Greening trade without a carbon tax

Carbon Border Adjustment Mechanism (CBAM): A Nonviable but Prospective Instrument of Climate Action

In line with its commitment to climate action under the Paris Agreement, the European Union (EU) aims to be climate-neutral by 2050.² Pledging to drastically reduce Europe’s greenhouse gas emissions, the 2019-2024 European Commission (EC) envisages a number of measures.³ One such decarbonisation measure has already jolted climate and trade discussions around the globe: China, Russia and the United States have made it known that they oppose it. The measure may appear to be a market-access anti-dumping and anti-subsidy defence instrument in disguise.

The Carbon Border Adjustment Mechanism (CBAM) is a measure tackling the carbon intensity of domestic and imported products. Three ways of CBAM implementation are being discussed: carbon tax on imports and domestic production, a customs duty on imports, and the extension of the EU Emission Trading System (ETS).⁴ All of these forms would require the calculation of carbon benchmarks for products covered by the measure. The purpose is multifold as well: a CBAM would preserve the integrity of EU climate policy and industrial competitiveness;⁵ it would ensure that all emissions come with a cost, regardless of their country of origin;⁶ and it would help avoid the risk of carbon leakage, i.e., the loss of sales or entire industries to cheaply-priced, carbon-intense imports (cf. below).

As it brushes against the non-discrimination and other rules of the World Trade Organisation (WTO),7 CBAM represents no silver bullet. The intended 2021 publication of a CBAM proposal will affect a delicate balancing act8 between EU’s “commitment to becoming the world’s first climate-neutral continent,”9 the preservation of its competitiveness, and the rules-based international trading system. Aligning trade policy with decarbonisation, a CBAM may cause more problems than it attempts to solve. Nevertheless, even if the current version of the EU’s CBAM proposal may be neither technically viable nor WTO-compatible, the EU should keep it on the agenda for increasing its leverage in debating climate action internationally, while developing parallel mechanisms and stronger clean-industry markets for a carbon-freer future.

The Problem(s)

With CBAM, the EU attempts to avoid the risk of carbon leakage caused by the high cost of EU’s emissions-cutting policies. Through “direct” carbon leakage companies might reduce output as the foreign companies’ output increases (i.e., operational leakage), and eventually relocate to other regions in order to avoid the carbon tax (i.e., investment leakage).

Through “indirect” leakage, EU climate policies would cause a lower fossil fuel consumption: the global fossil fuel prices would fall to the benefit of foreign fossil-fuel consumption. Even if there is little evidence of any carbon leakage to date,10 the risk will increase as the EU tightens its emissions target for 2030 and free allowances under the ETS continue to decline.11

Putatively, a CBAM might address such risks. It would be designed to protect businesses from carbon dumping outside the continent. According to President von der Leyen, “There is no point in only reducing greenhouse gas emissions at home, if we increase the import of CO2 from abroad.” For her, this climate issue is “an issue of fairness towards our businesses and our workers. We will protect them from unfair competition.”12 While such ecology-and-business protectionist ideas are not new,13 they have intensified with the 2019 European Green Deal package and have generated significant technical, political and legal challenges.

Technical challenges of a CBAM include the difficulty of assessing carbon content of products as data may be hard to trace. Industries may refuse to disclose information on their supply chain. Moreover, a significant portion of carbon leakage cannot be addressed by a CBAM (at least in its carbon border tax form) since the leakage is predominantly driven by the fossil fuels energy price channel (cf. indirect leakage, above).14 Furthermore, relatively few industries face the risk of potential carbon leakage: steel, mineral products/cement and aluminium production. While any CBAM would thus need to be sector-specific, an additional challenge arises. Other industries may be in a general sense equally or even more polluting and detrimental to the planet in terms of green-house emissions. The examples include the transportation sector, the energy sector and others. Finally, depending on the type of leakage, many factors can outweigh its effects: transportation, non-tariff costs, political risk, exchange rate concern, product differentiation, as well as the quality of capital, labour and energy available in an economy.15

Political challenges16 may first relate to the use of money. The current plan of the EU 2021-2027 financial framework stipulates that revenues from a CBAM will contribute to the “own resources” of the EU budget for redistribution to the economy.17 Such a proposal is damaging in terms of legal compliance and cooperation with foreign partners.18 Instead of adding to its budget, it might be politically more prudent to send CBAM revenues to developing countries affected by the measure. Moreover, the international community will very likely oppose negative impacts for carbon-intensive export, the cost of compliance and extraterritorial overreach. In 2012, the EU already tried to game carbon pricing through air transport services for the full distance of flights arriving from outside of Europe.19 The EU had not only to learn that carbon emissions may be correlated with distance but also to bury the proposal after Chinese threats to cancel Airbus orders.20 Finally, any EU preferential treatment of clean domestic and foreign producers would affect less developed countries, further disbalancing trade and climate negotiations. At least under its carbon border form, CBAM would exacerbate pre-existing income inequalities as richer countries would shift the burden of reducing emissions to poorer countries.21 True, the EU could exclude from CBAM the developing countries or countries with carbon-pricing mechanisms that the EU agrees are compatible with its own.22 However, that would defy the purpose of CBAM as its overall climate impact would decrease.23

