“This could become the mother of all trade issues if not handled right.”
(R. Morningstar, Feb 2020)¹

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

With CBAM, the EU attempts to avoid the risk of carbon leakage
caused by the high cost of EU’s emissions-cutting policies.

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

Legal challenges are probably the most burdensome and difficult to overcome,
especially those concerning the CBAM’s WTO compatibility.

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

Multiple political and regulatory manoeuvres would be necessary
for a CBAM to pass at the international and WTO levels.

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.

The optimal solution can only be a strategic one.

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.

Peter Rožič SJ,
JESC Director

For a dear and nature-loving friend.

I would like to thank Professor Marc L. Busch at Georgetown University for helpful comments on an earlier version of the text and the colleagues of the great IBP’s Business, Government and the Global Economy community.

Endnotes

1 Richard Morningstar, the founding chairman of the Atlantic Council’s Global Energy Center, at a 2020 February event, reported by Times, in “How Europe’s Border Carbon Tax Plan Could Force the U.S. To Act on Climate Change,” https://time.com/5793918/european-union-border-carbon-tax/, accessed Jan 31 2021.
2 Cf. “2050 long-term strategy”, EC webpage, at: https://ec.europa.eu/clima/policies/strategies/2050_en, accessed Jan 31 2021. Cf. also “The 2020 Climate and Energy Package” https://ec.europa.eu/clima/policies/strategies/2020_en, accessed Jan 31 2021.
3 “Out of 163 National Determined Contributions (NDCs) to the Paris Accord, 90 include the use of market and trade mechanisms. Such instruments are designed to reach the targets of the Paris Accord nationally, with subsidies for green technologies and environmentally friendly companies and producers, special taxes and the enforcement of strict environmental regulation. They also aim to externalize environmental protection with the use of tariffs, market access restrictions and clauses in Free Trade Agreements (FTAs). These measures are likely to increase conflicts which will be tackled through the framework of the WTO dispute settlement body.” P. R. Guix (Jan 25 2021) “Greening the World Trade Organization: five priorities for EU foreign policy” https://kingsthinktank.com/2021/01/25/greening-the-world-trade-organization-five-priorities-for-eu-foreign-policy/, accessed Feb 1, 2021.
4 Cf. S. Rilling (Dec 15 2020) “ICIS EU Carbon: Carbon Border Adjustment Mechanism – possible implementations and EUA market implications” https://www.icis.com/explore/resources/news/2020/12/15/10585694/icis-eu-carbon-carbon-border-adjustment-mechanism-possible-implementations-and-eua-market-implications, accessed Jan 31 2021.
5 As shown by Tsafos, “The most important reason to impose a carbon border adjustment mechanism is to secure the buy-in of local industry for deeper decarbonization policies.” N. Tsafos (Aug 7 2020) “How Can Europe Get Carbon Border Adjustment Right?” https://www.csis.org/analysis/how-can-europe-get-carbon-border-adjustment-rightt, accessed Feb 6 2021.
6 “Carbon Border Adjustment – EUROFER contribution to the public consultation” (November 12 2020) https://www.eurofer.eu/publications/position-papers/carbon-border-adjustment-eurofer-contribution-to-the-public-consultation/, accessed Feb 1, 2021.
7 Cf. K. Taylor, idem.
8 “The climate neutrality objective needs to be achieved in a way that preserves the EU’s competitiveness, including by developing effective measures to tackle carbon leakage in a WTO compatible way. In this context, the European Council takes note of the Commission’s intention to propose a carbon border adjustment mechanism concerning carbon-intensive sectors. Facilities in third countries need to adhere to the highest international environmental and safety standards.” From European Council Conclusions on Climate Change, Zagreb, 6 March 2020, “Subject: Long-term low greenhouse gas emission development strategy of the European Union and its Member States”, https://unfccc.int/sites/default/files/resource/HR-03-06-2020%20EU%20Submission%20on%20Long%20term%20strategy.pdf, accessed Feb 1, 2021.
9 Ursula von der Leyen (Sept 10 2019) “The von der Leyen Commission: for a Union that strives for more” https://ec.europa.eu/commission/presscorner/detail/en/IP_19_5542, accessed Feb 1, 2021.
10 G. Zachmann and B. McWilliams (Mar 2020) “A European carbon border tax: much pain, little gain” Bruegel Policy Contribution Issue n˚5, http://aei.pitt.edu/102592/1/PC-05-2020-050320v2.pdf, acc. Jan 31 2021, p. 4.
11 K. Taylor, idem.
12 “Davos 2020: Ursula von der Leyen warns China to price carbon or face tax” (Financial Times, Jan 22, 2020)
https://www.ft.com/content/c93694c8-3d15-11ea-a01a-bae547046735, accessed Jan 31, 2021.
