WORKING PAPER SERIESBORDER CARBON
ADJUSTMENTS:
RATIONALE, DESIGNAND IMPACT
Michael Keen (Tokyo College, The University of Tokyo)
Ian Parry (International Monetary Fund)James Roaf (International Monetary Fund)

December 5, 2021
TC-E-21-1

Tokyo College, The University of Tokyo

TC-E-21-1

BORDER CARBON ADJUSTMENTS: RATIONALE, DESIGN AND IMPACT

Michael Keen, Ian Parry, and James Roaf*
December 5, 2021

Abstract
This paper assesses the rationale, design, and impact of border carbon adjustments (BCAs). Large
disparities in carbon pricing between countries raise concerns about competitiveness and emissions
leakage. BCAs are potentially the most effective domestic instrument for addressing thesechallenges—but design details are critical. For example, limiting coverage of the BCA to energyintensive, trade-exposed industries facilitates administration, and initially benchmarking BCAs on
domestic emissions intensities would ease the transition for trading partners with emissionintensive production. It is also important to consider how to apply BCAs across countries withdifferent approaches to emissions mitigation, and the treatment of exports. BCAs alone do not solve
the free-rider problem in carbon pricing, but might be a step to an effective international carbon
price floor.

JEL Classification Numbers: Q31; Q35; Q38; Q48; H23.
Keywords : border carbon adjustment; climate mitigation; carbon pricing; competitiveness, emissions
leakage; allowance allocation, design issues, World Trade Organization rules.

*

Keen: Tokyo College, University of Tokyo, Institute for Fiscal Studies and Center for Business Taxation;

mickjkeen@gmail.com. Parry: Fiscal Affairs Department International Monetary Fund, iparry@imf.org. Roaf: Fiscal Affairs
Department, International Monetary Fund; jroaf@imf.org. We are grateful to Simon Black, Vitor Gaspar, Ben Jones,
Victor Mylonas, Kurt Van Dender, Jonas Teusch, Philippe Wingender and others for very helpful comments andsuggestions and to Danielle Minnett for excellent research assistance. Views are not necessarily those of the IMF, its
Executive Board, or IMF management.

1.

Introduction

As countries consider more aggressive climate mitigation policies, the question of whether some formof ‘border carbon adjustment’ (BCA) is appropriate has become central to the wider climate debate.
The EU’s proposal of a BCA in July 2021 1 , as well as BCA proposals in the United States 2 , haveheightened interest in this instrument, not least as many countries ramped up their climate strategies
ahead of COP26 in November 2021, with some further tightening expected for COP27.3 Underlying
this interest is a concern that more ambitious unilateral actions—higher domestic carbon pricing, inparticular—will be discouraged by adverse cross-border effects on those undertaking them. The
attraction of BCAs is as a possible way to limit such harm, arising from lack of uniformity in andcoordination of national policies. Put differently, carbon pricing, as is well-known, faces a fundamental
free-rider problem, since each country has an incentive to leave it to others to address the common
climate challenge: BCAs may be a way to help address this difficulty.
By ‘BCA’ is meant in this paper a charge on the carbon content of imported products that is intended
to ensure treatment equivalent to domestic carbon pricing, potentially combined with rebates for the
carbon content of exports. Two features of this definition should be noted. First, and moststraightforwardly, the term ‘charge’ allows for the BCA to be implemented either as an explicit tax, or
as a requirement for importers to purchase allowances from a domestic emissions trading system (ETS)or separate allowance pool. Second, the remission of tax on exports is treated as an optional feature—and indeed many proposals do not allow for such rebating. Without such an adjustment, however, a
BCA is different from a ‘border adjustment’ in the sense that the term is used, for example, in relation
to the VAT: there it is used to indicate that imports are effectively brought into domestic taxation, andexports taken out, so placing the tax on a ‘destination’ basis. This points to a potential tension in the
carbon context in that the Paris Agreement, in contrast, assigns to countries responsibility for theemissions generated within their borders – an ‘origin’ basis.4
Policymakers are considering BCAs for three main reasons:

1

The

proposed

BCA

would

becomeoperational

in

2026

followingatransition

period.

See

https://ec.europa.eu/info/sites/default/files/carbon_border_adjustment_mechanism_0.pdf.
2 See https://joebiden.com/climate-plan. Recent legislative proposals for carbon taxes in the United States have also

contained BCAs (see www.carbontax.org/bills).
3

See for example www.aljazeera.com/economy/2021/2/5/bb-uk-pm-to-push-allies-to-agree-on-carbon-border-taxes-

report. Only one BCA has been implemented to date, at the sub-national level: it applies to the embodied carbon in
imported electricity under California’s ETS (see Bushnell et al. 2014, Pauer 2018).
4 A third feature is that this definition excludes equalization with respect to domestic abatement measures other thancarbon pricing: the treatment of non-price measures is discussed in Section 2.A2

To help preserve the competitiveness of domestic industries in the presence of domestic carbon
pricing, particularly for energy-intensive, trade-exposed (EITE) industries—this improves
economic efficiency in the sense of preventing distortions in the relative prices of domestic
and foreign goods (i.e., clean and polluting industries at home and abroad are treated alike)5and can aid the political acceptability of carbon pricing;
To reduce the risk of emissions leakage, that is, partially offsetting emissions increases inforeign countries induced by domestic mitigation policy—this objective signals a concern not
only with national welfare but with global welfare more generally;6 andAt an international level, some have stressed that BCAs may strengthen incentives for carbon
pricing and mitigation action in other countries—there is a direct fiscal incentive to the extent
that non-BCA countries effectively forgo revenue on their exports collected by the importing
BCA country, and indirectly BCAs might help to strengthen the international credibility ofcarbon pricing schemes.
While related, these objectives are distinct: it will be seen, for instance, that leakage may be significant
even if the competitiveness effects of domestic carbon pricing—in the sense of an induced decline indomestic production—are small, and vice versa.
Policymakers considering BCAs will need to address two broad sets of issues:
How BCAs might be best designed (e.g., through choice of sectoral coverage, measurement of
embodied carbon in traded goods, treatment of exports, accounting for mitigation actions inforeign countries); andWhether BCAs are preferable to other instruments (e.g., free allowance allocations to EITE
industries) for addressing their underlying objectives.
In making these choices, policymakers will also need to consider the preservation of domestic
mitigation incentives, the impact on revenue, moderating administrative and compliance costs, andlimiting risks of challenges under World Trade Organization (WTO) rules.
Indeed, it will be important for policymakers to consider the likely reception of a BCA by theirinternational partners. Just as it is natural for the country implementing carbon pricing to be concerned
about competitiveness and carbon leakage, so it is also natural for trading partners to be concerned

5This is of course just one aspect of efficiency: the impact on the aggregate level and cross-country distribution ofemissions is another.
6 Adopting an explicitly global standard of efficiency, a form of BCA can indeed be shown to be required when carbon

prices are not appropriately set in all countries: see Keen and Kotsogiannis (2014).

3

that BCAs might camouflage protectionist measures. The impacts of carbon pricing and the BCA should
be considered jointly: rather than being seen as creating a competitive advantage for the country
imposing it, a BCA may be better thought of as mitigating a competitive disadvantage that its carbon
pricing would otherwise create for itself by raising costs on domestic producers. Further, to the extent
that countries with carbon pricing are already using measures such as free emissions permit allocations
in pursuit of their objectives, a BCA would simply replace one mechanism with another. These
considerations may alleviate trading partners’ concerns about the BCA—so long as it is designed
appropriately and does not over-compensate for the cost increases imposed on the domestic industry
by carbon pricing.
This paper seeks to provide practical guidance for policy making, both conceptual and quantitative.
Conceptually, we focus throughout on the analysis of BCAs from a national rather than a collective
perspective. Key empirical issues to which the analysis points include leakage rates, burdens of BCAs
on trading partners, emissions shares of traded products, embodied carbon in imports and exports fordifferent countries, and the impacts of BCAs on industrial costs.7
The paper is organized as follows. Sections 2, 3, and 4 focus on potential rationales for BCAs, design
issues, and instrument choice issues respectively. Section 5 provides brief concluding remarks.
Although the focus is on the tax policy aspects of BCAs, this cannot meaningfully be addressed without
recognizing the legal context, a brief account of which is given in Annex 5.

2.

Three Core Rationales for Border Carbon Adjustment

We consider in turn the three possible rationales for some form of BCA set out above.
Competitiveness
Carbon pricing can affect the competitiveness of emissions-intensive domestic industries by increasing
their costs relative to foreign competitors. Around 30 carbon pricing schemes had been implemented
by 2021 at the national and EU levels, with prices and coverage varying widely (and many not applying
to the industrial sector)—see Figure 1. Implicit carbon prices in mitigation pledges for 2030 also vary
widely.8 While some price dispersion may well be reasonable—for example, reflecting the principle
under the Paris Agreement that countries have “common but differentiated responsibilities” according

7 The analysis complements other recent discussions, for example, Chen et al. (2020), Cosbey et al. (2019), Flannery etal. (2018), Lowe (2021), Morris (2018), OECD (2020).
8 IMF (2019a, b).

4

to their level of development9—it may be difficult for countries to implement aggressive near-term
pledges without mechanisms for limiting perceived declines in their international competitiveness.

