Im­pact Se­ries: 06-21

The European Green Deal:
Transforming International Trade and Transportation

Michael Blanga-Gubbay
Senior Research Fellow at the Kühne Center for Sustainable Trade and Logistics at the University of Zurich

Roza Khoban
Senior Research Fellow at the Kühne Center for Sustainable Trade and Logistics at the University of Zurich

Outline

In this Kühne Impact Series, we analyze the effects of the European Green Deal on international trade and transportation. Our main point is that the Green Deal marks a step change in the EU’s climate policy, which will transform European trade and transportation. In particular, by strengthening the EU Emission Trading System and introducing a Carbon Border Adjustment Mechanism, it will increase the carbon price towards its social optimum. This will incentivize households and firms to buy greener products, from greener countries, using greener transportation, and thereby contribute to a more sustainable globalization. In contrast, we believe that the new green agenda in the EU’s trade policy strategy, while ambitious in spirit, is less likely to have concrete effects.

Full Article

An economic and geo-political outlook

Cli­mate change is one of the defin­ing chal­lenges of our cen­tu­ry. In re­sponse to this chal­lenge, the Eu­ro­pean Com­mis­sion has re­cent­ly launched the so-called Eu­ro­pean Green Deal, which at­tempts to trans­form the Eu­ro­pean econ­o­my and make Eu­rope the first cli­mate-neu­tral con­ti­nent glob­al­ly by 2050.

As a first step, the EU Mem­ber States have com­mit­ted to re­duc­ing net emis­sions by at least 55% by 2030, com­pared to 1990 lev­els. In 1990, to­tal emis­sions from all green­house gas­es in the EU reached 4,713.874 mil­lion met­ric tons of CO₂. Since then, the lev­el has been re­duced by 26% (in 2019). Fur­ther ac­tions are need­ed to achieve a 55% re­duc­tion by 2030 (see Fig­ure 1).

In July 2021, the Eu­ro­pean Com­mis­sion there­fore pre­sent­ed the so-called “Fit for 55” pack­age - a pack­age of pro­pos­als aimed to en­sure that the emis­sion re­duc­tion tar­get can be achieved.¹ The pro­posed mea­sures in­clude changes in the EU’s in­ter­nal pro­duc­tion, con­sump­tion, and re­la­tion­ship with non-EU coun­tries. The green agen­da is also sup­posed to be re­flect­ed more broad­ly in all EU ac­tions and poli­cies, such as the EU’s new trade pol­i­cy strat­e­gy. The “Fit for 55” pack­age is still sub­ject to ne­go­ti­a­tions by the Eu­ro­pean Par­lia­ment and the EU Mem­ber States.²

In this Kühne Im­pact Se­ries, we an­a­lyze the ef­fects of the Eu­ro­pean Green Deal on in­ter­na­tion­al trade and trans­porta­tion. Our main point is that the Green Deal marks a step change in the EU’s cli­mate pol­i­cy, which will trans­form Eu­ro­pean trade and trans­porta­tion. In par­tic­u­lar, by strength­en­ing the EU Emis­sion Trad­ing Sys­tem and in­tro­duc­ing a Car­bon Bor­der Ad­just­ment Mech­a­nism, it will in­crease the car­bon price to­wards its so­cial op­ti­mum. This will in­cen­tivize house­holds and firms to buy green­er prod­ucts, from green­er coun­tries, us­ing green­er trans­porta­tion, and there­by con­tribute to a more sus­tain­able glob­al­iza­tion. In con­trast, we be­lieve that the new green agen­da in the EU’s trade pol­i­cy strat­e­gy, while am­bi­tious in spir­it, is less like­ly to have con­crete ef­fects.

In the re­main­der of this Se­ries, we de­vel­op this ar­gu­ment, look­ing at these three pol­i­cy ini­tia­tives in turn.

Strengthening the EU Emission Trading System

The Eu­ro­pean Green Deal con­tains a vast num­ber of pro­pos­als that are of­ten es­sen­tial­ly in­ter­linked. How­ev­er, the EU Emis­sion Trad­ing Sys­tem (ETS) - EU’s car­bon pric­ing in­stru­ment - is a cor­ner­stone and key tool to achieve car­bon neu­tral­i­ty. It is a “cap and trade” sys­tem, which sets an an­nu­al lim­it on the green­house gas emis­sions of cov­ered en­ti­ties. This cap is grad­u­al­ly re­duced to achieve emis­sion re­duc­tions. With­in the cap, mar­ket play­ers buy or re­ceive emis­sions al­lowances, which they can choose to trade with one an­oth­er, cre­at­ing a price on emis­sions.

