here it has been argued that carbon leakage mainly applies to some heavy industrial producers such as steel, aluminum, paper, glass, chemicals, and electricity (Whalley et al. 2009). However, these producers account for over 75% of the GHG emissions and even if the effect of carbon leakage is not as big as perceived, the ETS is limited by only regulating the European Union’s internal emissions and therefore does not motivate global action. In the sense of generating global effects, even if carbon leakage is limited, the CBT is a better choice (Krugman, 2010).

Finally, the CBT can be perceived as protectionist since it in a sense violates the principles of free trade. This since it adds a tax on a border and thus imposes a barrier for trade. However, the WTO (2009) published a study on the issue and concluded that the WTO could accept a CBT as long as it fits within the rules of equal treatment and does not disrupt trade relations. For example, a European citizen will be charged 5 cents extra for carbon content when buying noodles produced in China, however if the noodles were produced in the EU, the consumer would also have had to pay 5 cents extra for carbon content. The main rationale is that products are not treated preferential and should be comparable to the domestic price.

The CBT, whether tax-based or allowance-based like the EU ETS, is not a perfect system. The challenges of the CBT are due to internal struggles as well as external struggles such as the difficulty to harmonize tariffs and administrative costs. External struggles of the policy ranges from perceived incompatibility to

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the WTO and rent seeking behavior as well as political opposition of a protectionist measure.

Now that the most important challenges of the EU ETS have been set out an alternative system should be considered to answer to any on these challenges.

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2. The Carbon Border Adjustment

The previous chapter has shown the advantages and disadvantages of two carbon regulating systems. The main advantage of the allowance-based ETS is the flexibility of trading emissions. Though, the political acceptance nowadays as an integrated system should also be noted as valuable. However, the main advantage is also its disadvantage; the flexibility does not incentivize green technology enough and does not prevent carbon leakage since no border barriers are present. That is why here it is proposed to extent the climate policy to the border. A border adjustment is a trade measure which is designed to level the playing field between domestic producers facing costly climate policy and foreign producers with no or little constraint on their GHG emissions (Ismer and Neuhoff, 2007). The reason for opting with an allowance-based border instead of a direct tax-based border measure has been explained by Monjon et al. (2011; 1) as:

“We find that the inclusion of imports and exports would reduce world emissions more than the inclusion of imports alone, that an obligation to buy EU allowances is more compatible with WTO rules than one based on a tax and would be better at reducing world emissions.”

However, in the article it is stressed that when the border adjustment is approached as a trade measure, it would perhaps not be approved by WTO but when approached as an environmental measure it could be approved under article 20. Though, the legal aspect will be discussed further in section 4.5. The advantage of a Carbon Border Tax is the border aspect which is likely to decrease carbon leakage and stimulate countries outside of EU to produce in a more sustainable way (Transport & Environment and the Trade Justice Movement, 2017). The main disadvantage of the system is the difficulty of

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carbon calculation and possible high administrative costs. However, as shown by the report of the Transport & Environment and the Trade Justice Movement (2017), these issues can be reduced by simplifying the system. According to them this can be done by trading emissions at the border.

The real question is; can the two systems be combined? It has been argued by many that it can (Andersen, 2010; Lockwood, 2010; Transport & Environment and the Trade Justice Movement, 2017). An ETS with the advantage of a CBT, tax interaction with a border, is possible. Lockwood (2010; 7) stresses the need for measures beyond at the border by stating;

“Among the countries that have embarked on what they see as stricter climate policies, emissions reductions in these countries are seen as generating accompanying leakage through a shift in consumption from carbon-based goods towards now cheaper importable substitutes allowing for more carbon-intensive production in regions without comparable carbon pricing”

The main reason for this is not just decreasing the carbon leakage effect, but also to avoid great differences in carbon prices or in other words; it would level the playing field. As stated by Lockwood (2010; 7):

“In a world of unequal cross-country carbon prices, BTAs are claimed to give more certainty for those involved in emissions reduction initiatives, especially for long-run investments in various key sectors.”

Also, in Jensen (2009) it is claimed that these border adjustments will level the playing field for domestic producers as well as stating that the CBTA provides a balance to non-competitive effects. An example is given by Lakshmi Mittal, chairman of Steel producer ArcelorMittal (2017); steel producers outside of the EU do not pay a tax, which gives them a competitive advantage of roughly €30 per ton over EU rivals. This because the EU steel demand is growing but more and more this is imported from countries with lower standards. To visualize this; almost 50% of the world steel is produced in non-annex B countries, countries that have chosen not to participate in reduction targets from the Kyoto protocol (Mathiesen and Maestad, 2004).7

7_{Annex B countries: EU, Liechtenstein, Monaco , Switzerland , US, Canada, New Zealand, Russian Federation,} Ukraine , Norway, Australia and Iceland.

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A border adjustment is a logical way of taking on this competitive disadvantage and continues from the various unilateral commitments towards carbon emissions reduction like the Paris Agreement or the Kyoto Protocol. This since the renewed tax interaction proposed next, could be a part of an implementable global climate change regime and “even pressure reluctant nations to the climate negotiation table” (Jensen, 2009; 9).