Figure 1. Selected Carbon Pricing Schemes, 2021
Bubble size shows value of pricing initiative:= 0.1% of GDP

160
SwedenCarbon tax

140

ETS
Carbon tax and ETS

Carbon price ($US/tCO2e)120

Color shows share of global GHGs:

Liechtenstein

Finland

100
UK

80
60
Portugal
Spain
20

LatviaEstonia

Ireland

Iceland
New Zealand0

Colombia
10

20

Korea

CanadaSouth Africa

Chile

Argentina

Slovenia
Poland>1%

NorwayDenmark

0-20

0.05% to 1%

EU

France40<0.05%

Switzerland

China

Kazakhstan

MexicoUkraine

30
40
50
60
Coverage of nationwide greenhouse gases (%)

Japan
70

Singapore80

90

Sources:
WBG(2021);
EMBER(2012);(2012);
ClimateClimate
Watch (2021);
IMF
staff calculations.
Sources:
WBG(2021);EMBER
Watch(2021);
IMF staff calculations.

Notes: Carbon prices are from April 01, 2021 from WBG (2021). EU ETS price is from July 19,2021 from EMBER.
GHGs are from 2018. EU includes Norway, Iceland, Liechtenstein. Values less than 0.005 percent of GDP are ofequal size for illustrative purposes. The value of the UK's ETS is an estimation for 2021 based on a £50/tCO2e
price. China's value estimate and price is based on the opening pricing of $7.40/tCO2e. Finland's transport fuels
are priced at $73/tCO2e. Ireland's F-gases are priced at $20/tCO2e . Norway has a reduced rate on natural gas for
EU ETS installations of $4/tCO2e. Norway and Mexico prices represent carbon price upper bounds. Lower bounds
are $3.9/tCO2e and $0.37/tCO2e respectively. Switzerland's price is a weighted average between carbon price andETS by emissions covered.

While competitiveness concerns apply in principle to all traded items, the policy focus has been on
EITE industries. This is because their costs are most heavily increased by carbon pricing (since theirproduction is energy intensive) and there is a reasonable presumption that demand for theseproducts may shift significantly from domestic to foreign suppliers under carbon pricing. Moreover,

9 Even without this notion of differential responsibility for accumulated emissions. Lower carbon process in lower

income countries could be rationalized on grounds of distibutional equity across countries.

5

EITE industries are typically 80 percent or more of manufacturing emissions—though manufacturing
is usually only around 10-30 percent of nationwide emissions (Figure 2). EITE industries may also
have particular political sensitivities, given that employment effects of carbon pricing may be larger
and more visible than for other sectors.

Figure 2. Nationwide CO2 Shares for Domestic EITE andManufacturing Industry, 2015
Australia
CanadaChina
EU-27
FranceGermany
India
Japan
Korea

EITE

RussiaNon-EITE

UK
US
0

10

20
30
40
50
Nationwide emissions share, percent

Source: OECD (2021); UNFCCC (2021).
Note: EITE includes metals, chemicals, wood/paper, and textiles.
Nationwide emissions exclude land use and land use change.

Primary examples of EITE industries include iron, steel, aluminum, refined petroleum products,
pharmaceuticals, plastics, glass, ceramics, cement, textiles, and wood products. Many of theseindustries produce raw materials for sale to firms further down the value chain producing final
consumer goods. In the EU ETS, for example, industries are classified as EITE if the ETS increases theirproduction costs at least 5 percent and their trade share with non-EU countries (imports plus exports
relative to production) is above 10 percent; these industries are currently eligible for free allowance
allocations determined by their historical production and by industry emission rate benchmarks for
relatively clean firms.10 In principle, electricity should count as an EITE industry under the EU criteria(as it is in California) but it is excluded as production costs are presumed to be largely passed forward
in higher consumer prices (see below) despite some trade exposure. Agriculture is another potential

10 Sectors are also deemed EITE (i.e., at significant risk of carbon leakage) if production cost increases or their tradeshare exceed 30 percent (see https://ec.europa.eu/clima/policies/ets/allowances/leakage_en). The industries defined as
an EITE will vary across countries with differences in classification criteria, energy intensity, and trade exposure (Cosbey
et al. (2012).

6

EITE industry, but (proxy) pricing schemes have not yet been applied to most greenhouse gas
emissions from this sector. EITE industries typically account for around 10-20 percent of GDP (Figure
3).
Figure 3. EITE Value Added as a Share of GDP, 2015
China
Thailand
Viet Nam
Malaysia
Argentina
Indonesia
Japan
MexicoTurkeyEU (27)
India
Peru
RussiaColombia
BrazilSouth Africa
Saudi Arabia
CanadaUnited States
Kazakhstan
United Kingdom
0

10

20

30

Percent of GDP
MetalsChemicals

Other Manufacturing

TextilesOther EITE

Sources: Based on OECD TiVA Database

The anatomy of the competitiveness issue is shown in Figure 4. Carbon pricing drives a wedge between
pre- and post-tax production cost curves. In the absence of carbon pricing, the curve C(E) shows unit
costs as a function of emissions per unit E (both direct and indirect—see below). The firm chooses to
produce at the minimum cost, at point X, with emissions of E0. Introducing a carbon price of P per unitof CO2 raises the cost curve to C(E) + P∙E. The firm now optimizes at point Y. Emissions per unit fallfrom E0 to E1, and unit production costs rise from UC0 to UC1.

7

Figure 4. Impact of Carbon Pricing on Firm
Cost
unit
cost

Post- carbon price cost curve, C(E) + P∙E

Y

UC1
Cost
increase
UC0

FigureFigure
5. Marginal
4. Marginal Abatement
abatement costsCosts

unit
cost/
CO2

Original
cost curve, C(E)

Transfer payment,
T = P∙E1

X

Efficiency cost, C
Carbon price schedule, P∙E

carbonprice

Marginal abatement cost

Y Efficiency cost, C

P
Transfer payment, T = P∙E1
P∙EdirP∙EindEmissions
reduction

E1
Emissions per unit of production, E

E0X

emissions remaining
E1 emissions cut E0
Emissions per unit of production, E

The increase in unit production costs has three main components, illustrated in Figure 5: this shows
the same information as Figure 4, but (on the vertical axis) on a per-unit of emissions basis (rather thanper unit of output). The first cost component, C, is the efficiency or social cost of the induced changes
in production methods (e.g., the cost of switching to cleaner technologies and fuels), indicated by therelevant area under the marginal abatement cost schedule. Next is the transfer payment to thegovernment (or to allowance sellers), T, equal to the carbon price times the remaining emissions perunit of output—this is a private rather than social cost (C and T correspond to the vertical distancesmarked in Figure 3). Viewed from the perspective of a particular firm, this transfer cost can be divided
further into payments made on: (i) the firm’s direct emissions (P∙Edir); and (ii) indirect emissions
embodied in the firm’s inputs, in practice likely to be chiefly electricity (P∙Eind).11 At moderate abatementlevels, the efficiency cost is likely small relative to the transfer payment, with the relative size of theefficiency cost rising with the extent of abatement.
Unit production cost increases from carbon pricing by itself would vary significantly across countries
and EITE industries. For illustration (Figure 6), a carbon price of $50 per ton in 2030 is estimated toincrease unit costs for basic metals by around 25-30 percent in India, 12-15 percent in China, and lessthan 10 percent in the EU and US, while cost increases for textiles, machinery, and fabricated metals
are less than 10 percent in each case (Figure 6). Empirical studies, however, have generally failed to
identify large production effects of carbon pricing, albeit at generally low levels of carbon pricing and

11 Direct and indirect emissions are sometimes referred to as scope 1 and scope 2 emissions respectively.

8

often in the presence of compensating instruments such as free allowances.12 And while there has been
Figure 6. Input Price Changes for $50/tCO2 Carbon Tax,in percent, 2030

China

EU27

India

UnitedStates0
Iron & Steel
Non-Ferrous Metals

10

Percent

TextilesFabricated Metals

2030
Machinery

Source: IMF staff calculations.

Note: EU27 uses a weighted average on sectoral output.

a general sense that EITE cost increases are difficult to pass forward in higher prices to downstream
firms or consumers, solid empirical evidence on this has been hard to pin down.13
A BCA could level the playing field, in terms of carbon charges, between sellers from different
jurisdictions competing in the same market. A BCA charging the carbon content of imports (direct andindirect) at a rate equal to the difference between domestic and any foreign carbon prices, andsymmetrically for exports, would fully adjust for differences in carbon prices. For imports from ajurisdiction without carbon pricing or other mitigation policies, such a charge means the foreign
producer faces the same transfer payment component (T in the diagrams above) as a domestic
producer with the same emissions intensity. Similarly, including export rebates in the BCA will put thedomestic producer on level terms with foreign producers in the external market. The competitiveness12

For example, Dechezleprêtre and Sato (2017), Venmans et al. (2020).

13 Most studies suggest pass through rates for EITE industries of between zero and about 50 percent (Neuhoff and Ritz

2019) in contrast to the power sector where carbon pricing in the EU has been largely passed forward in higher
consumer prices (e.g., Bushnell et al. 2013, Sijm et al. 2006).

