EU’s Carbon Border Adjustment Mechanism (CBAM) or a Combination of Pre-CBAM Climate Policies?

Unilateral CO ₂ emission reduction policies can induce carbon leakage. Under the EU Emissions Trading System (ETS), power-intensive and trade-exposed (PITE) industries have been granted free emission allowances, alongside optional CO ₂ indirect-cost compensation adopted by selected member states, to mitigate this risk. These measures are being phased out as the EU introduces the Carbon Border Adjustment Mechanism (CBAM), which levies imports of PITE goods based on embedded carbon emissions. This paper examines the welfare effects of CBAM and the pre-CBAM anti-leakage policy mix. Theoretical analysis shows that both policies can improve regional and global welfare under certain conditions. Numerical simulations within an EU ETS context indicates that CBAM generates larger regional welfare gains than the optimal combination of free allowances and CO ₂ compensation. However, these gains partly reflect terms-of-trade effects that transfer welfare from non-EU regions. Since such transfers cancel globally, CBAM and pre-CBAM policies generate comparable global welfare outcomes.

JEL Classification: D61, Allocative Efficiency; Cost-Benefit Analysis; F18, Trade and Environment; H23, Taxation and Subsidies: Externalities; Redistributive Effects; Environmental Taxes and Subsidies; Q54, Climate; Natural Disasters and Their Management; Global Warming