EU’s carbon border tax: The start of a new trade war?

Developing countries question whether such measures by rich nations are designed equitably and if they violate global anti-protectionist trade rules

In April this year, the Indian government spoke to its industries about how it is strategising to tackle an impending ‘carbon border tax’ on its exports to the EU, including iron ore and steel.

After two years of negotiating, the EU member states approved the Carbon Border Adjustment Mechanism (CBAM). The world’s first carbon border tax, that aims to equalise the price of carbon paid for EU products operating under its compliance-based carbon market, the EU Emissions Trading System (EU ETS) and the one for imported goods. 

Importers in the EU will have to purchase so-called CBAM certificates to pay the difference between the carbon price paid in the country of production and the price of carbon allowances in the EU ETS. In the absence of a carbon price in the production country, the cost of certificates is likely to be decided by the carbon emitted beyond a threshold set by the EU. The country-group believes that the law will incentivise non-EU countries to increase their climate ambition and ensure that EU and global climate efforts are not undermined by production being relocated from the EU to countries with less ambitious policies.

In the beginning, the EU carbon border tax will only apply to imports of a few goods with a high-carbon impact, including cement, iron, fertilisers and steel. The tax will be gradually expanded to cover lower-carbon goods. Although the carbon border tax will begin in 2026, businesses, however, will need to produce an annual report detailing the goods imported in the previous year from October 1 2023. This means all manufacturers across all countries exporting their products to the EU will be expected to assess their production emissions.

The EU’s carbon border tax is not an isolated case. A flurry of announcements by developed countries has come to light in the recent past using climate change as a pretext to weaponise trade as an emission reduction tool. The US, Japan and China are also considering similar border taxes on trade.  The latest, and perhaps clearest, indication that developed economies are closing ranks around a cross-border carbon taxation strategy came in the recently concluded G7 ministers meeting in Japan. The communique issued at the end of the meeting signals broad agreement in group around the legitimacy of trade policy instruments such as carbon taxes to facilitate emission reductions.

Beyond border taxes, the EU and US find themselves in competition with each other—the US through its Inflation Reduction Act is offering billions of dollars of subsidies to industries to lure them into doing business within the US. The EU fears that this could lead to industries shifting their base from the EU to the US. In response, the EU came up with their own green subsidies. While the two developed nations locked horns on the green subsidies, both the US and EU are also considering the imposition of new import tariffs on Chinese steel and aluminium on climate grounds, reigniting the talks of a global carbon club, a “carbon-based sectoral arrangement on steel and aluminium trade”. Target at China at the moment this tariff is likely to be imposed on all major steel producers.

States increasingly using climate change as a pretext for imposing new trade measures, have developing countries worried about their economies. While their potential positive impacts on the climate may be thin, developing countries are questioning whether these measures are legitimate and will achieve the stated goal of cutting global emissions, are designed equitably and whether they violate global anti-protectionist trade rules.

For instance, in the case of the EU carbon border tax, United Nations Conference on Trade and Development’s (UNCTAD) report states that the principle of the EU carbon border tax is “to impose on developing countries the environmental standards that developed countries are choosing”.

Not only does this go against the principle of common but differentiated responsibility (CBDR) enshrined in the Paris Agreement, the report says, “should the revenues from these mechanisms be used in developed countries, rather than be invested in climate adaption in developing countries, they would turn basic principles of climate finance on their head.”

One thing is clear, the impacts of these trade measures will be multi-pronged, which countries are in the process to assess. CarbonCopy looked at some of the larger debates around the scheme:

Impact on India and other developing countries

All countries are in the process of assessing how much of their exports would face carbon border tax and how much that tariff could be since the EU has proposed different mechanisms for taxation. For example, in steel, different furnace technologies used to produce it might attract different levels of taxation. 

India’s total annual export to the EU in 2022 was about $8.2 billion for the products categorised for the carbon tax, mostly steel, aluminium and iron. Largely, this is the quantum of export that might be hit by the EU’s carbon tax. 

While the Indian government is trying to figure out specific numbers, it believes the carbon tax, for now, will impact 2% of India’s total exports and the tariff could be between 25-35%, trade experts told CarbonCopy.

