Is border carbon adjustment the right tool for the power sector?

Carbon leakage occurs in any carbon pricing regime that is not global, which means all of them so far. That is inherently unfair to sectors that are subject to a carbon price but compete with those that are not. The European Green Deal aims to rectify the problem in the EU Emissions Trading System (ETS) by moving beyond the current second (or third) best option, which allocates emissions quotas for free for industrial sectors, and by putting a price on carbon at the EU border for selected but not yet named sectors. Our recent model-based analysis compares the impact of a future border carbon adjustment (BCA) mechanism for the power sector with the option of extending the EU ETS to countries exporting power to the EU. We demonstrate how differences in the two policy tools translate into markedly different impacts. We conclude that expanding the geographical scope of the EU ETS is a more effective climate policy tool than a BCA. First, it would reduce emissions, while a BCA would not. Second, emission trading brings real competition: Regions neighbouring the EU will be better integrated into the EU single market with a level playing field and lower greenhouse gas emissions. On the other hand, the BCA would fence off the EU power sector and increase greenhouse gas emissions. Third, compared to a border carbon tax, expanding the ETS also yields more revenue to exporting neighbouring countries facing higher-than-average challenges to change their fossil-heavy power systems. Key policy insights The introduction of a new policy tool, the border carbon adjustment mechanism, which aims to create fair competition and trigger more ambitious climate policy action in trading partners, is a legitimate action of the European Union. However, the extension of EU ETS is a more effective climate policy tool than a border carbon adjustment mechanism as the latter increases overall emissions. The border carbon adjustment mechanism is rather a competition policy tool that provides a level playing field for electricity producers inside and outside the EU. The price impact of the policy tool choice merits attention: the extension of the EU ETS drives up prices in neighbouring countries (except the West Balkan region), but the additional quota revenues can be used to alleviate the burden on vulnerable social groups.