Carbon Border Adjustments, Offsetting and Other Cross-border Initiatives

Carbon Border Adjustment Mechanisms (CBAMs)

Carbon border adjustments aim to avoid ‘carbon leakage’, which occurs when emissive activities move abroad in response to domestic climate policies.

Carbon border adjustments operate similarly to a carbon tax but impact goods coming from other countries – they are tariffs levied on imports based on their embodied carbon. CBAMs are always paired with a carbon price that taxes domestic goods for their climate pollution.

Exporters can escape costs associated with CBAMs if they have their own carbon price, in which case the CBAM is lowered to only cover the difference between the two prices.  This prevents ‘double taxing’ of emissions and acts as an incentive for other countries to implement carbon pricing regimes of their own.

Carbon border adjustments are a relatively new mechanism, but several governments and coalitions have shown interest in implementing them. Like other tariffs, however, CBAMs may cause diplomatic tension, and may be used to disguise protectionism.

The world’s first CBAM was launched by the European Union in October 2023. From 2026, imports into the EU will need to pay the same price that domestically produced goods pay under the EU ETS, or the difference (if any) between the carbon price paid under domestic regimes and the EU ETS price. Already, countries including Turkey, Indonesia, Vietnam and Thailand have started contemplating their own carbon prices, specifically to avoid the European CBAM. At the end of 2023, the UK announced it would implement a CBAM by the end of 2027.

The introduction of CBAMs has raised concerns among developing nations, who have argued that they go against the principle of fairness enshrined in the Paris Agreement. They say that developed countries have already made vast economic gains from generating the majority of historical GHG emissions. In theory, CBAMs that favour ‘cleaner’ exporters could reduce the global competitiveness of developing country exports, leading to further disadvantage. At the moment, introducing equivalent carbon pricing regimes in much of the Global South is stymied by a lack of capacity and resources, which means imports from those jurisdictions will likely need to pay higher carbon tariffs than countries with high carbon prices.

Global pricing initiatives

There have been calls for a global mechanism for carbon pricing. Indeed, COP26 saw progress towards the implementation of Article 6 of the Paris Agreement, which includes a provision for linking different emissions trading systems across the world.  Multiple emissions trading systems have already been linked across the world. For example, California and Quebec have linked their emissions trading systems. The EU and Switzerland have also linked their emissions trading systems. By enhancing the size of carbon markets, linking emissions trading systems can encourage more cost-effective emissions reductions. 

Recently, the IMF has promoted an international carbon price floor price (ICPF). It proposes a tiered pricing system, with different minimum carbon prices for low-, middle- and high- income countries. The IMF’s proposal integrates efforts (outlined earlier) to calculate the implied cost of carbon across pricing, subsidies, and other regulation, to properly equivalency and therefore fairness. However, analysis shows that questions of effort sharing and carbon leakage may persist under such a system.

Voluntary carbon markets

Voluntary carbon markets have developed alongside regulatory carbon pricing mechanisms. In the voluntary carbon market, organisations and individuals purchase ‘carbon credits’ which represent emission reductions or removals that have occurred elsewhere. Organisations often purchase carbon credits to ‘offset’ emissions from their activities and reach climate goals. Offsetting should supplement, rather than replace, direct emissions reductions within a company’s value chain, and can be particularly useful to address highly emissive activities without commercially viable alternative technologies. Organisations may also use carbon credits to go beyond net zero and finance further emissions reductions, for example by aiming to offset all historical emissions. 

While compliance carbon markets remain significantly larger than their voluntary counterparts, the voluntary carbon market has seen significant growth in recent years and is projected to scale rapidly as countries and organisations accelerate implementation of their climate targets. 

Some prominent private companies have faced significant headline and reputational risk using voluntary carbon credits. Emissions data or projections from certain carbon credits may not be accurate and in some cases reductions may not even occur for credits that represent avoided emissions. These risks are particularly salient in the case of nature-based offsets.  The risks for business associated with investing in the voluntary carbon markets are discussed in the section – Carbon pricing and the board.

Article 6 of the Paris Agreement aims to provide an international architecture for carbon credits, which would suceed the Clean Development Mechanism established under the Kyoto Protocol – however, with no agreement at COP28 on how this system can be formally operationalised, the voluntary carbon markets remain self-regulated. Private standard-setting initiatives including the Taskforce for Scaling the Voluntary Carbon Markets (TSVCM) and the Integrity Council for the Voluntary Carbon Market (ICVCM) have been established with the aim of improving the credibility and accelerating the use of carbon credits.

In some cases, voluntary carbon markets may interact with compliance markets. Some trading systems allow firms to meet their obligations, to a degree, through purchasing and retiring voluntary carbon credits rather than allowances. This a key feature of the Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA). Given the consensus that carbon removals will be necessary to meet many climate targets, carbon credits may also be key to creating a ‘negative emissions marketplace’ which would provide financial incentive for both technological and natural greenhouse gas removal solutions.

Broader guidance on responsible businesses may help organisations navigate the voluntary carbon markets. The OECD Guidelines for Multinational Enterprises on Responsible Business Conduct, for example, suggest that offsetting ‘may be considered as a means to address unabated emissions as a last resort’, and that businesses should ensure that any carbon credits they purchase have high environmental integrity.

Read more about opportunities and challenges associated with offsetting in our explainer for Chapter Zero.