Legal challenges are probably the most burdensome and difficult to overcome, especially those concerning the CBAM’s WTO compatibility. Questions that the EU must address in this regard are those of “national treatment” and the compatibility with Articles II and III of the General Agreement on Tariffs and Trade (GATT). While Art. II.2 requires any border tax to be implemented on “like” products to those taxed domestically,24 Art. III.2 does not allow the border tax to exceed the domestic tax rate (cf. below). The challenge is that the carbon emissions for “like” products can be drastically different. Also, to be effective, benchmarks would have to be determined for a whole array of products and variations of those products. In other words, determining whether products are alike creates a trade-off between the implementation ease and environmental effectiveness (e.g., is steel the same if produced by pollution-varying methods such as a blast furnace vs. an electric mill).25 Research suggests that the best option for WTO compatibility would be a “product-based tax that does not vary by reference to carbon intensity of production but is set at a fixed rate for specified categories of products.”26

The Solution(s)

Multiple political and regulatory manoeuvres would be necessary for a CBAM to pass at the international and WTO levels. The EU industry cannot expect any protection in competing with higher carbon prices since trade partners will be encouraged to retaliate legally. That is, the EU competitiveness argument is not WTO compatible. Measures of discrimination cannot stand.

Any CBAM that, for example, incorporates export rebates could appear as a protectionist measure (cf. Art. I, II, III of GATT). For WTO compliance, a CBAM must assure non-discrimination between imported and domestic goods (Art III.2; cf. above).

Some suggest that solution on this front might be the extension of the EU ETS since it would ensure that a CBAM applies to “like” domestic products.27 That is, domestic producers and importers would need to pay the same carbon price. Any rebates exceeding a firm’s actual carbon costs could otherwise be viewed as illegal subsidies.28 Also, importers would need to have the opportunity to demonstrate the specific carbon content of their imports in order to avoid a discriminatory treatment in the assessment process. While such a measure is burdensome and politically sensitive, it has a higher likelihood to be WTO compatible if challenged. However, EU tradeable permits markets seem to be crashing. So, how could one imagine this rolling out on an international basis?

What is more, CBAM must abide by the “most-favoured nation” clause (Art I.1). This is possible only if the method to determine the carbon content is the same for all imports and if importers are allowed to deduce the carbon price paid in their home country. That would make the measure non-discriminatory, given that the same conditions do not prevail in third countries. Yet, since the likeliness of products has yet to be defined with regards to carbon intensity of products, “products may or may not have to be taxed equally, and a differentiation by the carbon content of a product might breach international trade rules.”29

Should none of the above tactics work, the EU might have a final – even if non-viable – resort to the environmental argument. According to Art. XX(g), exemptions can be applied for tariffs that “protect human, animal, or plant life or health” or when they are related “to the conservation of exhaustible natural resources.” Nevertheless, this approach is politically delicate in addition to the difficulty of providing clear carbon leakage evidence.30 Moreover, the design of the tariff would need to be explicitly implemented for global environmental purposes rather than to shield the EU from competition.31 Finally, linked to economic status and sovereignty issues, countries like India have long objected to the environmental argument on the multilateral stage. In short, if the EU desires to keep advocating for free trade, its own CBAM should not be perceived as a restriction in disguise. The challenge is that invoking the Art. XX(g) item is easy, but clearing the Chapeau is not (i.e., the introductory clause of Art. XX, emphasizing GATT’s exceptions and the manner in which a measure in question is applied).32 Since any effort would have to be applied in a non-discriminatory way to clear the Chapeau, it would come down to how one defines national treatment.

An Extension: Create New Markets Instead

How could the EU avoid obvious pitfalls of the CBAM, avoid the risk of regulatory scrutiny,33 and capitalize on legally compliant opportunities?34 The optimal solution can only be a strategic one. The EU needs to acknowledge the concern of international businesses and politics over any form of a carbon tax.35 While the EU can and perhaps should push for legal and political benefits of a CBAM, it should at the same time invest in the creation of completely new markets for clean products.

Savvily pressuring the international community on climate action through CBAM-like taxation threats, the EU could – in a parallel action – create its own conditions for Europe’s most promising low-carbon sectors to grow.

Such support systems have worked in the past for renewables (e.g., solar panels): as foreign competitors saw not only a dramatic drop in costs but also that meeting higher targets is possible and the technology available, they were more likely to sign the Paris agreement. The EU – and the planet for that matter – would benefit from gaming a CBAM as a deterrent (even if not implemented) while supporting clean alternatives by relying on Europe’s capital, institutions, strong intellectual property rights, a relatively innovative industry and, after all, free trade.

Risorse