Climate change mitigation will alter global trade

The demand from investors and other stakeholders for a comprehensive corporate reporting framework, including sustainability reporting, will drive the programme for completion of standards over the coming months. Companies must commit time and resources to develop their knowledge of and familiarity with current developments and completion of standards. The standards when finalised are likely to have a relatively short lead-in period. ‘Failure to prepare, prepare to fail’ will become a reality for companies that do not make the commitment. Aaron Finley and Vanessa He from Deloitte China argue that companies’ ability to provide the highest standard of disclosure as soon as the standards become applicable will be essential to inspiring and maintaining confidence and support in the investor community.

Investors demand information

Investors say they currently cannot readily use companies’ sustainability disclosures and find themselves having to reconcile different company reporting to gather information needed for decision-making on a comparable basis. Over the past decade, a number of bodies have produced nearly a dozen major reporting frameworks and standards, which businesses have the discretion to apply as they see fit. This has escalated demand for a comprehensive corporate reporting framework, to include both financial reporting and sustainability reporting on an interconnected basis.

Regulators and standard-setters are responding. Of particular note is the establishment of the International Sustainability Standards Board (ISSB) announced at COP26 in November 2021. The ISSB operates under the oversight of the International Financial Reporting Standards Foundation, and aims to deliver a comprehensive global baseline of sustainability-related disclosure standards that provide investors and other capital market participants with information about companies’ sustainability-related risks and opportunities to help them make informed decisions. In March 2022, the ISSB published drafts of its first two standards on general disclosure requirements and on climate-related disclosure requirements.

In 2022, Europe saw the publication of drafts of the European Sustainability Reporting Standards (ESRS) on foot of the draft Corporate Sustainability Reporting Directive (CSRD), which was published by the European Commission in April 2021. Both can be expected to see substantial progress towards completion over the coming months.

Countries are increasingly committed to tackling climate change. In 2021, the United States re-joined the Paris Agreement[1] and China doubled down on its objective to be carbon neutral by 2060.[2] Under the Paris Agreement, 196 countries have committed to reducing greenhouse gas emissions.[3] For many, the top priorities are to reduce emissions in energy-intensive industries, electrify transportation and reduce coal consumption. As a result, energy-intensive industries, such as steel and aluminium production, will face considerable pressure to reduce emissions. Demand for coal and oil may fall, reducing global exports of these high-emitting goods. In the long run, nearly every industry may face higher costs owing to emissions.

As countries move toward their Paris Agreement goals, the flow of goods around the world could change dramatically. For this article, we will focus on the effects of the proposed carbon border adjustment tax in the European Union (EU) and the nearest-term policy responses to that tax.

The EU readies a carbon border adjustment tax

Before we examine how a carbon border adjustment tax in the EU will affect international trade, we need to establish how the adjustment will likely work. A carbon border adjustment tax should be set to equalise the price of carbon produced in the EU with that implicit in its imports. There are large operational hurdles for this to happen. First, the EU needs to know the price of carbon for that good in the exporting country. Second, the EU will need to know how much carbon was emitted in the production of that good. This latter issue is particularly tricky, as it would require monitoring production outside of EU borders. Exporters with lower carbon prices and higher-emitting production processes will face the highest tax rates. Conversely, exporters with higher carbon prices and lower carbon-emitting processes should receive at least some discount on the tax.[4]

Setting a border adjustment on energy-intensive goods will reduce the EU’s demand for such imports as their after-tax price would increase for EU buyers. In the short run, this should increase the balance of trade—as EU imports fall—and the value of the euro relative to these energy-intensive exporters. Because the EU is a large economy, this will initially lead to an oversupply of energy-intensive goods in the rest of the world, pushing exporters to lower prices. The fall in prices is expected to raise the demand for these goods from non-EU countries that do not have a carbon border adjustment tax or similar policy, thereby offsetting at least some of the export decline to the EU.[5] 

