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EU’s Carbon Border Tax: Is it regressive and protectionist or an incentive for global decarbonisation?

On December 13, 2022, the European Union (EU) agreed on a preliminary deal for an EU Carbon Border Adjustment Mechanism (CBAM) on imported goods such as iron and steel, cement, aluminium, fertilisers, electricity, and hydrogen, applicable from October 1, 2023. 

It may also be extended to polymers and chemicals.

The CBAM is also known as a carbon border tax or a carbon leakage instrument. The European Commission, the executive arm of the EU, formally submitted a proposal for it last July.

Its stated goal is to eliminate the difference in carbon price paid by companies subjected to the EU’s Emissions Trading System (ETS) or its domestic compliance-based carbon market, and the price paid by companies elsewhere, whose manufactured goods are imported into the EU.  

Those in favour of the CBAM believe that it will act as a signal to push other countries to implement stronger emission reduction efforts. According to a press release by the European Parliament:

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.

The undermining of global climate efforts due to relocation of production is defined as ‘carbon leakage’. 

“It is one of the only mechanisms we have to incentivise our trading partners to decarbonise their manufacturing industry. On top of this, it is an alternative to our current carbon leakage measures, which will allow us to apply the polluter pays principle to our own industry. A win-win situation,” Mohammed Chahim, lead negotiator for the deal, said in a press release.

Companies operating under the EU’s ETS pay about 85 euros per tonne of carbon emitted above a certain threshold. This adds about 20 per cent on each tonne of steel produced in the EU, according to the Financial Times.

From the EU’s perspective, it is “levelling the playing field” for its own firms, cushioning them from competitors who can manufacture more cheaply in countries with lenient environmental laws. 

“According to the standard economic theory of trade, imposing carbon taxes on domestic producers without an adjustment mechanism would certainly cause a shift of production to places where those taxes can be avoided,” Sanjay Reddy, chair of the Department of Economics at the New School for Social Research, told Down To Earth.

“An adjustment mechanism therefore causes the environmental benefits of the carbon tax to be felt more broadly and may spur foreign producers to undertake carbon abatement measures,” Reddy added.

But from an equity perspective it becomes more complex as it increases costs in poorer countries, due to the need for them to remit new taxes and pay the costs of calculating their carbon emissions, he noted.

From a longer-term perspective, this may well be beneficial to all if it encourages more rapid application of renewable technologies. But in the short run, this will be  harmful to industries in developing countries.

Moreover, carbon prices (often emissions trading schemes) are still relatively rare in most of the world, Ian Mitchell, co-director of development cooperation in Europe and senior policy fellow at the Center for Global Development, told DTE.

“Introducing them will be a major policy challenge for some lower income countries. For countries reliant on one of the targeted industries — like Mozambique’s aluminium extraction, this could be a major economic shock,” Mitchell added.

Critics have condemned the CBAM as being protectionist ever since the proposal was put forth last year, especially when one digs into why the field was uneven to begin with. 

Free trade agreements were signed in the 1990s because “the already rich world was finding the cost of production too high in its world”, wrote Sunita Narain, director-general of the Centre for Science and Environment, New Delhi.

It would be cheaper for its industries to set up shop in parts of the world, like in China, where labour was cheap, labour conditions were weak and environmental safeguards could be ignored, she added.

As a result, the rich world “exported” their emissions to the balance sheet of “other” countries and continued to consume goods at cheaper rates, while not reducing their domestic emissions.

Reddy believes that this measure is being imposed in an already uneven context, due to the prior failure of rich countries to make good on their promises to make green technologies more accessible to developing countries, whether through extending knowledge or providing financing.

“There is an efficiency case for an adjustment mechanism, to avoid simply causing “dirty” production to shift elsewhere, but equity and justice demand that rich countries at the very least accompany the imposition of a border adjustment mechanism with measures that substantially fulfill their earlier promises,” he added.

To operationalise the CBAM, importers will have to buy certificates to cover their emissions based on calculations linked to the EU’s own carbon price. The CBAM applies a national sectoral average to measure the greenness of a sector in each [non-EU] country, Tim Sahay, senior policy manager at the Green New Deal Network, told DTE

“There is little or no granular data to find a firm’s true emissions. If a firm uses on-site renewable energy, it literally does not matter to the amount of CBAM fees it pays. This undermines producers from outside the EU to invest in renewable energy. Indian firms may be on the hook for billions of euros in CBAM fees. There is little wonder that they oppose the CBAM together with BRICS allies,” he said. 

Instead, the EU should consider helping individual firms with technology transfer and get a lot more granular with tracking emissions, he adds.

Mitchell alluded to this as well, stating that although trade policy will eventually be essential to incentivise countries to decarbonise their industry, the CBAM would have achieved greater support if it also came with a commitment to financially support developing countries to introduce the carbon price.

“One simple way to implement such compensation would be to implement the mechanism but to remit all of the taxes collected to exporting countries (which could in turn choose to transfer some of these funds to affected industries and firms in the form of block grants to aid in the implementation of clean technologies),” said Reddy.

Any such measure should not, of course, substitute for the existing commitments of developed countries to aid in the transfer of green technologies.