9

impacts of the BCA will depend on key design features however, most notably the measurement of
embodied carbon (see Section 3).
Some form of border adjustment by countries using regulations or other non-price mitigation policies
could also be warranted. Non-price policies differ fundamentally from price-based policies in that they
do not impose on firms the rectangle of tax-transfer shown in Figure 4. However, both price and nonprice policies increase production costs by the triangle C: the efficiency cost being forced in the caseof non-price policies by a notional shadow price of carbon. So nonprice policies generally impose
markedly lower private costs on firms than carbon pricing (at equivalent shadow prices). Nonetheless,these costs could still be significant enough to cause competitiveness and leakage concerns, especiallyat higher levels of domestic abatement. Conceptually they would therefore merit some type of charge
on imports from jurisdictions with little or no mitigation in place.
However, in such circumstances a BCA that charges the domestic shadow price on embodied emissions
in imports would generally not be the appropriate response. This is because the domestic firm isexpressly not paying a price on its own embodied emissions: instead, the cost to the domestic firmarises only from the reduction in emissions. It would also be problematic from a legal point of view toimpose charges on imports that are not being paid by domestic firms. The objective of restoring
competitiveness would seem best met by charging imports some estimate of the efficiency cost facedby domestic firms.14 This though faces two practical constraints: the efficiency costs are unobserved,
unlike actual carbon pricing transfer costs; and this approach would not fit within WTO rules, so would
depend on interpretation under the “environmental exception”. Further, it is very hard to see howcompensation for efficiency costs could be effected for exports without falling foul of WTO rules on
subsidies.
The issue is explored further in Annex 1, examining the cases in which either the import country (asabove) or the exporting country uses regulations or other non-price policies. One key implication of
the difference discussed above between actual and shadow carbon pricing is that a country using
carbon pricing that adopts a BCA could well choose to apply it to imports from a country achieving
equivalent emissions reductions through regulations.

B.

Leakage

Unilateral carbon pricing creates the risk that reductions in domestic emissions will to some degree be
offset by additional emissions from increased production abroad—a risk that BCAs can reduce. Such
leakage can arise from the international migration of production, or an expansion of existing

14

An alternative, beyond the scope of border adjustment, would be to apply the same regulatory standards to imports

as faced by domestic firms, which would be tantamount to banning high-emissions imports altogether, which raises its
own legal and trade policy issues.

10

production abroad, following a deterioration in the relative competitiveness and/or profitability ofoperating in countries imposing carbon pricing—offsetting charges on imports and (see below)
remitting tax on exports can mitigate these risks. This type of leakage is most relevant for EITE
industries—in contrast, CO2 emissions from domestic transportation and buildings, for example, arelargely immobile.15
At the industry level, the potential leakage rate (i.e., the increase in foreign emissions relative to the
reduction in domestic emissions) is not always related to the scale of competitiveness impacts. The
reduction in domestic industry emissions induced by carbon pricing can be decomposed into threeeffects: a reduction in the emissions intensity of domestic production (as firms adopt cleaner
technologies and fuels); a reduction in domestic production due to lower domestic demand; and areduction in domestic production due to migration of production away from domestic to foreign firms.
Only the last channel causes leakage. Leakage generally goes hand-in-hand with competitivenessconcerns but—depending on the
Figure 7. Determinants of Leakage Rates
for EITE under domestic emissions intensity reduction of 25
relative foreign emissions intensity—it ispercent, assuming no demand effectpossible to have relatively high leakage
rates with small shifts of production. For
example, as shown in Figure 7 (holding
domestic
demandconstantforsimplicity), if carbon pricing incentivizes
a 25 percent reduction in domestic
industry emissions intensity, and 5
percent of production to shift abroad,then the leakage rate for the industry
will be 35 and 70 percent respectively if
the emissions intensity of foreign
production is 200, and 400 percent ofthat for domestic production16—see further discussion in Annex 2.17
Most of the empirical literature finds modest or no evidence of leakage, though in part this may reflect

15 International aviation and maritime are internationally mobile sectors but responsibility for mitigating their emissions

lies with the United Nations bodies overseeing these industries.
16 The approximation for the leakage rate set out in Annex 2 (with D̂ set at zero) of e*/e . Ŷ / (Ŷ + ê), gives 33 and 67

percent for e*/e equal to 2 and 4 respectively.
17

Note that the leakage calculations in Figure 6 are symmetric in exports and imports: they are the same whether thedomestic country is a net importer or net exporter of the product initially, and whether the leakage occurs through anincrease of imports or a reduction in exports.

11

Both the limited scope of carbon
Figure 8. Estimated National Level Leakage Rates
Australia
mitigation policies adopted so far andBrazilmethodological issues (see Annex 3).
CanadaRecent work by Misch and Wingender
ChinaEU(2021) suggests higher leakage rates—
Francewhile the absolute figures should be
Germany
treated with caution, this work also
India
Irelandprovides insight on the pattern of leakage
Italyacross countries (Figure 8). It suggests
Japan
Korea
that, on average, carbon leakage
Mexicoamounts to 25 percent, with rates varying
Norwayfrom 20 to almost 50 percent in individual
RussiaTurkeyEuropean countries, but less than 15
UK
percent in China, the EU14+UK
US
aggregate, India, and Japan, and 7
0
10
20
30
40
percent in the US. Overall, leakage rates
Leakage rate, percent
are larger for small open economies, such Source: Misch and Wingender (2021).
Note: Estimates for EU countries include leakage from them to
as most individual EU countries—thoughother EU countries and non-EU countries.
that does not mean that leakage isinherently less of a concern for larger countries, since the absolute level of emissions at stake is larger.
Leakage might also result from increased fossil fuel demand in foreign countries in response to
downward pressure on international fuel prices from countries taking mitigation action. This form ofleakage would be zero for unilateral mitigation for a small country that is a price taker in international
fuel markets but could be significant for a group of larger countries.18 However, as this form of leakage
depends on the reduction in aggregate consumption of fossil fuels in mitigating countries, it isessentially unaffected by both the form of mitigation instrument (carbon pricing or other) and any
accompanying measures (BCA or other).
National limits on emissions under the Paris Agreement will address leakage, to the extent that theybite. Under the Paris framework, countries are responsible for production emissions (i.e., emissions
released within their own borders). Potential emissions leakage in foreign countries (due to increasing
production or fuel demand) would therefore be neutralized by stronger mitigation policies if thoseforeign countries honor a binding target on nationwide emissions. In practice however, limited reliancecan be placed on this: pledges for the Paris Accord are voluntary, may not be fully achieved, and do
not always take the form of nationwide emissions caps.19

18 See, for example, Fischer and Fox (2012), Kuik and Marjan Hofkes (2010).
19 For example, China and India have set emissions to GDP targets for 2030 which would accommodate some increasein nationwide emissions if leakage increases their GDP.

12

C.

Promoting Carbon Pricing in Other Countries

Inherent in any BCA is a fiscal incentive for trading partners to impose some carbon pricing themselves.
By raising carbon pricing on its exports to the level in the BCA-imposing country (thereby eliminating
liabilities under the BCA) a foreign country would transfer tax revenue from the BCA country to itself.
This incentive will be stronger the greater are: (i) the BCA charge; and (ii) the share of CO2 emissions
embodied in foreign countries’ exports to BCA-imposing countries.
This incentive appears, however, to be modest given the small shares of emissions in trade flows (Figure9). For illustration, carbon embodied in EITE exports from China and India to the EU and US is only
about 3 percent of China and India’s domestic carbon emissions—the formal incidence on China andIndia of a $50 BCA imposed by the EU and US would be only 0.1-0.15 percent of the former’s GDP.
Moreover, the effective incidence—the burden that remains with Chinese and Indian producers—islikely to be much lower than this because a substantial part of the import charge is likely passed
forward to domestic consumers in the EU and US in the form of higher product prices. All this implies
only a modest incentive for these countries to scale up carbon pricing throughout the wider economy
in response to EU and US BCAs. The incentive would be slightly stronger if a broader range of countries
were to impose BCAs: embodied carbon in EITE exports to all trading partners from China and India is
10 and 8 percent of their domestic carbon emissions respectively, and the formal incidence would beapproximately 0.45 and 0.3 percent of GDP for China and India respectively. In contrast, embodied
carbon in the EU-27 and US EITE industry exports to the world is only 5 and 2 percent of domestic
emissions, and the formal incidence of a BCA imposed by the rest of the world on them is less than
0.05 percent of their GDP.

Figure 9. Emissions Shares in Trade Flows and Burdens of BCA on Trading Partners
a. Fraction of Domestic Carbon
Emissions Embodied in EITE Exports to
Trading Partners, 2015

b. Formal Burden on Foreign Country
from $50 per ton BCA Imposed by
Trading Partners, 2025

China

China

India

India

EU-27

EU-27

US
0

2

4

EU-27

US

Canada and UK

rest of world

6

8

10

US
12

Embodied carbon in EITE exports as percent ofdomestic CO2 emissions
Source: OECD (2021).

0.0

0.1

0.2

EU-27

US

Canada and UK

rest of world

0.3

0.4

Formal burden of BCA borne by foreigncountry , % of foreign country GDP
Source: OECD (2021); IMF staff calculations.