The carbon border tax on Indian imports could significantly impact the prices of Indian-made goods in the EU markets, thereby upsetting demand, two senior trade lawyers wrote in an Economic Times op-ed.

“It could heavily bear up the supply chain portion of industrial sectors such as automotive, construction, cement, packaging, and consumer appliances as costs for key inputs such as steel and aluminium may rise by 15-30% leading to a change in purchasing behaviour of end customers,” they wrote, forcing companies to take actions to maintain competitiveness. 

The direct implications of EU’s proposed CBAM, however, marks only the beginning of a challenging trade regime for India’s government and export-oriented industry. Much more significant is the precedent it sets. More evidence of broad alignment among developed economies on the issue of cross-border carbon taxation came in the G7 Clean Energy Economy Action Plan, released relatively quietly as a sort of unofficial addendum to the G7 communique. The action plan expounds on the broad agreement among developed economies to work together on trade policy instruments that reflect the price of carbon in global supply chains (read: cross-border taxes), in effect highlighting the possibility of legislation similar to EU’s CBAM in other developed economies. Under this eventuality, one can expect the portion of India’s exports affected to skyrocket. Further, the implications are likely to disproportionately burden India’s export-oriented MSME sector. Meanwhile, any positive prospects from such interventions are likely to be concentrated among the fat cats of Indian industry. Those with requisite capital or the ability to raise capital to undertake emission reductions will implicitly enjoy better access to markets overseas.

At the time of writing, the Indian government is engaged in talks with the EU counterpart to eke out a resolution. Both parties discussed the issue in ministerial-level meetings in Brussels in May. 

In the same month, the Indian government held a consultation with the affected industries to signal them to be ready for the carbon tax. The government told the industries that it will use bilateral channels to make the transition smooth as well as figure out if a waiver is possible for a section of the industries, likely small and medium enterprises which have little capacity to adopt newer technologies of production. 

The Indian government’s stand is that the carbon tax is largely a trade issue and not an environmental one. It has openly talked about these measures being protectionist in nature.

In February this year, the Indian government in a written statement to the World Trade Organisation (WTO) raised an issue against nations using carbon border taxes to hamper export, the Business Standard reported. Calling these initiatives discriminatory and protectionist, India pointed to the concerns over the selective application of carbon border rules to “trade-exposed industries” like steel, aluminium, chemicals, plastics, polymers, chemicals and fertilisers. Which, the country said in its statement, reflects the underlying competitiveness concerns driving such measures.

India said that “carbon border measures that are being considered (by the European Union and the United States) for imposition on imported products, effectively amount to prioritising a singular policy of the importing country over those of exporting countries and will amount to imposing a unilateral vision of how to combat climate change.”

According to the WTO rules, it is mandatory that there is non-discriminatory treatment for the same products, irrespective of their production methods and such border measures can lead to “behind-the-border” protectionist practices, India said.

“Any measures taken to combat climate change, including unilateral ones, should not constitute a means of arbitrary or unjustifiable discrimination or a disguised restriction on international trade,” India’s submission to WTO said.

Not only India, but most developing and least developed nations that export their products to the EU are threatened by the carbon border tax. They believe that a blanket imposition of tax could mean that weaker nations have to share the mitigation burden of industrialised nations. 

Ministers of Brazil, South Africa, India and China, representing the “BASIC” group, released a joint statement on November 15, 2022, and retaliated against the proposed carbon border tax. “Unilateral measures and discriminatory practices, such as carbon border taxes, that could result in market distortion and aggravate the trust deficit amongst parties must be avoided,” the statement said. BASIC countries, in the statement, called for a united solidarity response by developing countries to any unfair shifting of responsibility..from developed to developing countries.  

“While all the BASIC countries have put in place their strategies to reduce carbon emissions in a phased manner, developing nations require predictable and appropriate support, including climate finance and access to technology and markets from developed nations to ensure and enable their sustainable development,” said the statement.

Trade offers an interesting and important avenue to pursue a climate agenda, and potentially it could be effective if measures are fairly and meaningfully designed to address the true drivers of climate change and not guised as protectionism, Olivia Rumble and Andrew Gilder, both trade policy experts, said about the EU and the US news of carbon border taxes, focusing on its impact on African nations. 

