In EU-Malaysia Trade Relations, Urgent Need to Address Carbon Pricing

On 23 December deputy prime minister Fadillah Yusof complained about the European Union’s (EU) new regulations banning the import of commodities linked to deforestation. He called the restrictions “unfair”, based on “unsound reasoning” and said they were “offensive to Malaysia”. Fadillah’s comments are only the latest salvo by a Malaysian minister against the EU, with palm oil imports often entering the crossfire, and they will certainly not be the last. The EU is also planning to introduce a carbon import tax (CBAM), which will hit Malaysian exports of iron, steel and aluminum to the EU, and which will be expanded to other manufactured goods in the future. CBAM will likely have a far larger impact on the EU-Malaysia than its palm oil restrictions.

“So why is the EU doing this to Malaysia?” one might ask.

To put it simply, the EU (and especially the European Parliament) is very focused on climate change action, an area in which Malaysia appears to be lagging. An illustrative example is the fact that Malaysia only recently launched its voluntary Bursa Carbon Exchange, with the first auction of carbon credits expected in 2023, a very cautious first step towards carbon pricing. By comparison, the EU has had a full-fledged compulsory Emissions Trading System (ETS) since 2008! Therefore, although the EU’s “green” trade policies can seem unfair to Malaysia, they are consistent with the EU’s internal environmental-economic policies.

While it can be argued that Malaysia is an emerging economy, and therefore deserves certain exemptions, Malaysia’s per capita income is similar to that of EU-member states such as Bulgaria, Croatia and Greece. In this sense, Malaysia can also be viewed as a developed economy. As a result, Malaysia’s slow response to climate change is increasingly becoming a point of friction in EU-Malaysia economic relations, and one that requires action and accommodation from both sides.

Understanding CBAM, the EU’s Carbon Import Tax

The policy that will likely define the EU-Malaysia trade relationship during the coming decade is the EU’s Carbon Border Adjustment Mechanism (CBAM). Under CBAM, all non-EU goods sold in the EU would be subject to a “top up” carbon tax based on the difference between the foreign carbon price and the EU’s own domestic carbon price (ETS). With a metric ton of CO2 priced at approximately US$ 100 in the EU today, and expected to rise further, and most voluntary carbon markets typically pricing around US$ 4 per ton, this could mean a significant tax on Malaysian goods entering the EU.

While CBAM has been criticized, and some legal scholars have suggested that it violates WTO rules, the EU needs to impose some kind of trade barrier to avoid “carbon leakage” to other economies. So even if CBAM is modified, some kind of carbon import tax is highly likely to come into force. The United States is already planning an import tax under the Clean Competition Act (CCA) to avoid carbon leakage.

Developing a credible domestic carbon market framework with relatively high carbon prices may be an effective policy response by Malaysia in the face of these emerging “green” trade barriers. In addition to avoiding or limiting CBAM-type taxation, the policy could have wider benefits for the Malaysian economy.

Opportunities for Malaysia

Malaysia is in an interesting position, because it is a fairly large emitter of greenhouse gasses (per capita emissions are similar to Germany and China, according to World Bank data), but it also has large potential to develop carbon sinks through reforestation, conservation and other nature-based solutions. McKinsey & Co estimates that Malaysian nature-based projects could produce 40 million tonnes of CO2-equivalent offsets annually, which could amount to billions of ringgit in revenue. Nature-based carbon credits would mainly be generated by forest and mangrove restoration, which are often found on state land. As a result, state governments, such as Sabah and Sarawak, and rural communities, could be major beneficiaries of higher carbon prices.

Higher carbon prices also create a strong incentive for lowering carbon emissions by encouraging energy saving and the adoption of emission-reducing technologies. In Malaysia, a carbon pricing policy is supported by diverse stakeholders, including environmental groups (WWF), think-tanks (Penang Institute) and energy companies (Shell). Aside from reducing carbon emissions, higher carbon prices also encourage innovation. As finance minister Lawrence Wong explained in February, when introducing Singapore’s carbon tax: “We aim to move Singapore into the forefront of green technologies, where new innovations are developed, trialed, scaled up, and eventually exported to the rest of the world. We will work hard to grab the first-mover advantage.” Malaysia, which is already the world’s second-largest solar panel exporter, should take note. Singapore is raising carbon prices as part of a broader environmental-economic strategy, like the EU. One way to raise domestic carbon prices is by taxing greenhouse gas emissions. This would also raise government revenue, which could then be used to subsidize green innovation and emission reduction projects.

