23 Jul 2021, 11:26

Emission reduction panacea or recipe for trade war? The EU's carbon border tax debate

The European Union is taking steps towards introducing a carbon border adjustment mechanism, an instrument that has been hailed as a stimulus for climate action but also branded as a way to spark new trade wars between the bloc and its trading partners. As the EU is pursuing a higher climate-neutrality target and a green overhaul of its entire economy, the mechanism that has importers pay if their product has a higher carbon footprint than their European counterparts leaves many industries and non-EU governments concerned. But Europe has set its mind on decarbonising what is left of its energy-intensive industries while keeping them competitive at a global level, so the European Commission has made a first proposal on how such a complex, politically contentious and legally delicate system can be established. This factsheet explains the currently proposed design of the European carbon border tax, outlines the potential problems associated with this instrument and sums up the opinion of the stakeholders in and beyond Europe.

What does a carbon border adjustment do and why have it?

The European Union wants to become climate-neutral by the middle of the century, an objective that should turn the bloc into “a modern, resource-efficient and competitive economy, where there are no net emissions of greenhouse gases.” To achieve this, the EU has set up a carbon emissions trading scheme (EU ETS) and is introducing increasingly tougher climate and environmental standards for businesses. In June 2021, EU member states sealed their even more ambitious medium-term target of a 55 percent reduction in greenhouse gas emissions by 2030. All sectors will have to do more to meet that goal.

Putting a price on emissions gives an incentive to domestic companies to work and produce in an increasingly climate-friendly manner, but the European Commission is worried that this leads to a competitive disadvantage and “carbon leakage” if the EU’s trading partners are not pricing carbon in a similar way

What is carbon leakage?

Carbon leakage occurs when companies shift their carbon-intensive production activities from regions with tough emission reduction policies (e.g. a high carbon price) to a place with laxer policies. The same happens, when companies in countries with strict emission rules reduce production due to high costs, while the output from foreign installations in regions of less stringent regulation increases. As a result, the emissions saved in the place with tight emission regulations are instead emitted in another country (leakage), meaning there is no greenhouse gas emission reduction overall.  

While almost all nations are signatories to the Paris Agreement and are therefore theoretically on a similar pathway to net-zero emissions, the actual price for CO2 and the environmental standards in manufacturing differ widely across countries. The term “carbon leakage” describes emissions occurring when European companies transfer their production sites to countries with less stringent emission reduction rules or when formerly domestically produced goods are replaced by more carbon-intensive imports. Overall emissions would then not be reduced, despite the European efforts.  

Another concern is the potential loss of competitiveness of the European industries, whose manufacturing costs for the same product, e.g. steel, are higher because of CO2 pricing. This could lead to them being outpriced on the world market and eventually to their demise.

This issue could be alleviated by a so-called carbon border tax or adjustment. Simply put, such a levy would add the same CO2 costs to a product when it crosses the border into the EU that the manufacturer of a domestically produced item would have to pay.

The EU is referring to this instrument as "carbon border adjustment mechanism" or CBAM. It is the world’s first concrete proposal to impose carbon emission costs on imports of goods at an international border.

The carbon pricing gap measures how much countries fall short of pricing carbon emissions in line with a 30-euro benchmark value, the low-end estimate of carbon costs today. The difference between the benchmark value and the actual effective carbon rate is presented as a percentage. If the effective carbon rate on all emissions is at least as high as the benchmark, the gap is zero. Countries with a low gap tend to emit fewer emissions than countries that hardly price any carbon emissions. Data and Chart: OECD, 2018.

Some researchers have pointed out that carbon leakage is only a “perceived” threat for which there is too little evidence. Opponents of the tax have therefore highlighted the minimal benefits and many trade-offs that a carbon border adjustment mechanism (CBAM) would entail.

To which goods would an EU carbon border price apply?

