Green Gridlock

Green industrial policy is in vogue on both sides of the Atlantic. The United States and the European Union have ambitious plans to decarbonize their economies while rebuilding their manufacturing sectors. As they do so, the discord between Washington and Brussels over climate and trade policies will worsen if the two allies cannot align their starkly different and arguably incompatible proposals for carbon border measures to preserve competitiveness.

These measures are designed to impose additional costs on the import of products based on their level of carbon emissions. In December, after protracted and painful negotiations, the EU finalized its carbon border adjustment mechanism (CBAM), which will impose a tariff on imports of certain products such as steel and aluminum. The amount of the tariff is calculated based on the carbon price per ton of emissions paid by companies in the EU’s member countries. Meanwhile, the United States has proposed the Global Arrangement on Sustainable Steel and Aluminum (GASSA), an initiative in which a club of member countries could impose emission-related tariffs on countries that are not part of the consortium.

Either proposal, if it gains traction among other countries, could set the international standard for the use of tariffs to facilitate climate action. That means that the United States and the EU have a valuable opportunity to reach an agreement that would enable strong climate action at home and encourage low-carbon economic development around the world. If they can arrive at a shared vision of how to address heavily traded emission-intensive products, starting with steel and aluminum, they can establish a valuable global template for the decarbonization of a much wider group of high-carbon goods.

But the two sides have been negotiating for nearly six months and are reportedly still far from a deal. A failure to come to an agreement would further exacerbate trade tensions and derail progress toward the goals of the 2015 Paris climate accord. The clock is ticking—and with the next U.S. presidential election soon to be in full swing, the window for negotiations is shrinking.

Conflict Over the Carbon Price

The CBAM is part of Europe’s landmark Fit for 55 climate package, which aims to reduce the continent’s greenhouse gas emissions by at least 55 percent below 1990 levels by 2030. A cornerstone of the plan is the EU Emissions Trading System (ETS), a carbon market that sets a limit on emissions that can be produced by companies in certain sectors. The price of emission allowances (the carbon price) has increased to roughly 65 to 100 euros per metric ton of carbon dioxide over the past year. Under the CBAM, companies importing goods covered by the mechanism will need to purchase certificates whose price will be based on the weekly average auction price of EU ETS allowances.

The EU will now phase out the free allowances it had been providing to domestic producers of carbon-intensive products to compensate them for the costs imposed by the EU ETS. It is simultaneously phasing in the CBAM, which is designed to serve both domestic and international purposes. It allows the EU to protect the competitiveness of its domestic industries and avoid “carbon leakage,” when stringent domestic emissions standards result in the relocation of carbon-intensive production to a country with lax regulations. Imports from countries with comparable carbon prices avoid the tariff, so the CBAM also supports global climate goals by incentivizing Europe’s trade partners to implement their own domestic carbon prices.

On the other side of the Atlantic, the centerpiece of U.S. President Joe Biden’s ambitious domestic decarbonization plans is the Inflation Reduction Act (IRA), which provides unprecedented support for low-carbon industries, especially domestic producers that offer high-quality jobs to Americans. EU countries’ concerns about what they see as the IRA’s protectionist qualities have dominated headlines, but Brussels and Washington will almost certainly find a way to live with one another’s clean energy subsidies. Europe, through its proposed Net Zero Industry Act, may respond by implementing its own subsidies to meet its ambitious targets for domestic manufacturing.

At the same time, the United States has sought to leverage carbon tariffs for its own economic and geopolitical advantage. Although full details of the GASSA climate club proposal have not yet been made public, it would reportedly impose tariffs based on products’ carbon intensity, with steeper tariffs on countries outside the club than on those inside. To gain membership, a country must fall below a predetermined emissions intensity threshold of its steel or aluminum production.

Brussels and Washington will almost certainly find a way to live with one another’s clean energy subsidies.

The Biden administration’s GASSA plan is one of several U.S. carbon border tariff proposals that have gained momentum among both Republicans and Democrats in Congress. Both sides of the aisle perceive climate and economic benefits from reducing imports of carbon-intensive products, especially from China, which accounts for more than half of global steel production.

Although the EU and the U.S. proposals may appear similar because of their reliance on carbon-based tariffs, they differ markedly in their design and objectives. The EU’s CBAM is premised on complying with World Trade Organization rules by imposing the same carbon price on domestic and foreign-produced products. The U.S. approach has a fundamentally different goal: to create a coalition of countries and direct their strong environmental standards and economic leverage toward the decarbonization of certain industrial emission sources. A sticking point is that, unlike CBAM, the GASSA proposal is indifferent to whether countries address domestic emissions using a carbon price or other policy strategies. Countries could employ sticks, such as regulations and carbon pricing, or carrots, such as the subsidies in the IRA.

The EU is bound to reject GASSA because it intends to bypass CBAM, which has been carefully and painstakingly crafted among the EU member states. For its part, the United States has chafed at CBAM because it has no real prospect of passing legislation that establishes a broad federal carbon price.