Currently however, proceeds from the CBAM will go into the EU’s internal budget. 

There is also the possibility that the CBAM may violate World Trade Organization (WTO) rules. Companies in the sectors covered are allowed a limited number of free emissions allowances and must pay for permits for any emissions beyond this.

“Retaining free allowances alongside the carbon border tax during the phaseout could violate WTO rules,” reports the Financial Times. An agreement to overhaul the EU’s domestic carbon market (ETS) was reached on December 18, which states that the free allowances will be phased out by 2034, a contentious issue that industry is resistant to.

Yet the CBAM’s compatibility with WTO rules remains a grey area, Rashmi Banga, an economist at UNCTAD, told DTE. The issue will not be clear unless developing countries challenge it at the WTO, which points to an imminent legal fight, she added.

Banga was a co-author of UNCTAD’s Trade and Development Report 2021. The report states that the principle of CBAM is “to impose on developing countries the environmental standards that developed countries are choosing”.

This goes against the principle of common but differentiated responsibility (CBDR) enshrined in the Paris Agreement, it adds. If the revenues from these mechanisms are used in developed countries, rather than be invested in climate adaptation in developing countries, “they would turn basic principles of climate finance on their head”.

“UNCTAD estimates that a CBAM — at $44 per tonne — will reduce global carbon emissions by not more than 0.1 per cent but will have an adverse distributional impact because it will decrease global real income by $3.4 billion, with developed countries income rising by $2.5 billion while developing countries’ incomes fall by $5.9 billion,” said Banga.

Secondly, in this world of global value chains, carbon emitting activities like manufacturing have been outsourced by lead firms and low carbon emitting activities like branding and financing have been retained, she added. So, the comparative energy efficiency in the North cannot be delinked from the energy inefficiency in the South. 

And thirdly, carbon emissions in traded goods and services comprise only 27 per cent of global carbon emissions. This indicates that the scope of international trade policy, particularly the international trading rules, in achieving global green growth is limited. 

“So, it is the domestic or the national policies which are going to be more effective than international rules”, she said.

The report also raises the issue of intellectual property rights protection as a barrier to the transfer of low-carbon technology. The international community could support initiatives to transform rules governing intellectual property rights, such as through a WTO Ministerial Declaration on TRIPS and Climate Change, with a view to expanding TRIPS flexibilities for developing countries in relation to climate-related goods and services, the report recommends.

Who will be impacted?

So, who is likely to be most impacted by this carbon border tax? According to UNCTAD, Russia (now sanctioned by the EU), China, and Turkey would be most exposed to the CBAM. If considering “developing” countries, then India, Brazil, and South Africa would be the most affected, while Mozambique would be the most exposed Least Developed Country (LDC). 

Among the BRICS nations, South Africa and China have criticised the tax, while the steel industry in Brazil has expressed concern. Indian Finance Minister Nirmala Sitharaman recently warned Indian firms “to quickly understand the necessity for resetting yourselves so that tariff walls coming up newly in the name of climate change is something which we should face and be ready for”. 

India does not have a single domestic carbon price, but recently announced the approval of a new domestic carbon market in the Rajya Sabha, that will initially collate the infrastructure of two existing market-based mechanisms — the Perform Achieve and Trade (PAT) scheme, and the Renewable Energy Certificate (REC) mechanism. It will eventually take the form of a cap-and-trade system, with some features overlapping with existing carbon markets in the EU and China. 

At the level of individual industrial players, voluntary climate targets have been adopted by many large Indian companies.

In the case of the steel sector, analysis by CSE finds that many Indian steel players have set targets that are more ambitious than the National Steel Policy 2017.

“The National Steel Policy 2017 targets carbon dioxide (CO2) emissions from the Blast Furnace-Basic Oxygen Furnace (BF-BOF) route of 2.2 to 2.4 tonnes per tonne of steel, whereas companies like Tata and JSW have set targets which are below 2 tonnes of CO2 per tonne of steel. They are also developing pilots geared towards decarbonisation in areas such as carbon capture storage and utilization, scrap-based steel manufacturing and the use of plastics as a fuel to manufacture steel, despite the absence of a well-defined policy framework for such technologies and interventions,” said Parth Kumar, programme manager in the Industrial Pollution Unit at CSE, and author of CSE’s report.

How this patchwork of individual market-based schemes, a national NDC and net zero target, and voluntary climate targets by private industrial entities will strengthen Indian industry’s capacity to absorb price shocks coming its way from the CBAM is yet to be seen. Steel exports from India have already suffered setbacks this year due to a slowdown in global demand. 

This move by the EU could see other developed economies follow suit. The US expressed concerns about the CBAM on one hand, but also sent a proposal to the EU earlier this month for a carbon tariff on steel and aluminium, aimed primarily at countering China. Other (developed) countries such as Canada and Japan are planning similar measures to the CBAM, according to the European Commission. 

“Coordinated application of carbon taxes and related climate change avoidance measures would make it unnecessary to apply a border adjustment mechanism in the first place”, says Reddy. 

“We should still continue to pursue the first best of globally coordinated actions, without the “best being the enemy of the good” in the current urgent situation”.

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