In the “Fit for 55” package, presented in July 2021, the European Commission published its proposal for a CBAM regulation, including an impact assessment. So far, carbon leakage from sectors regulated under the EU ETS has been addressed by giving certain companies free allocations of emission allowances.

The CBAM will apply to imports of certain goods from all non-EU countries, unless they participate in the EU ETS or have an emission trading system linked to the ETS (such as Switzerland, Norway, Iceland, Liechtenstein).

In a first phase – due to start in 2023 – the CBAM will apply to goods from the following sectors: Cement, iron and steel, aluminium, fertiliser and electricity. The Commission selected them based on three criteria: They are at high risk of carbon leakage because they cause high levels of carbon emissions and there is brisk trade in these sectors; they cover more than 45 percent of CO2 emissions of ETS sectors and including them in the mechanism is practically feasible.

In the initial phase, the CBAM will only apply to direct emissions of greenhouse gases, caused during the production of the covered goods. It will not cover indirect emissions, which refer to CO2 from electricity generated and used to produce the good.

Following an evaluation, the Commission will decide whether to extend the CBAM to more sectors/goods and/or indirect emissions in the second phase of the mechanism, presumably starting in 2026.

How important is the long-term CO2 price for investments by your company? (2016; n= 58). Chart by UBA, 2020 with data from Thomson Reuters “Carbon 2016”.

How will the EU’s carbon border adjustment work?

The European Commission proposes a carbon border adjustment mechanism that is closely linked to the EU’s cap-and-trade system for emission allowances for the energy and industry sectors (EU ETS). The ETS requires emitters from these sectors to purchase emission allowances per tonne CO2, which creates a market price for emissions. Under the CBAM, EU importers will buy certificates corresponding to the EU’s carbon price that would have been paid had the goods been produced in the EU. If, however, the importer can prove that the manufacturer of the imported goods has already paid a price for the carbon used in the production in a third country, the corresponding cost can be fully deducted for the EU importer.

Importers will buy the CBAM certificates from the national authorities of the EU country they are trading with. The price of the certificate is based on the average trading price of EU ETS allowances (EUA) in the week prior to the import. Every year, by 31 May, importers have to declare the goods and their embedded emissions for the previous year and surrender the CBAM certificates corresponding to these emissions. Any CO2 price that they already paid in a third country will be deducted. If the emission information for the goods is not available, importers will be able to use default values on CO2 emissions.

While the Commission will not permit the trade of the CBAM certificates to avoid a parallel market, importers will be given the opportunity to return unused certificates to the authorities.

The European Commission plans to introduce the CBAM very gradually to give other countries and businesses as much legal certainty as possible. From 2023 to 2025, importers will have to report emissions embedded in their goods but they will not have to pay. This will also help the national authorities that will have to put a whole new system in place for the registration of importers, the review and verification of declarations and the sale of CBAM certificates.

Interaction between CBAM and EU ETS

The EU's main mechanism to prevent carbon leakage from industry is the allocation of free CO2 emission allowances under the EU ETS. Under the ETS, free emission rights are given to energy-intensive companies that meet product-related benchmarks and are at risk of carbon leakage. In addition, member states are permitted to return some of the ETS revenue to electricity-intensive businesses.

As a CBAM also provides carbon leakage protection, the two instruments have to be closely coordinated to avoid putting too much pressure on either the importer or the EU producers. The European Commission states that the CBAM will “progressively become an alternative” to the free allocation of allowances under the ETS. As of 2026, free allowances in the CBAM sectors will gradually be phased out, the Commission has proposed in a review of the EU ETS also published in the “Fit for 55” package. Free allocation will stop altogether in 2035. Until then, the CBAM will only apply to the proportion of emissions that does not benefit from free allowances under the ETS, “thus ensuring that importers are treated in an even-handed way compared to EU producers,” the Commission writes.

