The EU’s Carbon Border Adjustment Mechanism is ecologically justified but difficult to implement.
In the fight against climate change, the European Union seeks to reduce net greenhouse-gas (GHG) emissions by at least 55 per cent by 2030, compared with 1990 levels. By 2050, the EU should become climate-neutral. Under the Paris Agreement, many countries are committed to climate neutrality between 2040 and 2060 and are planning significant emissions reductions over the next ten years, but the EU’s plans remain quite ambitious in context.
Under the name ‘Fit for 55’, the European Commission presented last year a package of measures to that end. They include a Carbon Border Tax Adjustment Mechanism (CBAM), on which the commission presented a legislative proposal in July 2021. In a recent study, we provide an economic and legal analysis.
The commission proposal stipulated that importers of selected basic materials and basic products from the emission-intensive sectors of iron/steel, aluminum, cement and fertilisers, as well as electricity, would have to purchase carbon-dioxide certificates. Their prices would be equivalent to those of certificates under the domestic EU emissions-trading system (ETS). How much CO2 emission was embodied in the respective product would have to be quantified by the importer in each case or on the basis of reference values provided by the commission. CO2 prices already paid in third countries could be offset. The procedure was intended to compensate for cost differences between goods produced within the EU and abroad.
‘Trilogue’ consultations among the commission, the Council of the EU and the European Parliament in recent weeks have resulted in a provisional agreement to start the CBAM mechanism in October 2023—nine months later than foreseen in the commission proposal. The product scope was expanded to include hydrogen, certain precursors and indirect emissions and some downstream products. Agreement on other important aspects, including export rebates and the phasing out of free allowances, remains however pending.
The ETS is the central climate-policy instrument of the EU. Due to the planned reduction in emission certificates available each year and the expiry of their free allocation to manufacturing companies by 2035—including for emission-intensive sectors—rising CO2 prices should provide a strong incentive to increase energy and resource efficiency and to promote technological innovation towards GHG-free production processes.
A key concern is the risk of ‘carbon leakage’—the relocation of EU-based production (and associated emissions) to countries with less stringent climate policies. In extreme cases, such a shift could even increase total global emissions and so work against EU climate targets. The costs linked to GHG emissions could also affect the competitiveness of European firms and thus lead to a loss of production capacity and so of value creation and employment, with negative consequences for political acceptance of the EU’s climate goals.
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The empirical evidence for carbon leakage has however been mixed. Some countries that have joined the 1997 Kyoto Protocol, operationalising the United Nations Framework Convention on Climate Change, have reduced their own emissions but have imported more CO2-intensive goods from other countries—thus indicating a leakage effect. Yet surveys of EU companies and studies of EU emissions trading have not found any effect of significance.
The price of CO2 has though been low in the past and in the EU the risk of carbon leakage has been countered by the free allocation of emission allowances to energy-intensive sectors. But as emissions trading enters the next phase, the pressure on companies will increase. A unilateral CBAM then becomes an important support, which model simulations suggest should mitigate the risk of carbon leakage. The application of this instrument is however yet to come.
In terms of its effectiveness, concern arises primarily from the limitation of the scope of the CBAM to basic materials/products in specific sectors. There is still potential for carbon leakage with processed products: the CBAM could be circumvented if these were imported, instead of raw materials. With some exceptions (including steel pipes) included during the trilogue consultations, this worry has not been comprehensively addressed.
With some scientific support, the European Parliament has called for expansion of the CBAM’s scope to all products that contain the basic substances listed in the ETS. There are, however, questions of feasibility and the balance between costs and benefits. Two particularly CO2-intensive basic-material sectors, refinery and organic-chemical products, are excluded from the commission proposal, since the emissions of individual products cannot be clearly defined.
For processed products, this would only be possible if methods for measuring the CO2 content of the numerous raw materials and components contained in complex processed products were introduced, which would be methodologically complex and very burdensome for importers to administer. Important prerequisites for this are not in place. Even if the planned CBAM sectors cover 55 per cent of industrial emissions, the area of application will thus remain limited in the short and medium term.