13 Consider the 2007 draft by the Commission, the 2009 French non-paper or the 2016 French non-paper for cement. Cf. also C. Stam and L. R. Moscovenko (Sept 14 2020) “EU carbon border tax: How a French idea ended up in the limelight” https://www.euractiv.com/section/energy/news/eu-carbon-border-tax-how-a-french-idea-ended-up-in-the-limelight/, accessed Jan 31 2021 as well as “EU leaders to consider carbon border tax” (June 30 2020) https://www.argusmedia.com/en/news/2118909-eu-leaders-to-consider-carbon-border-tax, accessed Jan 31 2021.
14 Cf. G. Zachmann and B. McWilliams, idem., p. 4.
15 Cf. G. Zachmann and B. McWilliams, idem., p. 6.
16 Besides foreign political obstacles to CBAM, internal political challenges play a role as well. If CBAM is implemented as a carbon tax, it would require unanimity in the European Council in order to be adopted. Likewise, if it is a custom duty, it would require unanimity. True, “special legislative procedures” could be used to circumvent unanimity but that would infringe on the democratic process. Only the third implementation option – an extension of the EU ETS to imports – would require a lower threshold, a qualified majority in the European Council. In this case, “importers would have to buy allowances to cover their emissions or pay a levy based on the market price of allowances. The type of allowances accepted could be EUAs, a separate pool of virtual allowances or allowances from other established markets with clear emission caps.” S. Rilling, idem.
17 Cf. G. Claeys, S. Tagliapietra and Bruegel (Jul 23 2020) “Is the EU Council agreement aligned with the Green Deal ambitions?”, https://www.bruegel.org/2020/07/is-the-eu-council-agreement-aligned-with-the-green-deal-ambitions/, accessed Feb 6 2021, as well as Dr2 consultants (Aug 5 2020) “Summer recess – what’s next?” https://dr2consultants.eu/tag/multiannual-financial-framework/, accessed Feb 6 2021.
18 Cf. G. Zachmann and B. McWilliams, idem., p. 11-12.
19 Cf. A. Sapir and G. Zachmann (Mar 15 2012) “EU Carbon levy: try to avoid air turbulences” Bruegel Blog.
20 Cf. B. Lewis (May 13 2013) “Exclusive-Airbus to China: We support you, please buy our jets” Reuters.
21 Cf. Bohringer, C., J. Carbone and T. Rutherford (2016) “Embodied Carbon Tariffs” The Scandinavian Journal of Economics vol 120(1).
22 Cf. B. Aylor, M. Gilbert, N. Lang, M. McAdoo, J. Öberg, C. Pieper, B. Sudmeijer and N. Voigt (June 30 2020) “How an EU Carbon Border Tax Could Jolt World Trade” https://www.bcg.com/en-be/publications/2020/how-an-eu-carbon-border-tax-could-jolt-world-trade, accessed Jan 31 2021.
23 Cf. G. Zachmann and B. McWilliams, idem., p. 11.
24 Until now, the WTO has determined whether products are ‘like’ one another by “examining their end use, consumer tastes and habits, and their physical characteristics, along with whether they compete with each other.” Cf. Hillman J. (July 2013) “Changing Climate for Carbon Taxes: Who’s Afraid of the WTO?” Climate & Energy, Policy Paper Series, German Marshall Fund of the United States.
25 Cf. Hillman, J. (2013), idem.
26 Trachtman, J. (2016) “WTO Law Constraints on Border Tax Adjustment and Tax Credit Mechanisms to Reduce the Competitiveness Effects of Carbon Taxes” Resources for the Future Discussion Paper 16-03.
27 Consider a hypothetical and heuristically useful example provided by Zachmann and McWilliams, 2020 (cf. above), p.9: “Under the ETS, free emissions allowances are given to companies based on how well they perform against product-related benchmarks, with only the best 10 percent of performers receiving all allowances for free. Benchmarks (for example, 1.62 tonnes of CO2 generated per tonne of ammonia produced) have been determined for more than 50 products15. Using such a well-established methodology, which has not so far been challenged at the World Trade Organisation, could resolve some complicated technical questions at the beginning. But over time the question will arise whether the benchmarks should evolve in step with EU decarbonisation16 or if the benchmark should be kept at its initial level.”
28 Cf. S. Rilling, idem.
29 S. Rilling, idem.
30 Cf. S. Rilling, idem.
31 Hillman, J. (2013), idem.
32 See World Trade Organisation, “WTO rules and environmental policies: GATT exceptions” https://www.wto.org/english/tratop_e/envir_e/envt_rules_exceptions_e.htm, accessed Feb 15 2021.
33 There is a tactical possibility of creating a “wide international alliance with other countries that might join an EU initiative to introduce domestic climate policies, together with a jointly-designed CBAM that might alleviate some of the concerns. But some countries, including the US and China, might have structural reasons to dislike such an approach.” In Böhringer et al, idem.
34 Cf. N. Tsafos, idem.
35 As a response, the EC’s international policy need to continuously reiterate its promises to use “all positive avenues of our climate diplomacy to avoid a situation where proactive measures would somehow come as a surprise to our partners [and to make] sure that whatever is introduced will be compatible with WTO rules.” In K. Taylor, idem.