Legal issues when implementing a CBAM

One major challenge for the mechanism is designing it within World Trade Organisation (WTO) rules. The WTO’s free trade principle of “non-discrimination” by which the European Union must abide (contained in the General Agreement on Tariffs and Trade – GATT) would be breached if the bloc differentiated between low and high-carbon products that are otherwise alike.

The GATT provides for exceptions to this rule for environmental reasons, but the CBAM would have to be designed to exactly meet the requirements. Jennifer A. Hillman, a senior fellow at the Council on Foreign Relations, a U.S. non-profit think tank, told Reuters the EU could strengthen its case by ensuring that revenue from the mechanism goes to climate action.

The current practice of giving free allocations to industries that are in danger of carbon leakage when a CBAM is in place could be judged as an export subsidy, which is prohibited under the WTO’s Agreement on Subsidies and Countervailing Measures (SCM), a paper published by European Roundtable on Climate Change and Sustainable Transition (ERCST) states.

The European Commission stresses that the CBAM is designed in compliance with WTO rules, in particular because it is closely interlinked with the EU ETS. Through the phase-out of free allocations to European producers, importers are never “afforded less favourable treatment than domestic EU production,” the Commission writes.

What are the general issues of carbon border adjustments?

Depending on the exact design and the actual carbon cost used for the mechanism, the following risks have been mentioned by researchers and stakeholders:

  • If the cost of carbon is too low, it will give little impetus to invest in low-carbon technologies and carbon leakage will not be stopped.
  • If the EU’s emissions regime is joined by other large economies, such as the U.S. and Japan, high barriers between this trade bloc and the rest of the world would shut out emerging and developing economies.
  • If Europe alone implements a high carbon levy, only very low-carbon producers would be able to trade with the EU, high-carbon trade would continue but bypass the EU, and eventually European producers would have to increase their output.
  • Apart from the actual carbon content of a product, just complying with the new EU authentication and reporting rules  set up by the CBAM could lead to discrimination of producers from less developed countries.
  • A carbon border adjustment system should aim to specify the exact amount of emissions linked to each product, ideally including emissions along. its entire value chain – this is difficult, especially if a product is manufactured using electricity, e.g. aluminium.
  • Trade deviation and carbon leakage: Exporters from high-carbon countries could sell their products to other countries which do not have a carbon border tax, thereby replacing less carbon-intensive domestic production.
  • Distorting trade and damaging EU industry: If a CBAM prevents EU manufacturers from importing raw materials, e.g. steel, from a high-carbon country, the EU will likely import manufactured products (e.g. nails) instead from those countries – making life difficult for European producers of such downstream products.
  • Trade war: Depending on its design and the impact a CBAM will have on industries in different countries, their response may be to push back with their own tariffs (read more below).

First reactions and criticism of the EU’s CBAM proposal

During the preparation of the CBAM regulation proposal, the European Commission held stakeholder consultations and received a lot of input from trade and business associations, researchers, trade unions and public authorities, as well as responses from third countries. After publishing the final proposal and the report on the impact assessment in July 2021, experts have started to evaluate the Commission’s CBAM and have highlighted the following points:

  • Importers cannot receive positive credit for products that have been made adhering to foreign climate policies that do not take the explicit form of a CO2 price, e.g. pollution regulations, environmental standards.
  • The CBAM revenue only goes to the EU, no use of revenues for measures to support low carbon transitions in developing and climate vulnerable countries proposed.
  • Somewhat clashes with the spirit of the Paris Agreement which has opted for a bottom-up approach of nationally determined contributions.
  • Keeping free allocation of EUA in place for European industries while establishing a CBAM could undermine the principle of “common but differentiated responsibilities” laid down in the United Nations Framework Convention on Climate Change (UNFCCC), i.e. that developing nations should not face the same mitigation burden as richer countries; this could be alleviated by a special treatment (exemptions) for least developed countries.
  • There is no de minimis provision, relating to quantities traded, for importers.
  • How will the country-specific agreements on the recognition of their carbon pricing be negotiated and work in practice?
  • The new authorities needed to oversee the CBAM would create a “bureaucratic monster", Jürgen Hacker, former head of the Federal Association for Emissions Trading and Climate Protection (BVEK) said. The rules for determining emissions "are very complex and their verification is anything but trivial", Hacker warned.