The process of designing these measures needs to take into account the needs of developing countries, not impose unfair procedural burdens and associated costs on exporting states, follow a meaningful engagement process where developing country inputs are taken into account in the design, and where revenues and financial benefits are not used in a way that provides an unfair benefit to importing states at the expense of developing countries, they said.  

However, little consultation or engagement has preceded these planned measures, and the initial designs suggest that they predominantly stand to benefit the EU and US. 

Least Developed Countries (LDCs), especially African nations, are of the view that a blanket tax on carbon-intensive industries will most likely affect weaker economies and reduce their profit margins associated with goods from such industries. They suggest that the EU grant a delay in implementation for African countries given the unlikeliness of carbon leakage to Africa, and that CBAM proceeds should be used to foster low-carbon growth in LDCs. 

The European Union, however, says that the carbon tax is designed in a way that it promotes cleaner and more efficient production in countries outside its boundaries. And that its tax is in full compliance with the WTO rules. “…We were of course very careful to ensure WTO compatibility of the initiative. And a keyword for this is ‘non-discrimination’. So we apply the same price of carbon to imported goods that we are going to apply also on our domestic producers,” Valdis Dombrovskis, the EU trade commissioner said after the ministerial meeting with the Indian counterpart. 

Claiming WTO Rules, they have argued that it will not be possible to give an exemption to LDCs. In October this year, the EU Parliament pushed for all the revenue generated from certificate sales to be used to support LDC efforts to decarbonise, however, the latest EU Council and Parliament announcement makes no mention of the position on the use of revenues.

Negligible emission cuts but a fall in real incomes of poorer countries

The larger reason why developing countries are unsure of the EU’s carbon border tax making a dent in global warming causing emissions is the underlying numbers of its benefits and the underlying cost that the world, especially weaker nations, will have to pay.   

A UNCTAD report that analysed the EU’s carbon border tax and its gains for the world at large said at $44 per tonne of CO2, the carbon border tax reduces global emissions further by only 0.1%. The EU’s own emissions reduce by only 0.9%. While achieving these meagre cuts, the carbon border tax forces the global real income to fall by $3.4 billion.

The benefits of the carbon border tax are also skewed in rich countries’ favour. Through the implementation of the tax, developed countries’ incomes rise by $2.48 billion while developing countries’ incomes fall by $5.86 billion.

EU’s freebies to its industries in the fight against the US’s green subsidies

The passage of the US Inflation Reduction Act (IRA) has had an impact on the final contours of the EU ETS and CBAM, especially on the slow phasing out of the free allocation of pollution permits. Together with the energy price crunch caused by the Russian war in Ukraine, it was frequently cited as a reason by the EU as to why these two specific pieces of legislation could not go ahead as originally envisaged.

Experts who have been studying the EU’s policies for decades worry that in the face of the US Inflation Reduction Act, the EU’s moves regarding the free emission allocations to its large industries, especially steel, under its ETS continuing till late this decade and slow introduction of CBAM could hurt global fight of slashing emissions rapidly for staying within 1.5°C limit. 

For example, under the reformed Emissions Trading System (EU ETS) agreed at the end of 2022, heavy industries are required to slash their emissions more than in the past decade but remain nevertheless shielded from the price signal. These energy-intensive sectors–which have received about €200 billion in free pollution permits since the ETS was established–will continue to receive large amounts of their emission allowances for free until at least 2030 to the tune of over €400 billion, according to Carbon Market Watch (CMW), a global non-profit. 

This is not it. The EU Innovation Fund is endowed with more than €38 billion financed from the auctioning of EU ETS allowances, and to be used to help companies decarbonise and transition to the green economy. In addition, a significant share of the EU’s €800-billion COVID-19 recovery package and the €300-billion RePowerEU package has gone or will go to EU-heavy industry. “Then, there is the protection against the bogeyman of carbon leakage afforded by the CBAM,” CMW said.

The EU sees the slow phase-out of free allocation together with the slow phase-in of CBAM, as a “breathing space for industry”. 

What is in the making now with the industrial policy package will rather be an additional supply of oxygen to industry, as per the CMW. However, whether the industry will soon after that be able to breathe naturally and exhale something that is good for the climate is doubtful, the non-profit added.

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Bhasker Tripathi

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