A failure to coordinate these approaches would pose economic and climate risks. In a worst-case scenario, heightened trade tensions could lead to a vicious cycle of retaliatory tariffs that would impede the free flow of clean industrial products. But even if the worst case does not come to pass, the U.S. and EU markets could split over their different approaches to climate and trade policy, imposing measures that provide little incentive for foreign producers to decarbonize. Continued transatlantic discord promises to discourage other countries from following either the United States’ or the EU’s approach to achieving ambitious climate goals.

Designing a Successful Climate Club

Reaching an agreement that eases trade tensions and encourages global decarbonization will require compromise on both sides. The CBAM tariffs are not scheduled to kick in until 2026, giving the United States and the EU just under three years to iron out their differences.

The first step toward finding common ground would be for the EU to accept that other countries’ strategies for industrial decarbonization may not involve carbon prices and for the United States to accept that the EU will not abandon CBAM to partner with a White House that may have a different occupant in two years. Furthermore, Brussels is advancing its climate goals at a time when Russia’s invasion of Ukraine has led to a sharp increase in energy prices, which has raised real risks of deindustrialization. CBAM is part of a political agreement to retain its ambitious decarbonization commitments under such difficult circumstances.

The most viable path forward may be for the EU to open the door for CBAM specifications to work in concert with a redesigned GASSA, or an alternative but similar proposal from the G-7 climate club. The club can start with steel and aluminum, like the GASSA proposal, with the goal of expanding coverage over time.

To be successful, an international agreement needs to credibly drive down global emissions. And for a critical mass of countries to join, the club needs to be compatible with U.S. climate-focused industrial policy, the EU’s CBAM, and the development goals of low-income and lower-middle-income countries like India that will account for most future emissions. It’s not going to be easy to satisfy all these conditions with one agreement. Its architects will need to think carefully about the criteria for membership into the club, the framework for imposing tariffs on nonmember countries, and how best to support lower-income countries in their efforts to reduce their emissions intensity.

Friction between green industrial policies may become the norm.

The agreement must include clear criteria for who can join the club. Membership should be based on whether a country’s production in a particular industry meets an agreed-upon emissions threshold, excluding countries whose production of a specific good is too carbon intensive. The emission standard would need to tighten gradually over time to reach the level necessary to meet the climate goals enshrined in the Paris agreement. Ratcheting ambition within the club is critical. The rest of the world will balk at any U.S. proposal perceived as an attempt to capitalize on the relatively low carbon intensity of its heavy industry—especially steel, because of its plentiful access to recyclable scrap following a period of higher-carbon development—while placing no additional burden on American producers.

The total production for a particular industry, rather than just exports, should be used to assess whether a country meets the emissions threshold. By doing so, the club can avoid encouraging “resource shuffling”—that is, countries exporting clean products or derivatives while consuming dirty versions domestically.

Those within the club could trade freely in the products covered but charge tariffs on those not in the club. Each country or region could use its own approach to arrive at the tariff, which would allow the EU to stay faithful to CBAM and allow the United States to use a different method that skirts the politically challenging issue of introducing a national carbon price. This approach is similar to that employed by the Paris agreement, which succeeded because it provided countries with the independence to forge their own paths to net-zero decarbonization.

Finally, the tariff revenues collected by club members should be redirected toward funding emissions reductions in low-income and lower-middle-income countries, especially those with clear plans and policies for decarbonization. The club members, including the United States and the EU, should support projects to plan and finance ultralow emissions industrial projects in the developing world, including providing needed technical assistance, technology transfer, low-cost financing, and guaranteed market access to exports. The goal should be to help ensure that developing countries respond to these measures with decarbonization rather than retaliation. Many emerging economies, including India, have already strongly decried CBAM. It will likely face more opposition as these countries’ calls for increased support in the form of climate finance gain further momentum.

To be successful, an international agreement needs to credibly drive down global emissions.

The ultimate goal of any agreement is to bring down emissions and encourage low-carbon economic development across the globe, which is going to require support for developing countries across their economies. To this end, the club could also issue waivers to countries making strides toward net-zero compatible development. To be sure, assessing good faith progress will require objective and transparent information sharing and benchmarks, as well as clear criteria for defensible net-zero plans and policies.

These steps are essential to assisting developing countries in continuing to industrialize while meeting climate goals. Such efforts may appear to conflict with the U.S. and European aim of rebuilding their manufacturing sectors, but a well-designed club could be beneficial for both goals by encouraging the United States and the EU to focus their industrial policies on areas where competitive advantages, supply chain concerns, and energy security needs point to the importance of domestic production.

In crafting a climate club, the Kigali Amendment to the Montreal Protocol, which is phasing out products that produce hydrofluorocarbons, provides important lessons. The agreement, which received bipartisan support in the U.S. Senate last year, showed that binding commitments to international climate protocols are politically viable when U.S. producers can be highly competitive in global markets.

As free trade continues to wane in popularity and climate action gains momentum, friction between green industrial policies may become more the norm than the exception to the rule. By thinking ambitiously and creatively about how to bridge these divides, countries can simultaneously make critical progress toward their decarbonization and economic development goals.