Climate contribution: a smart policy solution for decarbonising material production and use in the EU

On 11^th December 2020, the European Council agreed on the 55% GHG reduction target for 2030. This is an important milestone in a longer journey to build a climate-neutral European economy by mid-century. Achieving this goal will not be possible without an appropriate policy framework for decarbonising material production and use in Europe. Such framework should provide clear incentives to adapt climate-friendly solutions both on supply and demand side, while also avoiding the risk of carbon leakage and encouraging the rest of the world to join the low-carbon transition. There is a consensus that current European policies in this area are not sufficient, and the reform is urgently needed. Current discussions are focused on introducing CBAM – carbon border adjustment mechanism, which should address current gaps in the EU industrial decarbonisation policy. While the debate is mostly centered around the border-focused forms of CBAM, in our policy brief we show that a consumption-focused mechanism – climate contribution – is an effective and robust alternative.

The climate contribution is a weight-based charge on consumption of carbon-intensive materials sold for final use in Europe. The charge is linked with the EU ETS, as its level it depends on the market prices of emission allowances and product benchmarks.

To understand the benefits of introducing climate contribution, it is important to first identify the weaknesses of current policy mix, i.e. the carbon price signal provided by the EU ETS combined with free allocation for industrial installations, which is designed to safeguard them against carbon leakage. We show that despite common criticisms, the free allocation mechanism can be adjusted to be compatible with deep decarbonisation of industry and to avoid the risk of windfall profits. This can be achieved by further shift towards fully dynamic allocation. Two structural problems remain:

dynamic free allocation mutes the carbon price signal on the demand side, which leads to underinvestment in material efficiency and substitution,
in the long run, the government may potentially need to provide additional funds from outside the EU ETS system to maintain the free allocation (buying allowances on the secondary market or switching to equivalent monetary transfers).

Adding climate contribution to the EU ETS solves both problems, by providing appropriate carbon price incentive on the demand side and ensuring that, on aggregate, climate action in the materials sector will not be a drain on the public budget. In other words, the climate contribution complements dynamic free allocation by passing through the carbon price signal to material users, as well as raising additional funds which can be used for supporting climate action.

When comparing the proposed solution to border-focused variants of CBAM, such as border charges or inclusion of imports in the emissions trading system, it is important to set a realistic benchmark. When taking into account administrative and legal limitations of introducing CBAM, it becomes clear that the combination of dynamic free allocation and climate contribution has several significant advantages compared to border-focused measures:

Low risk of trade conflict. The climate contribution is levied without differentiation by production process or location,
Maintaining level playing field for European exports. Maintaining free allocation avoids carbon leakage risks while providing incentive to shift it to low-carbon technologies,
Low administrative complexity. The required information is already available (benchmark values within the EU ETS, allowance prices) or easier to collect and verify than any carbon footprint information (unlike type of production process used, product weight is directly observable at the point of entry into the EU market),
Evolutionary reform of the EU ETS limits uncertainty for the industry,
Avoiding the risk of resource shuffling by covering material use and accounting for its marginal effect on primary production,
Avoiding the risk of carbon leakage spreading down the supply chain, as climate contribution covers materials embedded in the components and final goods, price impacts of using carbon-intensive materials apply both to European producers and importers of goods.

From the perspective of international climate policy, the proposed framework offers further benefits. First, by creating a robust “bubble” for scaling up low-carbon industrial innovations, it provides a credible pathway to even more ambitious long-term policy measures, e.g. introduction of low-carbon product standards. Second, it may be used as a regulatory template for other regions and countries.

Overall, addressing the carbon leakage risk at the point of domestic production (free allocation) and fixing the resulting carbon price distortion by introducing a consumption-side measure on the domestic market (climate contribution) emerges as a more robust and easily implementable solution than full auctioning combined with adjustments at the border. As the European Commission is planning to present its CBAM proposal in 2021, it is important that a broad set of alternative policy options is well-understood and discussed. Thus, we encourage policymakers and stakeholders to explore the climate contribution concept as a smart alternative to border-focused measures.

The Climate Friendly Materials (CFM) Platform analyse the transformation of basic material production and use to achieve carbon neutrality by 2050. Its collective aim is to aid progress toward nationally-led industrial decarbonisation policy frameworks compatible with long-term EU strategy, an to capture the potential of a just and inclusive clean energy transformation.