Will the EU Cbam Hurt Korean Manufacturers? An Empirical Analysis with Implications for Policy

(1) Policy Background: EU CBAM and Korean Emission Trading Systems A growing number of countries are strengthening their eco-friendly and low-carbon policies in the post-2020 climate regime under the Paris Agreement. In June 2021, the EU enacted the European Climate Law, which states that by 2050 carbon neutrality will be achieved. It also announced the Fit for 55 legislative package in July 2021, aimed at reducing greenhouse gas emissions by 55 percent by 2030 compared to 1990. This included legislation of the Carbon Border Adjustment Mechanism (CBAM). The EU CBAM aims to address the variations in greenhouse gas reduction regulations faced by producers in and out of EU, with the main goal of imposing costs on greenhouse gases emitted during the production of products traded into the EU. According to an EU’s announcement in July 2021, the CBAM will be applied to five items: steel, aluminum, cement, electricity, and fertilizer.Manufacturing and other carbon-intensive sectors account for a large proportion of the Korean economy, and so transitioning into a low-carbon society will necessitate a soft landing; efforts to cut greenhouse gas emissions must not impair the ability of economic growth to produce qualitative improvements in quality of life.In this context, it is essential for Korea to comprehensively examine the impact of the EU CBAM on Korea’s manufacturing industry and develop countermeasures. This paper examines domestic and foreign policy trends with regards to EU carbon border adjustment, and conceptually summarizes various pathways through which the EU carbon border adjustment may affect Korea’s economy. (2) Literature ReviewPrevious studies that attempted to analyze the effects of EU carbon border adjustment through quantitative analysis have largely employed input-output analysis or Computable General Equilibrium (CGE) models. These works contribute to the literature but have limitations. First, the advantage of input-output analyses in the literature is that an input-output framework between countries enables an analysis of various channels through which trades take place. However, an item-specific analysis is not possible because the industry is not classified in sufficient detail. In addition, as of 2021, the latest international input-output table publicly available uses data from 2014, and with all the developments since 2014 in the global economy (COVID-19, US-China trade conflict, etc.), it may as well be considered outdated.CGE, being a general equilibrium model, can quantitatively present the magnitude of welfare changes due to policy effects. However, research uses an overly simplified model, in which welfare changes are measured only in negative numbers. This limitation originates from the model’s assumptions of the production function and the consumption function that do not properly reflect reality. In the case of existing studies that evaluated the impact of carbon border adjustments with CGE, they only estimate an effect of increasing export prices due to tax imposition, but such an estimation does not accurately contain the possibility of the substitution between items and reorganization of competition between exporting countries within items. As a result, even if carbon border adjustments were set to favor Korean exports over major competitors, the income effect is overestimated, while the change in export share is underestimated, leading to a decrease in Korea’s welfare.(3) ContributionsThis first contribution of this study is that it performs a detailed item-level analysis. Previous studies assumed that carbon border adjustments were applied to all items exported to the EU in general, or they analyzed all items produced by the steel industry. However, the actual European carbon border adjustment is applied only to certain goods, such as steel, aluminum, cement, fertilizer, and electricity. For Korea, CBAM is expected to have the biggest impact on the steel industry, and especially on goods with high greenhouse gas intensity and high trade volume. Accordingly, by limiting the scope of the study to identify items that will absorb the largest shocks of the EU CBAM, we present more precise results that have not been previously produced in the literature. This study also accurately estimates the direction of CBAM impacts by comprehensively analyzing the trade reorganization effect through three pathways: direct, indirect, and trade. In order to analyze the impact of EU carbon border adjustment on Korea’s manufacturing exports, it is necessary to review at least five possibilities as follows: (1) as the price of items subject to the EU carbon border adjustment increases, European consumers substitute Korean goods for others; (2) the costs incurred by the EU carbon border adjustment depends on the stringency of each country’s greenhouse gas reduction policies; (3) each country is in a different situation in terms of how much of an increase in prices caused by carbon border adjustment can be passed on to consumers (that is, the incidence); (4) from the perspective of EU consumers, income effects occur in the direction where the consumers in the importing country (that is, the EU) becomes relatively poorer; and (5) there is a possibility that the global value chain will be reorganized around raw materials or intermediate goods with low concentrations of greenhouse gas in the process of determining the responsibility of carbon generated in the process of producing intermediate goods.Among the five important aspects of the EU CBAM, previous studies based on CGE and input-output analysis have replaced carbon border taxes with an higher export prices, focusing on (1) and (4), and in some studies incorporate the possibility of (2).This paper differs from previous studies in that it deals with the possibility of trade reorganization in depth by comprehensively reviewing substitution between items, producer replacement for any given good, and supply and demand pathways of raw materials by reflecting the specific imposition of EU carbon border adjustment. In other words, this study fills the gap by comprehensively reviewing the points that previous studies have been missing by oversimplifying production and consumption functions.