Designing effective carbon border adjustment with minimal information requirements. Theory and Empirics.

To prevent carbon leakage induced by unilateral carbon pricing, the EU has designed a Carbon Border Adjustment Mechanism (CBAM) that taxes imports based on their carbon content. Since estimating the carbon content of imports is very complex, CBAM will be applied only to a few emission-intensive sectors. We argue that, as a consequence of its limited applicability, CBAM is unlikely to effectively eliminate leakage. We propose a simple alternative route towards leakage prevention with significantly lower information requirements and administrative burden which can be applied to all tradable sectors: the Leakage Border Adjustment Mechanism (LBAM). LBAM offsets the cost disadvantages of domestic producers relative to foreign competitors induced by unilateral carbon pricing by implementing import tariffs and, potentially, export subsidies that hold trade constant at the level before the introduction of carbon pricing. LBAM requires knowledge only about domestic product-specific output-to-emissions elasticities and import demand and export supply elasticities but does not depend upon information on the carbon content of imports. To quantify the welfare and emission effects of LBAM and to compare it to CBAM, we simulate a unilateral carbon-price increase in the EU using a granular structural trade model with 57 countries and 121 sectors. We find that LBAM is very effective in preventing leakage, while the EU CBAM is not.