2.1 Implementation

Now it could be proposed to outlaw pollution all together in the European Union, however the EU’s ‘mandated participatory planning’ (MPP) approach makes this difficult. This approach implements policy through a combination of participatory components and multi-level governance. This approach mandates participatory governance across multiple levels for policy implementation and is mostly used in environmental policy making such as the Water Framework Directive, the Air quality directive, the Floods directive, Environmental Noise Directive and the Soil Protection Directive (Newig et al., 2014). It has been speculated that this implementation approach aims to make up for the democratic deficit and legitimacy claims by obliging national governments to involve citizens and private actors in the drafting of legislation as well as in the implementation (Newig and Fritsch, 2009).

Now it is not hard to imagine that not every Member State wishes to outlaw all pollution and thus will not participate, which is mandated in this approach. Consequently, this halts the policy making process which costs a lot of time and money to develop. A too radical approach is just not efficient to present. It is more feasible to present something that most Member States can get behind. So how do we tax what the EU consumes and not just what it produces? There are two ways in which such an adjustment can be implemented according to Jensen (2009), Lockwood (2010), Monjon et al. (2011) and the research done by the Transport & Environment and the Trade Justice Movement (2017). The first one is the classical idea of a carbon border tax, which puts a price on carbon and then implements a tax on imported goods calculated on their carbon content.

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The amount of this tax is determined by WTO regulation to be a maximum of the price of how much it would cost to produce in the homeland. However as stated before, this system comes with complex carbon calculation and administrative costs. Also, complexity to determine rules of origin and use of energy sources are important oppositions against this adjustment. Therefore, the next system is taken as the policy adjustment in this report.

The second option is the trading of emissions. Here the foreign importers that are importing into the EU would have to buy emission allowances in order to sell on EU soil. European Union exporters could sell some of their emissions permits acquired for production to gain offset (Lockwood, 2010). This policy adjustment complements the current origin-based tax with destination-based taxation. The origin-based taxation taxes goods based on production; in the case of the EU ETS it is an internal “tax” since the products produced within the EU have to pay for allowances. The adjustment adds a destination-based taxation. This taxation taxes goods based on consumption and is internal since EU importers are taxed as well for consumption but not external, since EU producers get to sell their emissions when exporting (Lockwood, 2010). This measure will mostly decrease competitive disadvantages of EU producers since foreign import is discouraged and local production encouraged.

Now that the method of taxing is discussed, the decision to include which sectors is easy. The need to select a few sectors is functional and efficient in various ways. First, it is stressed by Lockwood (2010) that carbon motivated border adjustments will have no real effects if it is applied to all products and no leakage issues will be addressed but rather motivated.

Second, it is functional in the sense of following international legislation. This since the border adjustment must be compatible with the WTO and follow the concept of equal treatment. So hypothetically if a foreign company is included in the border adjustment but a similar EU company would not be included, this could be seen as discrimination. There really is no other option than to follow current EU standards. Monjon et al. (2011) added that the proposed emission trading would be more compatible with WTO legislation than a border adjustment in the sense of a direct tax. The article also stated that the measure is more successful in reducing world emissions.

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Consequently, opinions of this in literature have been parallel on the issue. The few articles on the issue, that were present and discussed here, have presented a collective thought. Jensen (2009; 7), Lockwood (2010; 813) and Monjon et al. (2011; 1212) all recommend that BTAs should only be applied to energy-intensive industries. The sectors mentioned in the articles are the same as the sectors that have been strategically chosen to include in the EU ETS. These sectors are also the sectors prone to carbon leakage; iron and steel, pulp and paper, cement, aluminum, refineries and fertiliser. Only the article by Monjon includes energy and excludes paper and pulp, iron, refineries and fertilizer. The new border tax as proposed here will apply to a limited amount of energy-intensive industries power plants larger than 20MW. The reason for this is the compatibility with the EU ETS SYSTEM, where small companies are excluded since these will have trouble with the administrative burden. The specific sectors and companies subject to the new policy adjustment are not determined here since they will have to be analyzed and selected by the European Commission through data given by the Member States (Krugman, 2010; EU ETS Directive 2009/29/EC).

Practical working and effects of the border adjustment

For EU exporters some aspects will change. Now, they already pay for their emissions while trading within the EU, but the adjustment will lead to more players in the ETS system and a more complex yet more equal playing field. For example, EU exporters that export products made of steel will have to deal with changing prices. This since the border adjustment motivates foreign exporters to advance technology, so the technological advantage of EU exporters might be challenged. For the EU sectors that experience a trend of growing import and declining export it could benefit. This because the financial incentive to import from foreign exporters is expected to decrease with the adjustment. Change will occur for the EU importers if they import products from foreign sectors included in the expanded ETS system. These products will be subject to the market price of carbon allowances payed by the foreign exporter and could encourage EU importers to search for sustainable EU producers rather than foreign producers if these foreign products become more expensive. If you then look at the total emissions of the EU before (importing) versus the EU after (more local production), the total effect will be decreased emissions. Not only due to

Innovating the European Border: an Impact assesment of a transformed ETS in the Netherlands