Finally, the commission’s proposal did not envisage rebates to EU exporters for the carbon price paid under the ETS for goods exported from the EU. By contrast, the European Parliament advocates including a transparent regulation for export refunds compatible with the rules of the World Trade Organization (WTO). Apart from the legal problems associated with such export rebates, questions of technical feasibility and effectiveness however again arise.
While the commission’s draft clearly sought to avoid conflicts with WTO law, its compatibility with key WTO principles remains highly controversial. Depending on its final design, the CBAM may, for example, raise complex issues with regard to the agreed ceilings on customs duties and other duties or charges in connection with the import of the products covered or in light of the fundamental principles of non-discrimination stipulated in article I (Most-Favored-Nation Treatment, MFN) and article III (National Treatment) of the General Agreement on Tariffs and Trade. If so, the difficult question arises whether the CBAM could be justified under the General Exceptions clause in article XX of GATT.
A discrimination between imported products from different third countries could, for example, result from the fact that only a CO2 price paid in the country of origin would reduce the amount of CBAM certificates due, while other cost-effective emission-reduction measures would not be accounted for. This could constitute a violation of the MFN principle.
Legal problems could also result from the additional administrative burden EU importers would face under the CBAM in connection with the determination of relevant CO2emissions, which in turn could increase the price of imported products. Such less favourable treatment of imported products vis-à-vis like EU products would not be compatible with the principle of national treatment in article III:4 of GATT. This issue would arguably be exacerbated if the CBAM’s scope were extended to processed products, as the additional increase in costs due to more complex administrative processes would lead to only a relatively small additional climate benefit.
Against this background, the compatibility of the CBAM with the GATT appears ultimately to depend on whether the measure can be justified under article XX. Article XX(b) focuses on its ‘necessity’ to protect human, animal or plant life and health. Factors to be considered would include its effectiveness and contribution to achieving the policy goal (avoidance of carbon leakage and climate protection). Thus, it would be key for the EU to demonstrate convincingly that the CBAM was indeed effective. In this context, its ‘direct’ and ‘indirect’ effectiveness (the latter due, for example, to the use of proceeds from it) would have to be demonstrated.
Article XX(g) does not require the necessity of the measure and therefore grants WTO members more room for manoeuvre. What is relevant, among other things, is whether the burden associated with the conservation of natural resources would be distributed evenhandedly or primarily affect imported goods. In either case, application of the CBAM could not result in arbitrary or unjustified discrimination or constitute a disguised restriction on international trade.
Focus on innovation
The CBAM should thus be designed to be as easy to handle as possible from an administrative point of view and the focus should be on increasing its effectiveness indirectly. If the priority of EU climate policy is to reduce the GHG intensity of production as comprehensively and quickly as possible, then the CBAM and the ETS, respectively, should primarily be expanded to include non-price-based instruments with a focus on transformative research and innovation.
There is already great time pressure to achieve the EU climate targets by 2030 and the switch to carbon-free production processes in certain heavy industries is primarily a technological problem—in steel, the necessary alternative technologies are simply not available. The funds generated by the CBAM and the proceeds from the sale of emission certificates should therefore not flow into the general budget of the EU but be earmarked to fund research and innovation in breakthrough technologies, as well as to promote resource- and energy-saving production methods in energy-intensive areas. For example, the EU’s Innovation Fund could be expanded and basic research supported within the framework of Horizon Europe.
In this way, a triple dividend could be achieved:
- the likelihood of the CBAM’s compatibility with WTO law could be increased;
- it would be possible to create a lock-in effect through subsidised investments in low-emission technologies, mitigating potential relocation tendencies of EU companies, and
- the financial burden on EU companies resulting from high carbon prices could be reduced in the medium to long term, thus increasing their competitiveness.
If the EU also made the innovations achieved in this way available to the countries of the global south, via technology transfer, this would significantly increase the political acceptance of the CBAM internationally.
This article is part of a series, ‘Beyond the cost-of-living crisis: addressing Europe’s lack of strategic autonomy’, supported by the macroeconomic institute, IMK, of the Hans Böckler Stiftung