Regulatory Innovation: Internationalizing Carbon Credit Trading

An alternative and more innovative approach to raising carbon prices would be for Malaysia to internationalize its carbon market and attract international capital to finance its energy transition. Although the regulatory mechanisms for international carbon trading are still under development, article 6 of the Paris Agreement allows such trade if the carbon offsets are transferred from one country to another (under so-called NDC accounting). Within the context of EU-Malaysia trade relations, Malaysia could aim for a mechanism to link its carbon market to the EU ETS.

In practical terms, how would such a carbon credit trading mechanism work, and what would be the benefits for Malaysia?

As an example, let us take the early retirement of coal power plants. The International Energy Agency (IEA) has noted that replacing coal power with renewable energy alternatives pays for itself, because over their lifetime, renewable energy is now less expensive than coal power. Coal power is a large source of greenhouse gas emissions and in Malaysia around 40% of electricity is generated from coal. However, closing a relatively new coal power plant also means that the plant’s owners would have to write off a large investment. This means that the Malaysian treasury would probably have to finance the phasing-out of such plants for Malaysia to meet its emission reduction targets.

However, what if the closing of a power plant could be certified as an emission reduction and sold on a foreign carbon market like the EU ETS? A rough calculation based on data from the Energy Information Administration and Our World in Data suggests that Malaysia’s coal power plants represent an emission reduction opportunity of 150 million tonnes of CO2 annually, which at current EU ETS carbon prices, equates to RM60 billion in carbon credits.

From a Malaysian perspective, such a strategy of selling carbon credits would mean that the emission reductions would not be recognized in Malaysia’s national greenhouse gas accounts (NDC) for several years. Carbon credits are typically issued for a fixed period, so if Malaysia were to export 10 years’ worth of carbon credits to cover a project, these credits cannot be included in Malaysia’s NDC until 10 years later, say in 2033. After this period, the emissions reductions can be re-included in Malaysia’s NDC and count towards Malaysia’s net-zero emission goals.

For this transaction to work, the EU would have to accept Malaysian carbon credits on its ETS, something that it may be reluctant to do. There are many reasons for this, including the large regulatory gap, pricing gap and the fact that Malaysia’s carbon market is still voluntary. While Malaysia’s carbon market would have to quickly develop, Malaysia should also argue that the EU’s unilateral imposition of CBAM, which imposes a tax based on the EU ETS, justifies that EU trading partners be allowed a degree of access to the EU ETS.

Linking Malaysia to the EU ETS need not be done as a “free market”, as is the case with the EU and Switzerland. The EU and Malaysia could agree on a quota of credits linked to CBAM. Malaysia could also impose a carbon credit export tax (similar to its palm oil export tax) to ensure higher prices abroad, and lower prices domestically, for Malaysian carbon credits.

Linking Malaysia’s nascent carbon market to that of major trading partners could be part of a broader climate change-centric trade and investment policy. Carbon prices in other large trading partners such as China, Japan and South Korea are much lower than in the EU, but that might also make negotiating access to their carbon markets easier.

Need for Environmental-Economic Cooperation

Whatever direction Malaysia chooses, as a highly trade-dependent economy, it needs to factor climate change into its international trade and investment policies. If climate change is not addressed, it will increasingly emerge as a trade barrier.

On the EU’s part, it needs to make CBAM acceptable to its trading partners, including Malaysia. If climate change is seen as a kind of “green imperialism” or “green protectionism”, then both the EU and policies to promote climate change action will be harmed. Instead, CBAM should be part of a broader “Green New Deal” on trade and investment between the EU and its international partners, that could also include access to the EU ETS, among other areas of environmental-economic cooperation.