The ex­pe­ri­ence with the EU ETS so far is mixed. On the one hand, sev­er­al stud­ies show that the sys­tem has proven ef­fec­tive at dri­ving emis­sion re­duc­tions.³, ⁴ In­stal­la­tions cov­ered by the ETS re­duced emis­sions by about 35% be­tween 2005 and 2019. On the oth­er hand, the pace of emis­sion re­duc­tions has been too slow rel­a­tive to EU goals. This is large­ly due to the fact that the ETS car­bon price has long been be­low any rea­son­able es­ti­mate of the so­cial cost of car­bon, re­main­ing be­low €10/tCO₂ from 2013 to 2017 (see Fig­ure 2). The main cul­prit of this is an over-sup­ply of free al­lowances pro­vid­ed to pro­duc­ers at a high risk of car­bon leak­age.⁵ For ex­am­ple, more than 80% of al­lowances are cur­rent­ly al­lo­cat­ed free of charge in some steel sub­sec­tors.

In light of this, the Eu­ro­pean Com­mis­sion has pro­posed a sub­stan­tial strength­en­ing of the ETS as an es­sen­tial part of the Green Deal ini­tia­tive, in­volv­ing a de­crease of the emis­sions cap, a phase-out of free al­lowances, and an ex­ten­sion of the ETS to ad­di­tion­al sec­tors. A look at the ETS prices sug­gests that mar­ket par­tic­i­pants be­lieve in the im­ple­men­ta­tion of these new green com­mit­ments. In par­tic­u­lar, the car­bon price more than tripled to €90/t CO₂ un­til the be­gin­ning of De­cem­ber 2021 rel­a­tive to the 2019/2020 av­er­age val­ue of €25/t CO₂ (see Fig­ure 2). Some stud­ies es­ti­mate car­bon prices to in­crease fur­ther up to €130/t CO₂ for 2030.⁶

As part of this ef­fort, the Eu­ro­pean Com­mis­sion wants to broad­en the EU ETS to more ful­ly cov­er the trans­porta­tion sec­tor, with the over­all goal of re­duc­ing trans­porta­tion emis­sions by 90% by 2050. The cur­rent pro­pos­al in­cludes an ex­ten­sion of the cur­rent EU ETS to the mar­itime sec­tor for the first time in 2023-2025. Road trans­porta­tion is sug­gest­ed to be sub­ject to emis­sion trad­ing start­ing 2026, with a sep­a­rate sys­tem fo­cused on up­stream fuel sup­pli­ers. More­over, the ex­cep­tions cur­rent­ly ben­e­fit­ing the avi­a­tion sec­tor would be phased out.⁷

At this point, it is not straight­for­ward to es­ti­mate the po­ten­tial ef­fects on the costs of the trans­porta­tion sec­tor. A key ques­tion is whether the trans­porta­tion sec­tor would have to buy al­lowances or ob­tain them free of charge. Nev­er­the­less, be­ing in­clud­ed in the EU ETS would gen­er­ate in­cen­tives to de­car­bonize trans­porta­tion ei­ther way. In par­tic­u­lar, even freely al­lo­cat­ed emis­sion al­lowances pro­vide in­cen­tives for in­vest­ing in emis­sion re­duc­tions, giv­en that un­used al­lowances can be sold.

Over­all, the re­forms pro­posed by the Eu­ro­pean Com­mis­sion would amount to a sub­stan­tial strength­en­ing of the EU ETS, turn­ing it into a more pow­er­ful tool in the fight against cli­mate change. High­er ETS prices and an ex­pand­ing ETS cov­er­age would bring the con­ti­nent clos­er to hav­ing a so­cial­ly op­ti­mal car­bon price, even though the sys­tem would con­tin­ue to have many blind spots.

