COP29 and the Potential of Revenues from Carbon Markets and CBAM for a Just Transition to Net Zero.

COP29 in Baku Azerbaijan was hailed as the cop of climate finance. There is somehow a consensus that developed countries have a moral obligation to transfer funds to developing countries to enable the latter to address the conundrum of decarbonisation and embark on a path of sustainable development ultimately benefitting the global communities. Yet these funds are not being transferred at the promised rate and developing countries see no alternative than to raise money from the sale of fossil fuels to finance environmental protection. This is no good news for the global community.

The solution to this finance deadlock lays in whether we can raise and distribute the needed funds in a way consistent with economic efficiency (think of a least cost solution) and equity (to deploy just transitions to net zero so that no one is left behind). In economics, efficiency and equity are two sides of the same coin- in the case of the climate discourse representing the protection of our environment and livelihood - but they are difficult to combine. When it comes to the design and implementation of any project or policy, the notorious efficiency equity trade-off between maximising economic performance (typically returns on investment or GDP growth) and minimise inequalities (typically income inequality) is well established (see among others the seminal work by Okun back in 1975) but it does not have to be so. Indeed, we already widely use price mechanisms such as taxes, fees, and transfers for redistributive purposes. Taxes and fees also generate revenues that can be recycled back towards equality enhancing projects. Environmental taxes and fees for example are more favourably accepted if the revenue raised is earmarked towards environmental or other socially impactful projects including those that may benefit the most vulnerable in society.

Can we learn from the experience of existing redistributive policies to design an international redistributive system able to provide climate finance for a just transition to net zero? The answer is yes in principle but, as for most of climate policies, the devil is in the details. The case of the revenues generated by the EU ETS (Emissions Trading System) and CBAM (Carbon Border Adjustment Mechanism) discussed at COP29 can help us to appreciate this complexity.

Since its inception in 2005, the EU ETS has been very successful in achieving climate targets in the most economic efficient way. Indeed, given an emission cap, polluters that can abate emissions cheaply would abate and sell their emission permits; those for which abatement is too expensive will rather buy carbon permits. The overall emission target is therefore achieved at the least cost. As emission targets in the EU are steadily decreased (to follow on the Paris Agreement pledges, see for example the 2021 European Climate Law), the carbon price resulting from carbon trading increases, which is good news for solving the climate crisis. At the same time however the increasing carbon price exacerbates inequalities across income groups. Poor households are disproportionally disadvantaged in comparison to richer ones: they spend a larger share of their income on energy, are more likely to be employed in fossil fuel-based industries and face larger financial constraints when switching to renewables. Indeed, it seems that the efficiency-equity trade-off would bite hard. 

It does not have to be so. Permits are typically sold at auctions and the auctioneer country takes a fee in proportion to the carbon price achieved in the trading market. As the carbon price increases so is the revenue from the carbon permit auctions which is currently for the EU in the order of tens of billions of euros annually, with Germany leading on revenue raising. The key to remedy the efficiency-equity trade-off is in the way these revenues are recycled. A recent development in the EU ETS Directive, prescribe that 100% of auctioning revenue must be devoted to climate- and energy-related purposes starting in mid-2023. In addition, the 2023 regulation establishing the Climate Social Fund (CSF) for the period 2026-32 states that this fund should be used to support vulnerable groups and households. The EU has showed remarkable leadership in pledging to channel ETS revenues into the CSF; whether those fundings will reach the communities and groups mostly affected by carbon trading is yet to be seen.

The European Carbon Border Adjustment Mechanism (CBAM) entered into force in May 2023 with the aim to equalise carbon prices at the border and therefore minimise carbon leakage (the practice of shifting production to countries where low carbon prices hold, in turn causing an overall net increase in global carbon emissions). The CBAM regime implies that importers must purchase CBAM certificates (at the price emerging from the ETS carbon market) from the competent national authority and surrender them in proportion to the carbon emission content of the imported goods. Thus, the certificates essentially act as a carbon levy.  

The major controversies surrounding the CBAM are twofold. Countries exporting carbon intensive goods interpret the CBAM as a protectionist measure, in contrast with World Trade Organisation (WTO) rules. Furthermore, like with the ETS market, those who ultimately bear the costs of this mechanism are the most vulnerable: poor households in the EU who cannot benefit from cheaper imports, and SMEs (and their workers) in developing countries that cannot afford to deploy clean production technology.  

Although the revenue from the CBAM is not expected to reach the level raised by the ETS, discussion has been initiated about the use of this revenue as a source of international climate finance, especially to the benefit of developing countries. At COP29 a ‘Declaration on the Use of CBAM Revenues’ was presented on 20 November 2024 in a high-profile session organised by the European Roundtable on Climate Change and Sustainable Transition (ERCST) think tank. While there was agreement in using the CBAM revenues as climate finance, no consensus was achieved on whether those should be mobilised for developing or EU countries or towards enhancing cleaner production or benefitting those disproportionately affected by the CBAM. Interestingly, developing countries did not engage with the conversation.    

The efficiency-equity trade off does not have to be an impediment when it comes to mobilise climate finance. Instead, the opportunity raised by revenues from carbon markets and CBAM should be capitalised on as soon as possible.

References:

Okun, A M (1975), Equality and efficiency, the big tradeoff, Washington, DC: Brookings Institution.

Professor Laura Marsiliani is an environmental and energy economist at Durham University, UK. she has been a member of the Durham University observer delegation at the UNFCCC COPs for the last four years. She is a principal investigator of the research project JusTN0W (Just Transition to a Net Zero World). For further information see:  https://lauramarsiliani.webspace.durham.ac.uk/