Reactions from the rest of the world

While the EU’s climate policies are multilateral in principle, they are unilateral in practice. How the rest of the world reacts will largely determine how trade flows develop once the carbon border adjustment tax is in place. Assuming it takes some time for other countries to catch up to the EU’s climate policies and carbon prices, EU exports may face downward pressure. In 2019 alone, the EU exported iron and steel worth more than euro (EUR) 32 billion and aluminium worth more than EUR 16 billion. The US, Turkey and China are some of the largest recipients of these goods.[6] Until these countries implement their national carbon-pricing initiatives, they may switch to cheaper and higher-polluting alternatives, or they could implement countervailing duties on EU exports to pressure the bloc to lower or remove the tax.

As the US and other countries work to reduce their own emissions, global oil and coal consumption will fall further, with fewer opportunities for carbon leakage. However, widespread carbon pricing is expected to make oil export declines uneven. Most economies are highly dependent on these resources and, unless they can diversify away from those resource exports, they’ll face serious economic challenges.

The EU’s proposed carbon border adjustment tax demonstrates how climate-related policies can quickly become trade policies. As Europe and the rest of the world reduce emissions, exporters of energy-intensive goods will likely have to grapple with lower prices in the short-term and potentially significantly softer demand in the long-term. New export markets will be made available to countries that can effectively lower the emissions of their industries and develop cutting-edge green technologies. However, this is assuming more countries follow the EU’s lead on climate change mitigation and continue to pursue their commitments under the Paris Agreement.

Note: This article is an adaptation and update to a Deloitte Insight article of the same title written by Michael Wolf and published by Deloitte US on 15^th April 2021: https://www2.deloitte.com/us/en/insights/economy/eu-climate-change-carbon-tariff-global-trade.html.

Aaron Finley is the director for South China Business Development with Deloitte China, and a board member of the European Chamber South China Chapter. Vanessa He is manager of Sustainability and Climate Services with Deloitte China. She holds a master degree in Environmental and Engineering from University College London and 7 years of professional experience. As part of Deloitte China’s Climate and Sustainability Institute, she helps provide leading industry insights and policy research to our clients and helping them to fulfill our climate commitments together. 

Deloitte China provides integrated professional services, with our long-term commitment to be a leading contributor to China’s reform, opening-up and economic development. We are a globally connected firm with deep roots locally, owned by our partners in China. With over 20,000 professionals across 30 Chinese cities, we provide our clients with a one-stop shop offering world-leading audit and assurance, consulting, financial advisory, risk advisory, tax, and business advisory services. Deloitte China combines our end-to-end capabilities with domain expertise at global scale, delivering for our clients across sustainability strategy, implementation, and disclosure providing a cohesive view of the sustainable transformation journey.

[1] H.J. Mai, U.S. officially rejoins Paris Agreement on climate change， NPR，19^th February 2021, viewed 10^th October 2023, <https://www.npr.org/2021/02/19/969387323/u-s-officially-rejoins-paris-agreement-on-climate-change>.

[2] Lili Pike, China aims to be carbon neutral by 2060. Its new 5-year plan won’t cut it , Vox, 5^th March 2021, viewed 10^th October 2023, <https://www.vox.com/22313871/china-energy-climate-change-five-year-plan-wind-solar-coal-oil-gas>

[3]What is the Paris Agreement? , United Nations, viewed 10^th October 2023, <https://unfccc.int/process-and-meetings/the-paris-agreement>

[4] Kerstine Appunn &Julian Wettengel, Emission reduction panacea or recipe for trade war? The EU’s carbon border tax debate, Clean Energy Wire, 30^th November 2020, viewed 10^th October 2023, <https://www.cleanenergywire.org/factsheets/emission-reduction-panacea-or-recipe-trade-war-eus-carbon-border-tax-debate>

[5] Four briefings on trade-related aspects of carbon border adjustment mechanisms, European Parliament, April 2020, viewed 10^th October 2023, <https://www.europarl.europa.eu/RegData/etudes/BRIE/2020/603493/EXPO_BRI(2020)603493_EN.pdf>

[6] Ibid.