What do Europe’s trading partners think about a carbon border tax?

With a CBAM, the EU’s aim is to avoid carbon leakage and “motivate foreign producers and EU importers to reduce their carbon emissions, while ensuring that we have a level playing field in a WTO-compatible way,” Commission president Ursula von der Leyen said in September 2020.

In this sense, the CBAM is part of Europe’s climate diplomacy and even before a proposal has been adopted, observers credit it with having helped change attitudes towards climate action in other countries. With more countries having national climate policies and greenhouse gas reduction measures for industry in place, they are faced with their effect on competitiveness and with the issue of carbon leakage as well. This makes them more understanding of the EU’s carbon border adjustment approach, researcher Michael Mehling from the Centre for Energy and Environmental Policy Research (CEEPR) at the Massachusetts Institute of Technology (MIT) told Euractiv. The EU Commission writes that a number of countries, e.g. Canada and Japan are planning similar initiatives and that it would like to see its international partners replicate the European CBAM. In a communiqué following their meeting of 9-10 July 2021, G20 Finance Ministers mentioned the need for closer international coordination on the use of carbon pricing mechanisms. 

But while the EU wants to exert its power to “do good” and promote climate action in countries around the world it trades with, these same trading partners may not like to see their hands forced in this way and “reflexively push back against the CBAM,” an ERCST (European Roundtable on Climate Change and Sustainable Transition) paper says.

Some even consider unilateral carbon border adjustments “the latest form of economic imperialism” that is “antithetical to the principles of equity enshrined in the Paris Agreement.” A similar opinion is voiced by Oxfam Kenya, which suggests that other policy instruments could be used to avoid carbon leakage that would not be so harmful to developing countries, e.g. import standards regulation.

Large trading partners, such as Russia, India and China, could introduce countermeasures, i.e. import tariffs of their own. Some have therefore warned of a trade war, unleashed by the EU introducing a CBAM.

Overall, it is important to note that the effect of the CBAM on trade with a certain country depends very much on the goods and sectors chosen to be included in the mechanism and the particular manufacturing conditions and climate measures in place in this country. Countries with relatively clean energy mixes (e.g. Costa Rica) and with carbon prices of their own, would not have to fear the border tax. While others with high shares of coal power and carbon-intensive industries, such as South Africa and India, would likely have reason to oppose such a measure.

China

China produces half of the world’s steel and would thus be very exposed to the CBAM as proposed by the European Commission. The Chinese government voiced its concerns over a carbon border tax as early as 2019, saying it would damage the global fight against climate change. But within the country reactions are more mixed, China Dialogue reported, as there are businesses that already produce with small carbon footprint. These could use the CBAM as an opportunity to do business with Europe. Others, however, would have to adapt quickly and could be helped by the government implementing emissions trading for goods that would be covered by a CBAM. According to Dimitri de Boer, head of ClientEarth’s China office, it hangs in the balance whether a CBAM would spark a trade war with China or motivate the country to increase its own emission reduction efforts from industry.

Russia

The EU is Russia’s largest trading partner, and Russia is the EU’s fifth largest trading partner. Main EU imports from Russia are raw materials, oil, gas and metals (iron/steel, aluminium, nickel). With this track record and being the world’s fourth largest emitter of greenhouse gases, Russia is concerned about the EU “using its climate agenda to create new barriers.” In June 2021, Russian Deputy Prime Minister Alexander Novak said that a CBAM “may clash with global trade rules and threaten the safety of energy supplies.” In Russia, the introduction of a CBAM is mainly perceived as being a measure to protect European industry rather than a climate action instrument.

