The Environmental Audit Committee (EAC) of the United Kingdom (UK) House of Commons has called on the UK Government to develop plans for a carbon border adjustment mechanism (CBAM) to address carbon leakage as the date to achieve net zero emissions gets closer.

In its report, the EAC finds that the Government's current approach, principally the allocation of free emissions trading scheme (ETS) allowances, is insufficient to drive effective decarbonization. It notes that the current situation also means that the UK applies a carbon price to domestic production but not to imports, which according to government research made up 43% of the UK's consumption emissions in 2018 (the latest figures available).

Instead, the EAC calls for a policy response in the form of a UK carbon border approach. It proposes that this should include a UK CBAM to ensure an equivalent carbon price is applied to imports as is applied to domestic production. The EAC believes a UK CBAM has the potential to help build support for green policies in historic manufacturing areas where opportunities for a renaissance in low-carbon UK-based manufacturing are likely to be greatest.

Alongside a UK CBAM, the EAC contends that the UK's carbon border approach needs to include a set of complementary policies, including product standards, to tackle consumption emissions beyond those covered by explicit carbon pricing, and support decarbonization across the economy. The EAC recommends that the Government commence work on this UK carbon border approach immediately, to enable its implementation during the 2020s. It calls on the Chancellor of the Exchequer to provide an initial CBAM progress report to the UK House of Commons not later than Budget 2023.

The EAC notes that the European Commission has been developing plans for a European Union (EU) CBAM,¹ which the Commission envisages will be introduced in several stages, starting from 1 January 2023. The EAC calls on the UK Government to articulate how it intends to work with stakeholders on, and communicate progress towards, the actions it is taking to ensure that there are no adverse impacts to the UK.

The EAC believes that multilateral solutions remain the most effective way to address carbon leakage but notes the process to agree on these is lengthy. Accordingly, it contends that unilateral action is essential in the short-term, especially as unilateral action can also spur cooperation on multilateral measures and incentivize countries to strengthen their own carbon pricing and decarbonization measures.

The EAC therefore calls on the UK Government to continue to pursue multilateral solutions, including commencing action towards linking the UK and EU ETS, at the same time as developing its own carbon border approach. That carbon border approach must be aligned with the UK's international commitments and adhere to World Trade Organization rules and the principle of "common but differentiated responsibilities and respective capabilities" under the Glasgow Climate Pact in respect of low- and middle-income countries.

When designing the UK's carbon border approach, the EAC believes the UK Government should:

• Ensure design choices are led by clearly articulated objectives
• Engage with trade partners
• Consult with industry sectors
• Include a strategy to build public awareness and consensus on the need for the approach
• Carry out assessments to understand any impact on consumers
• Ensure the carbon border approach is aligned with existing environmental, trade, development and fiscal policy
• Establish a plan for monitoring the impact of the approach once implemented

Next steps

The EAC is a cross-party committee of the UK House of Commons. Its remit is to consider the extent to which the UK Government policies and programs contribute to environmental protection and sustainable development. It does not make policy itself and there is no requirement on the UK Government to follow the EAC's recommendations.

However, the UK Government does have to respond to the EAC's report; in this case, within two months. That response should provide an indication of the UK Government's thinking in this area.

The EAC's report follows the separate publication on 25 March 2022 by the Department for Business, Energy and Industrial Strategy (BEIS) and the devolved Governments of a consultation on developing the UK Emissions Trading Scheme (UK ETS). That consultation closes on 17 June 2022.

Implications

It seems clear that new measures to combat carbon leakage are on their way in the UK (and elsewhere). The UK and EU CBAM proposals are only the first in what is likely to be a wave of new carbon pricing and other environmental fiscal measures which will require a business response.

Businesses responding to the implementation of carbon pricing initiatives in their markets will need a coordinated approach to complying with any new regulations. This is likely to require consideration of the interaction between the various CBAMs that could be introduced in territories around the world and the interaction between those CBAMs and relevant ETS initiatives.

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For additional information with respect to this Alert, please contact the following:

Ernst & Young LLP (United Kingdom)

• Derek Leith, Aberdeen | dleith@uk.ey.com
• Alenka Turnsek, London | alenka.turnsek@uk.ey.com
• Alwyn Hopkins, London | alwyn.hopkins@uk.ey.com

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ENDNOTE

¹See EY Global Tax Alert, EU Finance Ministers reach agreement on EU Carbon Border Adjustment Mechanism, dated 16 March 2022.