13

0.5

BCAs may, however, also promote pricing in other countries in less tangible ways. For example, as
countries reinforce carbon pricing with BCAs, they send a clear message that carbon pricing is thecenterpiece of their mitigation strategy, which may influence other countries deciding how much to
rely on carbon pricing in their own mitigation strategies. In addition, even if BCAs are initiallyintroduced unilaterally, countries may subsequently coordinate to create border free trading zones
with a common external charge, which may ultimately lead to more formal and comprehensive
arrangements for coordinating over carbon pricing.
A BCA in combination with other incentives could promote participation in an international carbon
price floor (ICPF) arrangement among large emitting countries. The purpose of an ICPF would be tofacilitate a scaling up of global carbon pricing (or equivalent measures) through coordinated action toaddress free-rider and competitiveness obstacles that hamper countries when they act unilaterally. 20
It would be far more effective in scaling up global mitigation than, and potentially even avoid the needfor, BCAs, given that BCAs price only carbon embodied in trade flows rather than all emissions (seeAnnex 4). BCAs might be applied by ICPF participants to non-participants, though this could complicate
discussions over designing the ICPF, due to the need to agree on terms for the BCAs as well as for the
ICPF itself.

3.

Design Issues for BCAs

Designing a BCA is challenging, as there are multiple objectives and design features to consider.
Beyond the three core aims focused on above, other objectives include preserving domestic mitigation
incentives, raising revenue, and limiting both administrative/compliance burdens and risks of WTO
challenges. Legal risks are difficult to gauge ex ante, not least because trade rules were written before
the recent attention to BCAs; they are discussed in Annex 5. In essence, WTO rules permit countries toadopt harmonizing measures (e.g., BCAs) for indirect taxes, so a key uncertainty is whether carbon
pricing would count as an indirect tax (likely more difficult for an ETS than for a carbon tax). There isalso uncertainty about whether a charge varying by the exporting country’s carbon intensity would
violate the Most Favored Nation (MFN) principle which precludes differentiation based on the countryof-origin of the imports. If a BCA does not meet these rules, it might nonetheless qualify as an
exception under Article XX if it is viewed as addressing environmental issues (i.e., emissions leakage),though demanding legal tests must be met in this case.
Table 1 summarizes the implications of design features for meeting multiple objectives; the discussion
below elaborates on the main points. 21 In doing so we do not distinguish between BCAs in the form

20 See Parry et al. (2021). This would be to some extent analogous to the minimum effective rate of corporate tax

envisaged in Pillar 2 of the October 2021OECD/G20 Inclusive Framework agreement.
21 See also OECD (2020).

14

of an import tax rather than as an allowance purchase requirement, since the latter can be designed
to mimic the former, though price uncertainty may be greater. A simple requirement to acquire
allowances from a domestic ETS to cover embodied carbon for imported products (without changing
the total allowances available in the ETS) may be undesirable as it would put upward pressure on, andincrease uncertainty about, allowance prices—embodied carbon in EITE imports to the EU in 2015, for
Table 1. Design Choices for BCAs and How they Affect Multiple Objectives
Design Feature

MetricSectoral coverage:
EITE industries vs.
broader (allmanufacturing,
services, etc.)

Measuring embodied carbon
Recognize
foreign firms
Domestic vs. countrywith lower
specific benchmarks
embodiedcarbonRebates fordomestic
exporters

Revenue use

Lowering import
Exemptions forcharges forleast developed
carbon pricing
countries
abroadProtecting
competitiveness of
EITE industries

Either approachprovides same
protection

Country-specificpreserves relative
domestic/foregin
prices despite carbon
pricing

Little relevancePreservescompetitvenessof exports

Little relevanceAppropriate forpreserving levelplaying field

Little relevance

Limiting leakage

Broader coverage
addresses leakage formore products but
the benefits may bemodestCountry-specificaddresses leakage
more efficiently

Little relevance

Reduces leakage

Little relevanceCan help reduceleakage

Little relevance

Promotingmitigation andcarbon pricing inother countries

Broader coverageCountry-specific
Gives incentive on
increases the base ofprovides stronger
foreign firm toLittle relevancecharges on imports incentives on foreign
reduce emissions
from trading partners producers and govts.

Little relevance

Promotes pricing
but direct
Little relevanceincentives may bemodestMitigation
incentives fordomestic EITE
industries

Either approachpreserves incentives

Little relevancePreserves
incentives if
designed
appropriately

Little relevance

Little relevance

Little relevance

Revenue
implications

Broader coverage Country-specific raises
increases revenue
more revenue if
Small reduction
from import charges trading partners havein revenue(and revenue losses
higher embodied
from export rebates)
carbonLoses revenue

Not applicable

Reduces revenue

Forgoes somerevenue

Administrative
burdenComplex for broader
coverage (moreproducts, difficulties
in measuring
embodied carbon)

Additionalburden but
modestNot applicable

Adds to burden,
limited by EITE Modest reduction
focus

Risk of legal
challenge under
WTO

Leakage rationale
more questionable
for broader BCA

Rebuttability
Domestic might help
provison shouldby reducing tariff andhelp with WTO
showing like treatmentcompatibility

Preliminary
recommendation

EITE(at least initially)

Domestic initially toease transition;
later aim forcountry- specificEither approachpreserves incentives

Administration for
country-specific is
more complex

Small if third
parties provide
verification

Yes

May bechallenged as a
subsidy

Yes

Using revenues
May increasefor green
legal risks if nottranstion or intl. applied equallyfinance may
and equivalently
reduce legal risks across countries
Considerenvironmental
uses

Yes
(or mutual BCAs
each with export
rebates)PossibleYes

15

for example, was equivalent to about 15 percent of the allowable ETS cap.22 One approach would beto require importers to purchase allowances from a separate pool where the allowance price is alignedwith the domestic ETS price—which would be operationally equivalent to an import tax. Administration
is a little more complex under an allowance purchase requirement than under a tax as customs officials
may need to collaborate with environment ministries monitoring the ETS or a separate allowance pool.
What sectoral coverage (EITE industries or broader)?
Limiting the BCA to EITE industries, at least initially, may make sense on competitiveness, targetedleakage, administrative, and legal grounds. Competitiveness and leakage concerns are less severe for
sectors like non-EITE manufacturing and services with low carbon intensity. The narrow focus also limits
administrative burdens: products would need to be classified as EITE or non-EITE, but this should bestraightforward given clearly specified criteria. Determining embodied carbon (with input-output
tables and emissions factor data) is also relatively straightforward for the raw materials that many EITE
industries produce. This narrow focus may also limit legal risks because the motivation based onleakage is more transparent and credible for EITE products than for products with low embodied
carbon.
A broader BCA would more comprehensively address competitiveness and leakage and provide
stronger incentives for carbon pricing elsewhere. Extending the BCA coverage to include charges onimported non-EITE manufacturing, services, mining, and perhaps electricity, combined withcorresponding export rebates, would address competitiveness and leakage issues for a broader rangeof sectors, though these benefits may be small where carbon intensities are low. Incentives to shift“carbon imports” further down the production chain would be avoided, and charges collected fromtrading partner imports would also be larger. The near-term administrative practicability of broad BCAs,
however, is very questionable. Besides the additional administrative and compliance burdens ofcollecting charges on a much broader range of sectors, there are also considerable challenges tomeasuring embodied carbon in, for example, services and high value manufacturing products.23
How to measure embodied carbon?
Using emissions-intensity data specific to the foreign exporting country addresses the three main
rationales for BCAs: it enables preservation of the relative costs of equivalent domestic and foreign
products despite carbon pricing; trading partners for whom leakage risks are greater (due to higher
embodied carbon) can be accordingly subject to higher charges; and foreign governments with higher
emissions intensities could be given be stronger incentives to implement carbon pricing to avoid theBCA. This differentiation across countries is important given the dispersion in embodied carbon within

22 Calculated from EEA (2021) and Wiebe and Yamano (2016).
23 See for example Marcu et al. (2020), OECD (2021), Prag (2020) and Wiebe and Yamano (2016).

16

productgroupsacrosscountries—

accounting for both direct and indirect

Figure 10. Embodied Carbon by Product andSector, 2015

emissions is also important (Figure 10).

US

Using

UK

domestic

emissions-intensity

benchmarks would be less effective inachieving BCA objectives but may be

Russiaappropriate over some transition to limit
administrativecomplexities

andformalburdens on trading partners. Use ofdomestic benchmarks would provide little orno incentive for foreign exporters to reduce
emissions

and

would

imply

(if

the

benchmark is updated) that, as domestic
industries incur abatement costs in response
to carbon pricing, this would in turn lead tolower charges on competing imports eventhough their emissions may not haveindirectIndia

directGermany

China

Canada
0

500

1000

1500

2000

2500

3000

CO2 metric tons per million $USD of output
Source. IMF (2021b).

Wood

TextilesChem./Pharm.