Ukraine / Turkey / India

Ukraine’s main exports to the EU are iron/steel, mining products, agricultural products, chemical products and machinery. In its response to the European Commission’s impact assessment consultation, Ukraine’s Ministry of Economic Development, Trade and Agriculture voiced concerns about the CBAM’s effects on the steel industry in particular. The Ukrainian steel industry association UKRMETALURGPROM pointed out that the country’s own carbon tax and willingness to integrate into the EU’s Green Deal initiatives mean that “trade in steel goods […] should not be subject to any CBAM.” The Ukrainian think tank GMC Center has calculated a high risk for a decline in the country’s power, chemicals and steel exports to the EU, coupled with a subsequent job loss and the deterioration of trade relations.

The Turkish Business and Industry Association (TUSIAD) and Ukraine’s Ministry of Economic Development have both expressed an interest in aligning their policies with the EU standard and asked for a mechanism and funding to facilitate this approach.

The EU’s imports from India are manifold, with textiles, chemicals and metals all playing a role. The Boston Consulting Group has pointed out that, for example, India’s (and Turkey’s) steel industries would probably pay less tax than other sectors because of their higher share of minimills, which are generally more carbon-efficient.

U.S. and Canada

The EU is not the only world power mulling the idea of introducing CO2 fees at its borders.

During his campaign for president, Joe Biden embraced the aim of imposing “carbon adjustment fees or quotas on carbon-intensive goods from countries that are failing to meet their climate and environmental obligations.” Shortly after the EU published its CBAM proposal, U.S. Democratic lawmakers proposed a legislative bill on a border carbon adjustment for aluminium, cement, iron, steel, natural gas, petroleum and coal from 1 January 2024. The import fee would be based on the domestic environmental costs incurred by U.S. producers under their domestic climate policies. U.S. agencies would be tasked with determining the level of ambition of the trading partners’ climate change laws. The poorest countries would be exempt from paying the fee.

At the same time, many politicians and industry in the U.S. are keeping a wary eye on the EU’s plans, arguing that new trade disputes could be triggered if a CBAM should penalise U.S. companies for not having a carbon price when they are reducing emissions through other measures.

Like the U.S., Canada’s government is also exploring the introduction of a border carbon adjustment scheme but plans have not been finalised as far as the EU’s proposal.

California and Quebec are the only two regions in the world that actually have a CBAM in place. Electricity traders have to surrender allowances when importing electricity into these jurisdictions.

What do European and German industries think about a carbon border adjustment?

European industries’ perception of a carbon border fee depends very much on the type of industry and the design of a carbon tax. German industry association BDI agrees with the notion that a stricter European climate regime will need a carbon border adjustment, as the system of free allocations would not suffice to prevent carbon leakage. Their biggest fear is retaliation measures by trading partners. They also stress that the system of free allocations under the EU ETS must under no circumstances be substituted by a carbon border payment.

The German Chemicals Industry Association (VCI) strongly opposed the idea of a CBAM, saying the “risks and burdens that come with carbon border adjustments by far outweigh the opportunities.” The export-oriented chemicals industry would bear the brunt of trading partners responding with “tough countermeasures.” Defining the CO2 content of products would be costly and would require the disclosure of sensitive information. “Carbon border adjustment must not replace existing instruments to prevent carbon leakage (free allocation, indirect cost compensation). These must be maintained and expanded even if carbon border adjustment should be introduced – because only these instruments protect competitiveness for exporters,” they write.

The German Steel Federation (WV Stahl) criticised the reduction of free allocation of EUA. It warned that because of sharply rising costs, production could be relocated to third countries despite the CBAM. Border adjustment is at risk of being circumvented by foreign competitors, they added. The federation has suggested that revenues from the mechanism should be used to support the low-carbon transformation of steel production in Europe.