As a re­sult of these re­forms, we ex­pect trade pat­terns with­in the EU to shift sig­nif­i­cant­ly. Specif­i­cal­ly, pro­duc­tion and ex­port vol­umes will like­ly move to­wards green­er coun­tries, green­er sec­tors, and green­er trans­port modes over time, as a high­er car­bon price pe­nal­izes emis­sion-in­ten­sive ac­tiv­i­ties. This would im­ply more sus­tain­abil­i­ty in in­tra-Eu­ro­pean trade.

Fig­ure 3 pro­vides a sense of the like­ly win­ners and losers of this change by show­ing Eu­ro­pean coun­tries’ emis­sion in­ten­si­ties and their pro­duc­tion vol­umes of goods cov­ered by the ETS sys­tem. Not sur­pris­ing­ly, the four biggest EU economies are the main pro­duc­ers of prod­ucts un­der the cur­rent ETS scope (iron and steel, alu­minum, and fer­til­iz­ers). In terms of emis­sion in­ten­si­ty, they are rel­a­tive­ly ef­fi­cient, per­form­ing bet­ter than East­ern EU coun­tries. A steep in­crease in ETS prices might shift pro­duc­tion from rel­a­tive­ly high­ly pol­lut­ing coun­tries such as Ro­ma­nia, Slo­va­kia, Poland, and the Czech Re­pub­lic to­wards green­er economies. This will most prob­a­bly ben­e­fit the biggest EU’s economies and, with­out some ad­e­quate com­pen­sa­tion mech­a­nisms, could ex­ac­er­bate the po­lar­iza­tion with­in EU coun­tries.⁸

Introduction of a Carbon Border Adjustment Mechanism

An in­creased price on car­bon is like­ly to af­fect Eu­ro­pean firms’ com­pet­i­tive­ness both in the home mar­ket and glob­al­ly, im­pact­ing trade pat­terns be­tween EU and third coun­tries. In par­tic­u­lar, Eu­ro­pean firms’ mar­ket share with­in Eu­rope and their ex­port mar­ket share to third coun­tries may be re­duced rel­a­tive to firms that do not face car­bon prices. More­over, a ma­jor con­cern as­so­ci­at­ed with in­creased car­bon prices in the EU is that it could in­duce car­bon-in­ten­sive pro­duc­tion to shift abroad. If pro­duc­tion moves to more car­bon-in­ten­sive coun­tries, such leak­age could even in­crease over­all emis­sions, mak­ing the EU car­bon price coun­ter­pro­duc­tive.

His­tor­i­cal­ly, the EU ETS does not seem to have trig­gered sub­stan­tial car­bon leak­age in the sec­tors in which it is ap­plied. A 2020 OECD re­port shows lit­tle change in for­eign emis­sions em­bod­ied in do­mes­tic fi­nal de­mand in EU coun­tries.⁹ How­ev­er, this as­sess­ment con­cerns a pe­ri­od of gen­er­ous anti-leak­age mea­sures, such as the free al­lowances for pro­duc­ers in some steel sub­sec­tors men­tioned above. There­fore, it is un­like­ly to pro­vide a re­li­able guide to the po­ten­tial car­bon leak­age as­so­ci­at­ed with a strength­ened EU ETS.

To tack­le and pre­vent car­bon leak­age, the Com­mis­sion has there­fore is­sued a pro­pos­al for sta­b­lish­ing a Car­bon Bor­der Ad­just­ment Mech­a­nism (CBAM). If im­ple­ment­ed, this would be the world’s first sys­tem of car­bon tar­iffs. The CBAM would en­sure equiv­a­lent car­bon pric­ing for im­ports and do­mes­tic prod­ucts and there­by lev­el the play­ing field in the Eu­ro­pean mar­ket be­tween the EU and third-coun­try pro­duc­ers for the sec­tors cov­ered by the EU ETS.