Basic Metals

Source: Based on OECD Input-Output Tables.

changed. Administration is simpler for domestic benchmarks however as it avoids the need to calculatea different set of charges for each country. Emerging market economies (EMEs) would also face much
lower formal burdens if the US or EU imposed a BCA based on domestic rather than country-specificbenchmarks (Figure 11). WTO concerns may also be eased given uncertainties about whether charges
can vary across countries with carbon intensity. A pragmatic approach may be to use domestic
embodied carbon initially (most obviously the industry average rather than that of the cleanest firms)
while the BCA is being established, with a view to transitioning to country-specific BCAs over time.24
If charges vary by country, a further issue is whether to use industry-, or firm- (even plant-) levelmeasures of embodied carbon. In principle, it would be more precise to use to use firm-level measures
given the heterogeneity of production methods within many EITE industries25 and this approach might
be least likely to raise WTO concerns. It would greatly add to administrative complexity, however, and24 Other possibilities include: (i) using a global average emission benchmarks, which could be a middle ground between

the two extremes of domestic and foreign benchmarking; and (ii) using foreign emissions intensities, but varying thecarbon price in the BCA according to development status (to respect “common but differentiated responsibilities” as
per the ICPF proposal, see Parry et al., 2021). However, both may raise their own legal issues.
25 For example, in steel production there are a variety of traditional (e.g., using coal combustion) and emerging (e.g.,using coal gasification) technologies with very different emissions intensities (e.g., van Ruijven et al. 2016).

17

Figure 11. Potential Revenues from Border Carbon Adjustments on Energy-Intensive,
Trade-Exposed Imports with $50 Carbon Price, 2015
USA

EU27

China

China

CanadaRussiaMexicoUnited States

EU27

South Africa

Japan

India

Korea

UK

India
RussiaTaiwanSouth Africa

Country
BenchmarkTurkeyDomestic
BenchmarkKorea

0 2 4 6 8 10 12 14
Revenues raised ($USD, billions)Japan

BrazilCountry
BenchmarkDomestic
Benchmark02
4
6
Revenues raised ($USD, billions)

Source: Based on OECD (2020).

consistent data on embodied carbon by firm, product, and country would need to be developed andapproved. For now, using industry-level data may be the more practical approach.
A ‘rebuttability’ provision allowing individual firms to claim rebates on the basis that their embodied
carbon is lower than this average (subject to third-party verification or risk of audit), should improve
WTO compatibility (Annex 5). There could be a risk of gaming, however, if the BCA induces firms toswitch production from their cleaner plants for export to the BCA-imposing jurisdiction while
redirecting products from their dirtier plants to other countries.
Rebates for domestic exporters?
Rebates for domestic carbon pricing on embodied carbon in domestic exports are in principle
warranted on competitiveness, and potentially on environmental, grounds. Rebates offset the increasein cost of domestic exports relative to foreign products caused by domestic carbon pricing— thispreserves the competitiveness of the average exporter and limits leakage (as discussed in Section 2
and Annex 2, leakage is symmetric across imports and exports). Indeed, preserving export
competitiveness may reduce global emissions if the emissions-intensity of production is lower at homethan abroad. Rebates would vary strongly across countries—for example, embodied carbon in EITE
exports is 10 percent of domestic emissions in China and 8 percent in India, though only 2 percent for
the US (Figure 12). Rebates should be based on firms’ overall production, or industry-wide benchmarks,
to avoid incentives for using more emissions-intensive production for export.

18

Figure 12. Embodied Carbon in EITE
Imports and Exports, 2015

Export rebates reduce BCA revenues in themselves,
but from a broader perspective are likely to enableChinahigher carbon pricing and revenue. A $50 per ton BCA

India

charges of around 0.1-0.2 percent of GDP in China,

on imports would have raised revenues from import
India, EU-27, and US in 2015 (Figure 13). Export

EU-27

rebates would offset 25 and 60 percent of theExports

US

Imports

revenues from import charges on EITE products in the
US and EU-27 respectively—while in China and India

0

2
4
6
8
10
Embodied carbon in EITE imports/exports aspercent of domestic CO2 emissions

Source: OECD (2021).

revenue losses from export rebates would
substantially outweigh revenues from importcharges (Figure 13). These effects are minor,
however, compared to the overall revenue
gain from comprehensive pricing of domestic
carbon emissions—indeed carefully designed
export rebates may help pave the way formore ambitious domestic carbon pricing and,hence, revenue.

Figure 13. Revenues from $50 BCA, 2015
China
India
EU-27
with export rebate
without export rebate

US
-0.4

-0.3

-0.2

-0.1

0.0

0.1

0.2

Revenue gains from BCA, percent of GDP
Source: OECD (2021).

What use to make of the revenue?
Such revenue as is raised by a BCA might be used in ways that reduce legal risks by increasing the
likelihood of its being considered as an environmental (rather than protectionist) measure. Legal risk
might be reduced if revenues are earmarked for green investment, just transitions, or international
climate finance—though the usual difficulties of ensuring true additionality of earmarked funds, andof earmarking more generally, will apply.
How to adjust import charges for carbon pricing or other mitigation efforts abroad?
The measures needed to achieve the central objective of equating the domestic treatment of imports
with that of domestic production depend on whether or not the exporting country rebates whatevertax it charges its own producers. If it does not rebate, then there is a clear case for reducing the carbon
price charged in the BCA by the amount of carbon pricing in the exporting jurisdiction. If the foreigncountry does rebate—perhaps as part of its own BCA arrangement—then all that is needed is to charge

19the full domestic tax upon import.26 From a wider political or environmental point of view, it may also
seem appropriate to exempt from a BCA exporting countries that have “done enough” to meet
mitigation goals under the Paris Agreement—even if that means lower carbon pricing than in thedomestic economy (or non-price mitigation methods). There is no single “best” approach here, butsome considerations follow.
Lowering the BCA rate for imports from a country with carbon pricing but not rebating on exports
seems appropriate for competitiveness and leakage reasons, as discussed above, but is subject to datarequirements and legal questions. Charges on embodied emissions in EITE products will largely dependon prices for industry and power sector emissions—pricing for residential and transport fuels havelittle relevance for production costs for EITE industries. Up-to-date details on carbon pricing for the
power and industry sectors are widely available27 and historically fuels in these sectors were largely
untaxed, or subject to minimal excises in terms of CO2 equivalent taxes.28 But adjustments would beneeded if foreign firms are subject to emissions pricing but receive free allocations. Conventions mightalso be needed to account for volatility in exchange rates and in overseas emissions prices. Legally it
may be difficult to justify why and how the BCA rate is differentiated across countries.
An alternative and in some respect cleanest approach—most analogous to familiar norms under theVAT—would be for trading partners using carbon pricing to each maintain separate BCAs with export
rebating.29 In economic terms this approach is similar to having the BCA-imposing jurisdiction adjusts
the charge for carbon-pricing but is more straightforward legally and administratively. 30 It also
accommodates the case where the foreign country imposes a higher carbon price than the domestic
jurisdiction and depends less on international cooperation.
Adjustments or exemptions to a BCA to recognize other countries’ mitigation efforts raise conflicting
concerns. On one hand, as noted above, the Paris Agreement embodies the concept of “common but
differentiated responsibilities”, which can imply lower carbon prices in EMEs compared to advanced
countries. Or countries might meet their Paris commitments using non-pricing instruments. In either

26

One issue that arises under the former approach is how to deal with the ‘excess credit’ case in which the foreign

carbon tax exceeds the domestic.
27 For example, many ETSs are limited to these sectors. See WBG (2021).
28 See IMF (2019b), pp. 91-93, OECD (2019).
29

This approach is recommended, for example, in Flannery et al. (2020).

30 However, one issue is that some industries might be classified as EITE in one country but not in a trading partner.

This could be a problem with separate schemes with export rebates: a good not covered by a BCA would get no rebate
on carbon tax paid when leaving one country but would still be subject to BCA entering the other country, implying
double taxation. This could suggest a need to agree a common list of identified EITE industries across countries.

20

case, exemptions from a BCA could be justified from the perspective of international environmental
cooperation, and potentially from a leakage perspective (if Paris commitments are regarded as binding
in levels terms on both sides, though as noted above this is not always obviously the case). On theother hand, such exemptions would generally not be warranted from a narrow EITE competitivenessperspective, since lower carbon prices, or non-price measures, generally impose lower private costs on
foreign exports than on domestic production. And the legal justifications for adjustments or
exemptions based on interpretations of trading partners’ price and non-price mitigation policies might
be questioned from a WTO perspective of non-discrimination.
Exemptions for least development countries?
Applying a lower BCA rate for exporters in least developed countries (LDCs) would make LDC exporters
more competitive (relative to applying a full BCA to them) with little at stake for BCA-implementing
countries. It might also be WTO compatible. Excluding LDCs would, in a blunt way, be consistent withthe principles of equity and of common but differentiated responsibilities, and in legal terms may beconsistent with the WTO’s Enabling Clause if the exemption criteria are based on objective
development indicators (Annex 5). Country-based exemptions would need to be designed to preventthe trans-shipment of goods from covered countries through exempted countries, requiring rules oforigin; while these might well prove burdensome, they may nonetheless be warranted.31

4.

BCAs versus Alternative Instruments

The strength of any case for BCAs also depends on the potential for addressing the multiple objectives
above through other instruments. These other instruments—see Table 2 on what some countries are
currently using—might include:
Exempting all, or some, of the emissions from EITE industries from carbon pricing (in adownstream pricing program), as in South Africa, or rebating them for carbon prices implicit
in fuel and electricity inputs (in an upstream pricing program);
Allowing EITE industries to participate in a tradable emissions rate standard (i.e., where firms
can fall short of the standard if they buy credits from firms exceeding the standard) in lieu ofcarbon pricing, as in Canada, which is another way of limiting charges on firms’ remaining
emissions after they meet the standard;

31 Such regimes are in place for most regional trade agreements as part of their rules-of-origin requirements. See

www.wto.org/english/tratop_e/roi_e/roi_info_e.htm.