The Association of German Chambers of Industry and Commerce (DIHK) and the German Engineering Federation (VDMA) both voiced the concern that distortions in trade flows would negatively affect the competitiveness of companies that process products subject to a carbon border adjustment. The German economy, which is highly dependent on international trade, would particularly stand to suffer, the DIHK argued.

The German Pulp and Paper Association (VDP) said that protecting parts of the industry through a CBAM was unsuitable for the purpose. The mechanism would provoke trade conflicts and is not at all practicable for the paper industry, VDP president Winfried Schaur said. Instead, the EU should create other carbon leakage prevention measures, e.g. a special electricity price for industry or a broad funding offensive for decarbonisation projects.

The organisation Fertilizers Europe is in favour of a carbon border levy that arises from the difference between the product (e.g. ammonia, fertilizers) benchmark set in the EU ETS and the actual carbon intensity of imported products.

Eurometaux, representing the European non-ferrous metals industry, said that aluminium would “regrettably” be one of the five sectors included in the CBAM’s pilot phase “despite specific unresolved issues related to EU electricity markets and the likelihood of resource shuffling from third countries.” However, the organisation is satisfied that indirect emissions have not been included in the CBAM proposal, arguing that a CBAM is generally “ill-fitted for sectors indirectly emitting carbon through their electricity consumption.”

In a summary of the public consultation that ended in October 2020, the ERCST found that “stakeholders remain positive towards the border adjustment, but worried about the impact on the current domestic measures to address carbon leakage and the functioning of the EU ETS at large.” Some are also worried about the irreversibility of the process.

How much revenue could be generated by the tax and what will the money be used for?

A CBAM could bring in revenues of around 9 billion euros per year, depending on the year of its introduction and on how much money is freed up from phasing out free allocation under the EU ETS, the Commission estimates in the impact assessment report. To make the mechanism comply with WTO rules, this revenue should be dedicated to climate action, legal experts have said (see above). The Commission has suggested that the money – which will be part of the EU’s own budget – should be used to help low-carbon innovation in European industry.

European Commission officials have stressed that the revenue is not the reason why the EU is proposing the introduction of a CBAM.

Is it realistic for the EU to impose a CBAM, what do member states say?

The EU has come up with three proposals for a CBAM since 2007 but none of them made it through the legislative process, either because the system of free allowance allocations under the ETS was favoured or because concerns over WTO challenges were too strong.

However, this time, the CBAM proposal is an official part of the bloc’s attempt to reach the new 2030 climate target (“Fit for 55” package), the European Green Deal, and it is interlinked with a reform of the EU ETS. And although posing the risk of upsetting trading partners, just the preparation of the carbon border adjustment bill has led other countries to think about introducing carbon reduction measures and to design them in a way that is credited under the CBAM. The European Parliament’s Committee on Budgets  and the Committee on the Environment, Public Health and Food Safety have both signalled their general approval of a CBAM.

Germany and France, the two largest EU member states, are supporting the idea of establishing a CBAM as long as it is in line with WTO rules. Positive remarks have also been heard from Italian and Spanish officials, and Poland is also a supporter. However, only the actual design of the mechanism will now elicit detailed responses from the member states, e.g. on elements such as replacing the free allocation of emission allowances. Depending on what commodities a member state imports – e.g. Germany natural gas from Russia, or Spain electricity from Morocco – positions will also likely differ on how the carbon content of a product should be calculated.

At a more general level, Commission officials have stated that an EU carbon border tax becomes less important as more countries commit themselves to similar CO2 reduction schemes. But since even the recent climate target announcements by China, Japan and the Republic of Korea will not immediately and completely alleviate European industry’s carbon leakage concerns, the Commission continues to pursue the mechanism.

What is the timeframe for Europe’s implementation of a CBAM?

The European Commission’s legislative proposal for the CBAM marks the beginning of the legislative process in the EU institutions. The European Parliament, the Council of Ministers and the European Council (of heads of state and government) are likely to introduce changes to the bill. If all goes smoothly, the CBAM could enter into force in 2023.

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