To pre­serve its ef­fec­tive­ness as a car­bon leak­age mea­sure, the price of CBAM cer­tifi­cates has to re­flect the EU ETS price close­ly. While the price of EU ETS al­lowances is de­ter­mined through auc­tions, the price of the CBAM cer­tifi­cates is sug­gest­ed to be cal­cu­lat­ed as the week­ly av­er­age of the ETS prices. More­over, the CBAM cer­tifi­cates would be based on ac­tu­al emis­sions of im­port­ed goods. This ap­proach should en­sure fair and equal treat­ment of all im­ports, en­cour­age the use of more emis­sion-ef­fi­cient tech­nolo­gies by pro­duc­ers in third coun­tries, and, im­por­tant­ly, make the CBAM com­pat­i­ble with WTO rules and oth­er in­ter­na­tion­al com­mit­ments.¹⁰

To en­sure a pru­dent and pre­dictable tran­si­tion, the Com­mis­sion pro­pos­es that the CBAM should be im­ple­ment­ed in 2026, fol­low­ing a tran­si­tion pe­ri­od of three years char­ac­ter­ized by data col­lec­tion only. The sug­ges­tion is to have the CBAM pro­gres­sive­ly phased in while free ETS al­lowances in sec­tors cov­ered by CBAM are phased out by 10 p.p. per year be­tween 2026 and 2035.

If suc­cess­ful­ly im­ple­ment­ed, we be­lieve the CBAM would con­tribute to lev­el­ing the play­ing field be­tween Eu­ro­pean firms and third-coun­try com­peti­tors in the Eu­ro­pean mar­ket. As a re­sult, some of the pre­vi­ous­ly men­tioned ef­fects of the EU ETS on the Eu­ro­pean mar­ket, such as a shift to­wards green­er source coun­tries and green­er prod­ucts, would ex­tend to im­port pat­terns from third coun­tries. Ac­cord­ing to our cal­cu­la­tions, Chi­na, Rus­sia, Turkey, USA, and In­dia are the five coun­tries that would be most af­fect­ed by the in­tro­duc­tion of the sug­gest­ed CBAM (see Fig­ure 4).¹¹ To­geth­er these five coun­tries ac­count for 43% of EU im­ports of prod­ucts cov­ered by the CBAM. Al­though the emis­sion in­ten­si­ty in these five coun­tries varies, they all cur­rent­ly ex­ceed the av­er­age emis­sion in­ten­si­ty in Eu­rope.¹²

While ad­dress­ing con­cerns about car­bon leak­age and com­pe­ti­tion in the Eu­ro­pean mar­ket, the pro­posed CBAM would not lev­el the play­ing field be­tween Eu­ro­pean firms and third-coun­try com­peti­tors in third-coun­try mar­kets. If high­er car­bon prices re­duce the com­pet­i­tive­ness of pro­duc­ers in Eu­ro­pean coun­tries com­pared to pro­duc­ers in third coun­tries, firms in the EU may lose ex­port mar­ket shares in third-coun­try mar­kets. Such a sit­u­a­tion may still im­ply a trans­fer in pro­duc­tion to coun­tries with less emis­sion con­straints, lead­ing to car­bon leak­age.

EU Trade Policy Strategy

In line with the Green Deal, the EU has also adopt­ed a new trade strat­e­gy that in­te­grates en­vi­ron­men­tal con­cerns into its ex­ter­nal re­la­tions and trade poli­cies. In the­o­ry, this could in­duce a more sus­tain­able glob­al econ­o­my.

As the world’s largest trad­ing bloc and the top trad­ing part­ner for 80 coun­tries, the EU could con­sid­er­ably im­pact third coun­tries through trade.¹³ This im­pact in­cludes how in­ter­na­tion­al trade is con­duct­ed but also how en­vi­ron­men­tal and wider sus­tain­abil­i­ty-re­lat­ed as­pects are ad­dressed. The EU has used its in­flu­ence to in­clude en­vi­ron­men­tal pro­vi­sions as part of the Trade and Sus­tain­able De­vel­op­ment (TSD) chap­ter in trade agree­ments.¹⁴ As il­lus­trat­ed in Fig­ure 5, the depth of En­vi­ron­men­tal chap­ters with­in EU FTAs has in­creased both in ab­solute terms and rel­a­tive to non-EU FTAs.¹⁵

How­ev­er, these en­vi­ron­men­tal pro­vi­sions lack en­force­abil­i­ty. While this has al­lowed the EU to in­cor­po­rate more as­pi­ra­tional lan­guage in its FTAs, it has si­mul­ta­ne­ous­ly weak­ened the cred­i­bil­i­ty of the en­vi­ron­men­tal stan­dards in­clud­ed in the trade agree­ments. In fact, if a coun­try re­fus­es to com­ply with the sus­tain­abil­i­ty stan­dards stat­ed in the TSD Chap­ter, no sanc­tions are en­vis­aged. This hap­pened in Jan­u­ary 2021, when a pan­el of ex­perts con­firmed that South Ko­rea breached la­bor com­mit­ments un­der the trade agree­ment with the EU, but no fur­ther con­crete or eco­nom­ic mea­sures could be tak­en with­in the cur­rent frame­work.

