A border adjustment for the EU ETS: Reconciling WTO rules and capacity to tackle carbon leakage

This article compares several configurations of a border adjustment (BA) to the EU ETS defined so as to maximise their WTO‐compatibility, either with the GATT general regime or with Article XX, its environmental exception rule. The different BAs are assessed quantitatively using the partial equilibrium model CASE II which represents four sectors (cement, aluminium, steel and electricity) included in the EU ETS. We find that the inclusion of imports and exports would reduce world emissions more than the inclusion of imports alone, that an obligation to buy EU allowances is more compatible with WTO rules than one based on a tax, and would be better at reducing world emissions. Moreover, if the BA is based on best available technologies, more precisely on the recently defined EU product‐specific benchmarks, the adjustment is only partial but carbon leakage is nevertheless significantly reduced. Lastly, we highlight a frequent misunderstanding, i.e. that a BA contributes to both carbon leakage limitation and to domestic production preservation: it would efficiently limit leakage, but a decrease in European production of GHG‐intensive products is to be expected. Industries which consume cement, aluminium and steel would pay more for these GHG‐ intensive goods with a border adjustment. Consequently, the price signal should be preserved and diffused in the rest of the economy, a key expected result of climate policy. Free allocation efficiently preserves domestic production but does not preserve and diffuse the price signal and is less efficient in limiting leakage.