As global average temperatures exceed the 1.5°C mark, we are ushering in a new chapter of environmental governance. Historically, regulations have been created and enforced at local levels, with some international agreements providing overarching guidelines, such as the Montreal Protocol designed to phase out substances that deplete the ozone layer.
At present, proposed environmental initiatives are moving beyond local boundaries, with the potential to impact international trade and diplomatic relations. A prominent example of this shift is the EU’s Carbon Border Adjustment Mechanism (CBAM).
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Understanding CBAM
Localized carbon taxes have been implemented in various regions to combat climate change. However, a unified global carbon pricing system has yet to be established, which leads to significant variations in carbon pricing or complete absence thereof. This inconsistency heightens the risk of carbon leakage; rather than reducing emissions as the tax is intended, manufacturing may shift to areas with no or lower carbon taxes, creating opportunities for carbon tax arbitrage. The CBAM aims to equalize carbon pricing between domestically produced and imported goods by levying a fee on the carbon footprint of imports. This fee can be adjusted or mitigated based on any carbon tax imposed by the jurisdiction of the exporting country.
Considering geopolitical and policy outcomes, three potential scenarios may arise:
- Scenario 1: Unified Pricing, Unified Market. If G7[1] countries adopt the CBAM, it could motivate all nations to implement similar local carbon tax frameworks, ultimately resulting in a globally standardized carbon price that becomes essential for commodity pricing.
- Scenario 2: Dual Market Dynamics. A G7 market with strict CBAM enforcement would establish a robust carbon pricing, contrasted with a non-G7 market comprising countries that opt not to impose a carbon tax. This would result in two distinct markets: one that integrates carbon pricing and another that does not. In this scenario, the second market might become more competitive due to lower barriers (as carbon intensity of production wouldn’t be a factor).
- Scenario 3: CBAM Targeting Key Commodities. Should the CBAM apply to critical commodities necessary for economic development (like cement, fertilizer, and steel), non-G7 countries may implement protective measures to bolster local industries through border taxes or local subsidies. This could lead to highly localized markets governed by national policies, with increasing trade barriers akin to a quasi-trade war.
Each of these scenarios will have an impact on the pricing of goods subject to CBAM. Scenario 1 could lead to global inflation, as prices for steel, fertilizer, and cement increase. These commodities exist in ‘hard to abate sectors,’ making it currently difficult to achieve zero emissions in these industries. Attaining zero emissions is necessary to maintain stable commodity prices.
In Scenario 2, inflation may occur in the carbon-priced market, while increased competition from more players pursuing limited resources could drive down prices in the non-carbon priced market.
Scenario 3 stands to considerably impede global trade, making commodity prices contingent on trading partners, local production capabilities, and geographic factors.
Furthermore, the CBAM is likely to create distinctions among manufacturers based on their carbon intensity. Traditionally, competitive advantage stemmed from low production costs. In this emerging landscape, both cost and carbon intensity will come to be pivotal for competitiveness.
Manufacturers with low costs and low carbon intensity (the A-players) will likely be the most competitive, regardless of the scenario that unfolds.
B-players, who are currently less competitive, may find new opportunities if Scenario 1 materializes, as they perform better than low-cost, high-carbon intensity companies (X-players). In Scenario 2, they may gain market share in the premium carbon-price segment but could struggle in the competitive non-carbon priced market.
X-players might enjoy temporary protection in Scenarios 2 and 3 due to local policies, but they face significant risks in Scenario 1.
R-players are threatened across all scenarios; a CBAM could drive them towards existential threats. The competitive pressures instigated by the evolving carbon market may be the turning point leading to their decline.
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Unfortunately, South Africa is positioned within the X-player and R-player categories. The carbon intensity of products born from South Africa’s electricity grid remains high, largely due to a reliance on coal-fired power generation.
Consequences for Local Manufacturers
The secondary and tertiary effects of any of these scenarios could be widespread for local manufacturers. Should the CBAM extend its reach to include additional goods and commodities (like vehicles), the competitiveness of South Africa may significantly diminish. Additionally, price volatility and the decline of companies producing locally made inputs could complicate and escalate the costs related to local production, further undermining competitiveness. Moreover, these evolving global regulatory frameworks may necessitate South African manufacturers to rethink their capital allocation, prioritizing renewable energy investments over expansions or innovations in production, threatening the country’s medium-term productivity.
Amidst these risks, new opportunities may emerge for gaining a competitive advantage through enhanced localization and strategic partnerships with like-minded market players. To mitigate potential losses in export income, localization may be improved by building domestic production capabilities for goods that were once exported but are now essential for local production processes. This strategy promises to boost productivity, create jobs, and enhance skills development while contributing to the industrialization and diversification of the South African economy, thereby increasing resilience against external economic shocks.
The enhanced trade relations with like-minded nations could unlock the benefits associated with progressive frameworks like the African Continental Free Trade Area Agreement. A more diversified demand, coupled with increased knowledge sharing and greater autonomy among African nations, could manifest as positive outcomes subsequent to the implementation of CBAM and its associated momentum for African economic growth.
While these proposed regulations challenge the foundational principles of the Paris Agreement’s concept of common but differentiated responsibilities, the enduring strength of South Africa—and Africa as a whole—lies in its people, resilience, and ability to navigate difficult power dynamics. It is crucial that we come together to strengthen South Africa and ensure our long-term sustainability.
Heidi Barends is head of sustainable finance at Absa CIB.
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