21

Allocating free allowances related to industry benchmarks and past emissions for relatively
clean producers for EITE industries (under an ETS) which are cancelled if firms shut down ormove abroad, as in California, the EU, Korea, and New Zealand. While these are effectively lumpsum payments with no immediate impact on current direct emissions, they do impact
profitability in a way that dulls the incentive to relocate abroad.
Table 2. Assistance Measures for EITE Industries in Selected Countries/Regionswith Carbon Pricing
Country/region withcarbon pricing

Assistance Measure

CanadaA tradable emission rate scheme.

California

Free allowances under the ETS. BCA applies to imported electricity.

EU

Free allowances under the ETS but planning transition to BCA.

Korea

Free allowances under the ETS to qualifying EITE industries.

Netherlands

Levy on emissions above bechmark level (based on relatively clean firms)

New Zealand

EITE facilities receive free allowances of 60-90 percent of the industry
benchmark.

South Africa

Exemptions for the first 70 percent of emissions from the carbon tax.

Source: World Bank Group (2021).
Note: Free allowances are typically based on firms' historical production and industry benchmarks foremission rates based on relatively clean producers.

This is not an exhaustive list, but other possibilities have approximately equivalent effects to one of
the above instruments. For example, feebates 32 or returning the revenues from carbon pricing
collected from EITE industries in output-based rebates to those industries, are both broadly equivalent
to the tradable emission rate standard (all three approaches encourage EITE industries to reduce theiremissions per unit of output but, to an approximation, not to reduce their level of output). Table 3
summarizes how different instruments perform against the key metrics of concern.33

32Feebates apply a sliding scale of fees/rebates on products with above/below average emission rates (see IMF 2019a,

Annexes 1.4 and 1.5).
33 For further discussion of instrument choice issues see Fischer et al. (2015). There may be some transitory overlap

between instruments, for example, if BCAs are introduced before free allowance allocations in a domestic ETS are fully

22

Table 3. The Choice of BCAs versus Other Instruments
Exemptions for EITE
MetricBCAs

Tradable emission

Free allowances

rate standard

under ETS

Partially

Partially

Partially

Partially

No incentive

No incentive

incentives for direct

Reduces emissions

Maintains all(but not indirect)

per unit of output

incentives

Forgoes revenue

Forgoes revenue

Forgoes revenue

ModestModestModestna

na

industry emissions
from pricing
Full exemption is lessProtecting
competitiveness of

Yes

EITE industries

Limiting leakage
Promotingmitigation andcarbon pricing indomestic EITE

emissions)
Full exemption is lesseffective witheffective (if it does notdomestic industry

apply to indirect

benchmarks)

emissions)

Modest incentive

No incentive
Full exemption remove

Yes

industries
Revenue
implications
Administrative
burdenRisk of legal
challenge under
WTO

apply to indirect

Yes (though lessother countries
Mitigation
incentives for

effective (if it does not

emissions
Preserves revenue
from pricing
domestic emissionsa
Significant if
coverage beyond
EITE products
Depends on design
features

Could be challenged
as subsidy but has
not beenNote. The BCA itself raises additional revenue (unless forgone revenue from export rebates
exceeds collections from import charges).
a

BCAs are potentially more effective than other instruments in addressing competitiveness and leakage.
This is especially the case, as discussed above, if the BCA varies across trading partners according toembodied carbon and includes export rebates. Exemptions for EITE industries from carbon pricing
would be less effective unless they also included compensation for charges on indirect emissions (andimport prices would not vary across countries depending on emissions intensity). Tradable emissions
standards and free allowance allocation under ETSs are partially effective. In both cases firms are notcharged for (a large portion) of their direct emissions that remain after they have complied with theregulation, but they are charged for indirect emissions and they incur corresponding abatement costs.
Indeed, the effectiveness of these instruments, relative to that of a BCA based on foreign carbon

phased out. In this case, the BCA charge on foreign exports should apply to embodied carbon net of emissions thatwould have received free allowances under the domestic ETS.

23

content, will progressively decline with deeper decarbonization, as efficiency costs become moresignificant relative to transfers (recall Section 2).
To varying degrees, most other instruments also reduce mitigation incentives for domestic industries,
and forgo revenue. Full exemptions and free allowances independent of current emissions remove
mitigation incentives, at least for direct emissions; and tradable performance standards promote
reductions in the emissions intensity of production but do little to reduce output levels of emissionsintensive products. Other instruments forgo revenues that could be collected from pricing domestic
industry emissions (exemptions, emission rate standards, allocating allowances for free instead of
auctioning them).
Administrative and legal concerns are less relevant for instruments other than BCA, however. They haverelatively modest administrative burdens as they largely build off existing capacity. And they have faced
no legal challenges to date (even though free allowance allocations might be interpreted as a subsidy
under WTO law).

6.

Conclusions

In principle, BCAs have appeal over other instruments for addressing competitiveness and leakage—and this appeal will likely rise over time with greater decarbonization—but much turns on the details,
which raise a series of complex conceptual and practical issues. If BCAs are related to country-specificmeasures of embodied carbon they neutralize the effects of carbon pricing on the relative costs ofdomestic and foreign products with equivalent emissions intensity. Nevertheless, it may be advisable,
initially at least, to benchmark against domestic industry embodied carbon, for administrative
simplicity and to ease the transition for emissions-intensive trading partners, and to considertransitioning later to country-specific measures. Limiting BCAs to EITE industries should help moderatecompliance costs and might increase their credibility as a measure to target leakage—indeed from a
WTO perspective the motivation and design of a BCA in legislation should be based on environmental,
rather than protectionist or revenue raising, considerations. Allowing foreign firms to “rebut” industrylevel assessments with third-party certifications on their individual emissions intensity could also help
in this regard.
The key global challenge over the coming decade, however, is to rapidly scale up mitigation amonglarge emitters, and BCAs by themselves provide only limited incentives in this regard. BCAs covering
only a minor fraction of trading partners’ emissions and imposed unilaterally by multiple countries
could result in significant international price dispersion. Moreover, BCA simply frees countries to set
their carbon prices in line with national objectives, without fear of adverse cross-border effects: it
attenuates the free-rider problem, but (since damage from emissions related to its consumption
accrues outside its borders) does not remove it. In contrast, an ICPF could have more comprehensive

24

coverage of emissions, and prices could be coordinated and ramped up progressively, over time, toencourage the ambition needed to address the common global challenge.
The scale of competitiveness and leakage effects may not be large enough to warrant theadministrative, political, and legal complexities of implementing a BCA (compared to alternative
instruments) in the early stages of carbon pricing. But pressure for BCAs will rise as regions andcountries adopt more ambitious emissions pricing. If BCAs do begin to emerge on a unilateral basis
this may increase interest in the possibility of formal price coordination mechanisms—which may wellhold the key to effective and efficient mitigation of climate change.

25Annex 1. Cost Increases for EITE Industries under Carbon Pricing vs. Non-Pricing Measures

Part A: Graphical Treatment
Figure 1.1 recalls the domestic cost
increase due to carbon pricing, with amoderate level of emissions reduction
in mind. From a competitiveness

Figure 1.1.
Costs
Under
Moderate
Pricing
Figure1.1 Costs
undermoderateCarbon
carbon pricing
Unit
cost

Post- carbon price cost curve, C(E) + P∙EY

UC1

perspective, if a foreign firm with thesame cost structure but facing nocarbon pricing continues to produce at

Cost
increase

UCr
UC0

Original
cost curve, C(E)amount T—on the foreign firm ’s

Carbon price schedule, P∙E

emissions could be justified to levelplayingfield.

Now

Z

X

Efficiency cost, C

X, a BCA—in the sense of a charge intheTransfer payment, T = P∙E1

supposeEmissions
reduction

E1
Emissions per unit of production, E

domestic or foreign firms are instead
subject to emissions regulations.

E0

Case 1 – Domestic firm subject to regulationsFirst, consider the case when the domestic firm is subject to regulations achieving the same emissions
reduction per unit of production as the carbon price. The firm’s cost curve remains unchanged, so the
production process moves back from X to Z. Costs increase only by C, to UCr. Thus, although theregulation imposes the same “shadow price” of P on emissions, the private cost increase is much lessthan under actual carbon pricing, especially for the moderate emissions reduction shown in Figure 1.1.
A BCA based on the emissions content of imports would impose much higher costs on the foreign firm
than faced by the domestic firm, which
would likely raise legal issues, as wellas granting the domestic firm acompetitive advantage.