The EU strives to achieve high­er en­vi­ron­men­tal goals in the new trade strat­e­gy. At the mul­ti­lat­er­al lev­el, the aim is to set an en­vi­ron­men­tal agen­da at the WTO. Bi­lat­er­al­ly, the EU pro­pos­es to in­clude the Paris agree­ment as an es­sen­tial el­e­ment in all fu­ture agree­ments, while com­mit­ments of car­bon neu­tral­i­ty will be sought for FTAs with G20 coun­tries. The Com­mis­sion also wish­es to im­prove the im­ple­men­ta­tion and en­force­ment of the TSD Chap­ter of FTAs. Al­though the trade strat­e­gy for­mu­lates an agen­da for green­er trade pol­i­cy, the ac­tu­al course of ac­tion and en­force­abil­i­ty re­mains un­clear. There­fore, the im­pli­ca­tions of the EU’s new trade strat­e­gy on in­ter­na­tion­al trade and trans­porta­tion, if any, are far less cer­tain at this point.

How­ev­er, oth­er trade pol­i­cy ini­tia­tives, with more clear im­pli­ca­tions, have been tak­en. Specif­i­cal­ly, ini­tia­tives to pre­vent en­vi­ron­men­tal­ly harm­ful prod­ucts from en­ter­ing the EU mar­ket have been an­nounced. This in­cludes a pro­pos­al to pre­vent im­port­ing of goods linked to de­for­esta­tion,¹⁶ de­mands of high­er agri­cul­tur­al stan­dards for im­port­ed goods,¹⁷ and the phas­ing out of non-sus­tain­able im­ports to pro­mote a cir­cu­lar econ­o­my. If im­ple­ment­ed, these mea­sures are more like­ly to af­fect trade pat­terns di­rect­ly.

Concluding remarks

Cli­mate change pos­es an im­mense threat to our so­ci­eties. A swift re­duc­tion of emis­sions is need­ed to tack­le this. The Eu­ro­pean Green Deal aims to achieve this by trans­form­ing the Eu­ro­pean econ­o­my, mak­ing Eu­rope the first cli­mate-neu­tral con­ti­nent glob­al­ly by 2050.

We be­lieve that the “Fit for 55” pack­age - if ful­ly im­ple­ment­ed - marks a step change in the right di­rec­tion. Nev­er­the­less, to be ef­fec­tive, it is cru­cial for pol­i­cy mak­ers to adopt it in its en­tire­ty prompt­ly. While it may not go all the way, it would bring Eu­rope sub­stan­tial­ly clos­er to a sus­tain­able pat­tern of trade and trans­porta­tion. For the first time, mar­ket par­tic­i­pants seem to be­lieve in the im­ple­men­ta­tion of these new green com­mit­ments, as re­flect­ed in the re­cent surge in the EU car­bon prices. As we have made clear, im­ple­men­ta­tion of the pack­age will have im­por­tant im­pli­ca­tions for firms, re­quir­ing ad­just­ments to in­ter­nal­ize high­er car­bon prices and tack­le pos­si­ble re­duced com­pet­i­tive­ness in third-coun­try mar­kets.

Fi­nal­ly, we think that the EU, giv­en its pre­dom­i­nant role in glob­al trade, should be more am­bi­tious in ty­ing in en­vi­ron­men­tal con­cerns with­in trade re­la­tions. The new­ly an­nounced trade pol­i­cy strat­e­gy is clear­ly an at­tempt in this di­rec­tion, but it is still too vague and lacks clear eco­nom­ic and po­lit­i­cal im­pli­ca­tions in its cur­rent form. En­vi­ron­men­tal con­cerns are a glob­al phe­nom­e­non. There­fore, the EU needs to push for more bind­ing en­vi­ron­men­tal pro­vi­sions in its bi­lat­er­al agree­ments, as well as in the mul­ti­lat­er­al are­na, to pave the road for a more sus­tain­able glob­al­iza­tion world­wide.