Climate ChangeGovernance & Policy

EU’s “Carbon Border Tax”: Implications for WTO & Developing Countries

By Sanjay Notani, Partner & Naghm Ghei, Sr Associate, Economic Laws Practice

To meet their targets under the Paris Agreement, several countries have adopted measures to tackle emissions, including carbon pricing. Carbon pricing commonly occurs in two scenarios. The first is Emission Trading Schemes (ETS) where a cap is placed on the maximum level of greenhouse gas emissions permitted in particular sectors. ETS also enables industries with low emissions to sell their extra allowances to those with higher emissions. The second is Carbon Taxes which are pre-defined by the government, rather than set by market forces.

Presently, the EU has an ETS in place, which may run the risk of industries moving to jurisdictions with less robust regulation, commonly referred to as “carbon leakage”.

To address this, the European Commission (EC) released a “Proposal for a Regulation of The European Parliament and of The Council establishing a carbon border adjustment mechanism” (CBAM Proposal) in mid-July.

Scope of CBAM

The CBAM will place a “carbon price” on goods imported from countries that are considered to have less stringent carbon pricing arrangements than the EU.

Under the CBAM Proposal, only authorized declarants can import such goods and they would need to submit CBAM declarations annually, reflecting the Green House Gas Emissions embedded in the imported products along with a corresponding amount of “CBAM certificates.” The price of these certificates would reflect the price of the EU ETS allowances. Nations can enter into agreements with the EU for exemptions from the CBAM if they can demonstrate that they have an equivalent carbon pricing mechanism.

The CBAM will initially apply to sectors deemed as high risk of carbon leakage, including cement, certain fertilizers, iron and steel, and aluminum and electricity imported from all third non-EU countries.

CBAM and WTO

As per Article I:1 of the General Agreement on Tariffs and Trade, 1994 (GATT), Members cannot discriminate between their trading partners – The Most Favoured Nation Treatment.

Presently, differences in the processes and production methods that do not leave a physical trace in the final product cannot be used to classify two products as not being like articles. Hence, goods produced with a lower carbon footprint are still “like products” to those that are not and must be accorded the same treatment.

The CBAM proposal allows declarants to offset carbon taxes already paid in a third country, but only if they are in a specified form. Therefore, if a country has in fact made efforts to reduce carbon emissions, but not in the specific form the EU desires, they may possibly face less favourable treatment. This may open up further questions from the perspective of WTO rules.

Another factor to consider is that as per GATT, domestic and foreign goods must be granted the same treatment – National Treatment.

The EU presently grants free carbon emission allowances to a large number of industries already covered by its ETS. The CBAM Proposal will continue these allowances. To avoid violating WTO rules, the CBAM proposes to reduce the CBAM certificates to be provided for imported products to the extent to which free allowances continue to be allocated to the EU domestic industry.

Both the above issues however violate the WTO’s principles of fair and non – discriminatory trading.

Possible Justifications

A possible justification for CBAM, could be Article XX of the GATT which exempts measures from being considered WTO violations based on various domestic policy goals, including protection of human, animal or plant life or health and protection of natural resources.

Hence the CBAM’s proposal to treat products originating in different countries differently based on their carbon footprint may find some justification under Article XX.

However, compliance with Article XX is no easy task and necessitates compliance with several conditions. These include the need for a sufficient and direct connection between the CBAM and its environmental objective and a requirement that the measure not be applied in a manner that would constitute “a means of arbitrary or unjustifiable discrimination between countries where the same conditions prevail”. With respect to the former, there is considerable debate as to whether such measures will actually be effective in reducing “carbon leakage” and whether “carbon leakage” is indeed an actual consequence of the ETS.

The implications

While the aim of reducing emissions is commendable, one cannot ignore the commercial reasons that may underly such a decision, i.e., to level the playing field for sensitive sectors against competition from cheaper imports. When seen from this perspective, a carbon border adjustment mechanism runs the risk of enhancing protectionism. Border carbon adjustments are so new that there is very little evidence to evaluate their effectiveness and no other country presently has a national version of the same.

Further, not only does a CBAM mechanism affect the primary sector in which it operates it also affects the entire value chain from logistics to sourcing quality control to raw material sourcing, etc., and even ultimately downstream and consumer industries as producers try to pass on the “cost of compliance”. This is crucial from the perspective of developing countries that still have a long way to go to develop their manufacturing capabilities. It is also difficult to determine the carbon impact of products given complex value chains.

Additionally, the burden of such border measures on developed vs developing countries also needs to be assessed. There is a significant risk that developing countries such as India which do not have significant carbon emissions or commitments under the Paris Agreement, yet less robust cap/taxes on emissions, may nonetheless be at a disadvantage compared to highly industrialized and developed nations that have caused the emission problem to begin with. The element of equity that the Paris Agreement tried to achieve through voluntary commitments may be defeated if developed countries such as the EU are able to strong-arm other nations to adopt the same measures.

With various other countries, including Canada, the UK, and the US considering such mechanisms as a matter of climate policy, it is likely these measures may become a more prominent feature of climate policies and measures worldwide, affecting global trade flows.  International collaboration will be essential to avoid unilateralism.

Disclaimer: The views are the authors’ personal ones and do not necessarily reflect those of the firm.

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