Figure 1.2. Costs Under High Carbon Pricing
unit
cost
UC1

C(E) + P∙E
TThe situation is somewhat different
under much more ambitious emissions

UCr

reductions, as shown in Figure 1.2. The
efficiency cost C can then become verysignificant,andcomparable

C(E)

C
UC0

in

magnitude to the additional transfer

P∙E

payment T that would apply undercarbon pricing. So, in the regulationsonly scenario, the domestic firm could

emissions per unit of production, E

suffer a more significant competitive26

disadvantage. However, a BCA based on the foreign firm’s emissions would still not be justified,because it would not be directly related to the actual competitiveness loss suffered. In principle, an
import charge related instead to estimates of the efficiency cost C would be appropriate, but could be
difficult to gauge, being unobserved (unlike T). The consistency of such a solution with WTO rules
would likely remain an issue.
Case 2 – Foreign firm subject to regulations
Now consider the situation where the domestic firm faces carbon pricing while the foreign firm faces
equivalent emissions control via regulation, so both operate at the same emissions intensity. The
arguments above suggest that—especially at moderate abatement levels—the foreign firm would still
enjoy a cost advantage (the difference between UC1 and UCr), so exempting it from the BCA would not
be warranted on competitiveness grounds.
From an environmental perspective, the domestic cost disadvantage (in the absence of a BCA) would
still tend to result in carbon leakage, but the scale of the leakage would be limited by the action of theregulations in keeping foreign emissions intensity at the same level as the domestic firm’s (as discussed
in the main text, Section 2). So, while the competitiveness motivation for a BCA may be less affectedby the foreign regulations, the environmental motivation for it is likely to be more significantly
diminished.
Part B: Algebraic Treatment
For the home country, unit production costs are ( ) + . , where E denotes emissions per unit
output, P is the domestic carbon price and unit costs C are assumed convex in E. Emissions may be

set by regulatory fiat or chosen freely to minimize costs, in the latter case satisfying the necessary
condition − ( ) = . Analogously, unit costs of the foreign producer selling into the domestic market
are

∗( ∗)

+

.

∗ ∗ 34In aiming to ‘level the playing field,’ the view might reasonably be take that, on

efficiency grounds, one would not want to adjust for differences in costs that would arise even atcommon levels of emissions. That dictates benchmarking by some common technology. Taking this(as suggested, pragmatically, in the text) to be that at home, equating the deemed unit costs of serving
the domestic market across domestic and foreign producers requires setting a charge , per unit of
the product,35 such that ( ) + . = + ( ∗ ) + ∗ ∗, and hence
= ( −

∗ ).

∗

+ { ( ) − ( ∗ ) − . ( ∗ − )} .

(A1.1)

The first term on the right of (A1.1) is a ‘traditional’ BCA: a charge on foreign emissions at a rate equal
to the excess of the domestic carbon price over the foreign. The second term adds an additional charge

34 If the foreign country rebates carbon charges on its exports,
35 The analysis on the export side is symmetric, with

∗ = 0.

> 0 then corresponding to an export subsidy.

27

to the extent that any cost saving from (say) higher emissions abroad exceeds the consequent increasein domestic tax payable at import.
If, for example, the home country uses only regulation (so(A1.1) is= 0), then the import charge implied by= − ∗ ∗ + { ( ) − ( ∗ )}(A1.2)and so is positive only if domestic regulation is tight enough to lead to higher costs at home thanabroad (so that<∗), and also offsets any tax levied abroad (assuming this is not removed by anexport-rebating BCA abroad). To a first order approximation, the cost differential term is . ( ∗ − ),where

≡ − ( ) is the shadow price of domestic emissions: so this component of the tax can bethought of imposing a charge, at the domestic shadow price, on the excess of foreign over domestic
emissions.

If, on the other hand, the home country deploys a carbon tax, so that − ( ) = , then to a first orderapproximation the second term in (A1.1) is zero, and all that remains is the traditional BCA: that is,≈( − ) . More generally, the traditional BCA will somewhat overstate the import charge needed tolevel the playing field, to an extent that increases with the price responsiveness of emissions. 36∗

36 This∗follows on noting that=( −∗) ∗ −

overstatement is that (taking the case in which∗ >( )( ∗ − ) ,for some∈( ,∗ ). The

reason for this) the cost saving associated with the higher emissions level mustbe less than the tax that would be saved at the rate which generates the lower level, otherwise those higher emissions
would have been preferred when faced with that tax rate.

28

Annex 2: Carbon Leakage and Competitiveness
Although a loss of competitiveness and any consequent reduction in domestic production arising fromcarbon pricing (or other mitigation policy) is the ultimate cause of carbon leakage, the relationshipbetween the two is complex and depends on a range of factors. This annex examines some of theinteractions between these two concepts and shows that the competitiveness and leakage motivations
for a BCA may only be loosely linked.
Leakage is defined as
≡−

Δ ∗
,
Δ

where E and E* are domestic and foreign CO2 emissions. Writing the former as(A2.1), where e denotes=

emissions intensity, the change in domestic emissions in response to the imposition or increase of adomestic carbon price is approximately

where

Δ = Δ( ∙ ) ≈

+

∙

.

can be assumed negative. Suppose for clarity that production abroad,same amount as the net exports of the home country, NX, fall. Since∗(A2.2), increases by the=− , where D denotes) .

(A2.3)

domestic demand, and with foreign emissions intensity unchanged, the change in emissions abroad isΔ ∗ =− ∗∙Δ= − ∗(−

Substituting (A2.2) and (A2.3) into (A2.1) gives, after some rearrangement,
≈

∗

(+)

(-)

−

(-)

/( + ̂ )(-) (-)( 2.4)

where ̂ denotes a proportionate change, with expected signs of terms shown in parentheses, and weassume and ̂ are both strictly negative. Then:-

Leakage is symmetric in exports and imports: (A2.4) applies whether considering an increasein imports due to loss of competitiveness, a reduction in exports, or both.

-

Leakage is proportional to the original relative emissions intensity of foreign production-

Leakage is positive if home’s net exports fall; it can in principle be negative, but only in theunlikely case that domestic demand falls by even more than domestic production.

-

If emissions intensity abroad exceeds that at home by a large enough margin, leakage canexceed 100 percent—meaning that total emissions increase.

29Equation (A2.4) can be used to explore the influence of different factors on the leakage rate. Figure 7
in the main text showed the simplest case, with no domestic demand decline. Figure 2.1 introduces anillustrative 5 percent decline in

Figure 2.1. EITE Leakage Rates with Demand Effects

domestic demand, in a scenario
with half of local demand met
by domestic production andhalf by (net) imports. The
horizontal

axis

shows

the

change in the share of demand
met by domestic production.
The chart illustrates the wide
range

of

possible

leakageoutcomes, including negative inthe (probably very unlikely) casein which the shift of production
abroad is not large enough to prevent imports falling and over 100 percent when the relative intensityof foreign emissions is very high.
Figure 2.2 shows how leakage can vary according to the scale of the domestic emissions cut (with scale
reversed for readability). For low emissions reductions, leakage can be high even with only a small shiftofproduction

abroad.

The

intuition behind the lower leakage

Figure 2.2. EITE Leakage Rates by Emissions Reduction

for higher domestic emissions
cuts

(at

a

given

shift

of

production) is simply that thenumerator (increase in foreign
emissions) stays the same while
the denominator (decrease indomestic emissions) increases. Of
course,inpracticeaemissions

reduction

will

associated

with

a

largerbelargerproduction shift, making its final
effect on leakage ambiguous.

30

The extent to which carbon leakage necessarily increases total emissions is not straightforward either.
If production abroad still has lower emissions intensity than the domestic industry after carbon pricing(for example, if the foreign country has abundant hydro or nuclear power), then any shift of production
will still count as leakage (since foreign emissions rise while domestic emissions fall) but would resultin a reduction of total emissions –
over

and

above

the

fall

in

Figure 2.3. Total Net Emissions Charge

domestic emissions due to thecarbon pricing. Figure 2.3 gives anexample: at low foreign emissions
intensity, the change in total
emissions becomes more negative
as production shifts, but it rises
when foreign emissions are muchdirtier. A reading above zero on
this

chart

corresponds

toaleakage rate above 100 percent.
The final question is how all thesechanges in industry emissions
translate into an actual effect on
total

globalemissions.

This

depends on the overall climate policies of the countries concerned. Table 2.1 summarizes the relation
between changes in emissions due to leakage, and the countries’ respective overall emissions policies
and commitments. If a country has a firm cap on its emissions path in levels terms, which is binding
over a long horizon, then in theory changes in a single industry’s emissions would be fully offset bychanges elsewhere. But while virtually all countries have made pledges under the Paris Agreement, inmany cases they are either not binding, or set in relation to GDP, in which case changes due to leakage
would still carry through to their overall emissions. Table 2.1 describes the set of possible outcomesfrom this perspective.
Table 2.1 Leakage and Paris commitments
Does the country have a binding
long-term cap on overall CO2
emissions in levels terms?
Domestic country(imposing carbon price)

Foreign country (no change in mitigation policy)
Yes

No

Yes

Leakage does not affect global
emissionsNo

Leakage reduces global emissions(domestic emissions fall but
foreign do not rise)

Leakage “doubly” increases global
emissions (foreign emissions rise
but domestic do not fall)
Leakage increases* global
emissions (domestic emissions fall
and foreign rise)* Except for the case mentioned in the text that foreign emissions intensity is lower than domestic intensity after carbon
pricing, in which case leakage will reduce global emissions here. Leakage is assumed to be positive for this table.

31Annex 3. Empirical Literature on Emissions Leakage: A Quick Summary
A large empirical literature has estimated leakage rates, mostly for large countries or broad groups ofadvanced countries implementing carbon pricing, at around 10-30 percent—but reflecting leakage
from both changes in the international location of production and in international fuel prices.37 This
literature largely relies on ex ante analyses using computable general equilibrium models that combine
estimates of the impacts of carbon pricing on industrial production costs and assumptions about thedegree of substitution between goods produced in different countries.
Misch and Wingender (2021). discussed in the text (and as shown in Figure 8), take an ex post
econometric approach for estimating leakage from production migration, using data on how changes
in sectoral energy prices in different countries and over time affect the carbon embodied in trade flows.
Some other ex post studies suggest little evidence of leakage for EU climate policy;38 instead otherfactors (e.g., proximity to market, transport costs, quality of the local labor force, availability of raw
materials) appear to be more important determinants of production location decisions. These studies,
however, look at previous periods where the EU ETS price was relatively low and EITE industries werereceiving free allowance allocations (which are conditional on them remaining in the EU). Goingforward, as recent increases in EU ETS prices continue, and allowance allocations become less effectiveat preserving the profitability of EITE industries, potential emissions leakage (in the absence of a BCA)
would likely increase.39

Annex 4. International Carbon Price Floor (ICPF)
There are two main practical obstacles to scaling up global mitigation over the next decade under theParis Agreement. First, there are many parties (195), negotiating over many pledges (one per party),and pledges for 2030 are difficult to compare.40 Second, it is challenging for countries to scale up
mitigation unilaterally due to concerns about competitiveness and that trading partners will free ride
and/or renege on their mitigation pledges. An ICPF could complement and reinforce the Paris
Agreement as its two key elements seek to address both obstacles.

37 See, for example, Aldy (2017), Böhringer et al. (2012), Branger and Quirion (2014), Burniaux et al. (2013), Carbone andRivers (2017), and Ellis et al. (2019).
38 For example, CPLC (2019), Dechezleprêtre et al. (2019), and Naegele and Zaklan (2019).
39

The EU ETS price jumped from $6 per ton in 2017 to over $70 per ton in 2021 (https://ember-climate.org/data/carbon-

price-viewer). And the EU recently tightened its 2030 emission pledge from a 40 to a 55 percent reduction relative to1990 levels.
40 2030 pledges currently vary in terms of: (i) target variables (e.g., emissions, emission intensity of GDP, clean energy

shares); (2) nominal stringency (e.g., percent emission reductions); and (iii) baseline years against which targets apply(e.g., historical versus projected baseline emissions).

32

One element would be a focus on a small number of key emitting countries, the most importantcandidates (from a perspective of global emissions mitigation potential) being China, India, and theUnited States, though other participants might include the EU, UK and some other G20 countries. The
second element would be a focus on a minimum carbon price, which is an efficient and easily
understood parameter, and simultaneous coordinated action to scale up carbon pricing would directly
tackle competitiveness and free rider concerns. The focus on a price floor rather than a single common
price level allows flexibility if countries need higher prices than the floor to meet their NDC pledges so
the ICPF and the Paris Agreement would complement and reinforce each other.
An ICPF could be designed equitably with stricter requirements for higher income countries and/or
simple and transparent (financial or technical) mechanisms to assist lower income countries. It could
also be designed flexibly to accommodate differing approaches at the national level (e.g., different
combinations of pricing and sector-based fiscal and regulatory incentives) so long as they achieve theequivalent emissions outcome as would have been achieved by meeting the price floor (as verified bythird parties). Exempting participants from a common BCA applied to all those outside thearrangement (except low income countries) could be a mechanism to promote participation in an
ICPF.41 However, as noted in Section 3, differentiation of a BCA based on the country-of-origin of theimports may violate GATT’s Most Favored Nation principle (with reliance on an Article XX defense thennecessary).

41 See Parry et al. (2021) for further discussion of an ICPF.

33

Annex 5. Compatibility of BCAs with Trade Law: A Quick Look
In short, WTO rules allow countries (before needing to rely on exceptions) to provide rebates forindirect taxes on products that are exported (not to exceed the domestic tax paid on like products thatare consumed domestically) and to apply a charge to imported products (not in excess of the indirect
tax on like domestic products). In this sense, the WTO rules permit BCAs that are non-discriminatory
harmonizing measures. Possible channels for compatibility of BCAs with WTO rules include thefollowing.42
BCAs with carbon taxes. Charges on imports accompanying a domestic carbon tax might becharacterized as a ‘customs duty’ or a ‘charge imposed on or in connection with importation’ under
GATT Article II:2(a) which allows import charges equivalent to domestic taxes. The BCA must however
be imposed on a specific product or input to that product—it is not entirely clear whether this allows
for the taxing of embodied carbon which might be interpreted as a by-product rather than an input.
Moreover, according to Article III:2, the BCA could not exceed the tax rate on ‘like’ domestic products,
raising some uncertainty about applying higher charges to imports with higher embodied carbon,
unless the latter are interpreted as ‘unlike’ domestic products.
Export rebates for carbon taxes might be allowable under the WTO Agreement on Subsidies andCountervailing Measures (SCM Agreement), footnote 1, which specifies that rebates of domestic
indirect taxes—in principle including energy taxes—should not be deemed export subsidies. Again
however, the rebate would have to be offered on the same terms to all domestic firms covered by the
carbon tax—if ‘like’ products are interpreted by characteristics other than embodied carbon, the nogreater-than requirement would imply the rebate could not exceed the lowest tax rate levied on
domestic producers, that is, the rate assessed on the cleanest producer.
BCAs with ETSs. If a BCA requires importers to purchase allowances from a domestic ETS or separate
allowance pool this would likely be considered a form of domestic regulation under GATT Article III:4,
which requires that the imported product receive regulatory treatment no less favorable than the likedomestic product. Again, if imports are viewed as ‘like’ domestic products requiring allowancepurchases according to the carbon content of imports, rather than the carbon content of domestic
products, this might breach WTO rules. On the other hand, a BCA on exports, taking the form of arebate for the costs of an ETS, could be considered a prohibited export subsidy if rebates were notavailable for like products sold domestically—there is no provision in WTO law for border rebates ofregulatory costs.

42 The discussion here draws from Cosbey et al. (2019) and OECD (2020). See also Flannery et al. (2018), Holzer (2014),

Mehling et al. (2019), Pauwelyn (2013), and Trachtman (2016).

34

Irrespective of whether the BCA accompanies a carbon tax or an ETS, Article I prohibits discrimination
among imports based on their country of origin. If a BCA regime differentiates imports based on
country-specific estimates of embodied carbon, rather than applying the same embodied carbon to
all countries, it could violate the Most Favored Nations (MFN) principle if measures of embodied
carbon were viewed as arbitrary—though allowing relatively clean individual exporters to request lower
BCAs might lower the risks of measurement procedures being viewed as arbitrary. Special treatment
for some countries (e.g., those meeting ambitious Paris mitigation pledges) might also violate the MFN
principle, in the absence of an objective test applicable to all. Exemptions for least developed countries
might be allowed under the WTO’s Enabling Clause, if the exemption criteria are based on
development indicators, and countries in similar conditions are treated the same way.
Even if a BCA is found to violate other Articles, it may still be allowable under GATT Article XX (General
Exceptions). This would apply if, according to sub-paragraph (a), it is necessary to protect human,
animal, or plant life or health or, according to sub-paragraph (g), it relates to the conservation of
exhaustible natural resources. Most analysts see sub-paragraph (g) as easier to comply with given therequirement to prove necessity in paragraph (a). In effect, any BCA must demonstrate that it iseffectively addressing climate change, for example, through containing leakage. The BCA would alsoneed to satisfy the introductory paragraph (the “chapeau”) of Article XX, which requires that it not beapplied in a manner that would constitute “a means of arbitrary or unjustifiable discrimination between
countries where the same conditions prevail” and is not “a disguised restriction on international trade.”
Historically, very few measures have survived scrutiny under the chapeau, underscoring the importanceof designing BCAs in a WTO-compliant fashion, with the need to rely on the exceptions only as afallback.
A BCA may fail to satisfy Article XX if it:
Requires specific policy changes as a basis for exemption from the BCA which might constitutearbitrary discrimination under GATT’s exceptions provisions because measures tied to countrylevel policies will punish all producers from targeted countries, regardless of their individual
environmental performance—instead, the BCA should offset the differential between foreignand domestic carbon pricing;
Assesses adjustments based on the country of origin, rather than on objective criteria
applicable to all countries (which may include emissions-related policies, or the environmental
performance of individual producers);
Implements the BCA without having tried to negotiate in good faith to reach some multilateralsolution to the problem of carbon leakage (negotiations under the Paris process could
arguably be considered steps in this direction);
Allows exemptions from coverage of the BCA (e.g. for parties that have ambitious climate goals
under the Paris Agreement) or for specific domestic producers that are not based on theobjective of mitigating climate change by preventing leakage.

35

Importantly, while GATT Article XX can provide justification for breaches of GATT obligations, mostanalysts agree that it does not cover breaches of obligations in other WTO Agreements, such at thaton Subsidies and Countervailing Measures (SCM). For example, a BCA considered to provide aprohibited export subsidy under the SCM Agreement would have no recourse to GATT Article XX.
Nonetheless, under the SCM, a carbon tax would likely be an indirect tax, and therefore export
adjustments would be legal provided that the amount of the adjustment is not more than the domestic
carbon tax incurred.43

43 A possible precedent for BCAs is the WTO ruling that the US tax on imported substances produced or manufactured

using chemicals subject to the Superfund tax was consistent with Article II:2 (a) and the principle of national treatment(see Genasci 2008).

36

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