Flaws in a multipurpose CBAM

EU's tax on carbon-intensive imports contradicts multilateral climate and trade norms

The regulation on the carbon border adjustment mechanism (CBAM) to be implemented by the European Union (EU) entered into force on May 16, 2023. CBAM, which is a price on the carbon emitted, directly and indirectly, during production of carbon-intensive goods entering the EU, will be implemented in two phases. The transitional phase beginning October 1, 2023, will cover carbon-intensive imports in six sectors: Aluminium, cement, electricity, fertilisers, iron and steel and hydrogen, imposing only reporting requirements on the importers. The CBAM charge will be effective from January 1, 2026, and will apply to imports from all countries except those linked to the EU emission trading system (ETS) or with an equivalent carbon pricing mechanism.

The CBAM is expected to encourage decarbonisation at the global level while also preventing “carbon leakages”. However, a careful review of the CBAM’s design and proposed implementation reveals  inherent inconsistencies and contradictions with multilateral agreements both in climate change and global trade, as well as with the EU’s free trade agreements (FTAs). If not suitably amended, the CBAM may end up being implemented more as an exclusionary trade policy tool than as an effective climate action tool.

In an evident deviation from the burden-sharing principle of Common but Differentiated Responsibility and Respective Capabilities under the Paris Agreement, the CBAM makes no distinction and offers no concessions or exemptions to developing countries and least developed countries (LDCs). Given the lower institutional capabilities of many developing countries and all LDCs to set up domestic carbon markets or a comprehensive accounting and reporting system for the carbon-emitting intensity of production processes in these sectors, due differentiation in burden-sharing ought to have been incorporated in the design of CBAM.  The unequitable design is further reinforced by the fact that the revenue collected from CBAM charges will be directed to the EU budget instead of being utilised to lead capacity building initiatives in developing countries or LDCs.

The departure from the Paris Agreement is even more glaring when viewed against EU’s commitments in its FTAs. A distinct reference to the commitments of the Paris Agreement has always been included in the chapter on Trade and Sustainable Development in recent EU FTAs. In fact, in a significant departure from the past, when it was considered a largely symbolic inclusion, the EU-New Zealand FTA signed in June 2022 for the first time provides for the application of trade sanctions to breaches related to the objectives and principles of Paris Agreement. There is, therefore, an apparent inconsistency between the EU’s climate policies and its trade policy.

The CBAM is also in apparent contradiction with multilateral norms in the trade context. The fundamental World Trade Organization (WTO) principles of non-discrimination, that is most favoured nation (MFN) and national treatment (NT) appear obfuscated by the CBAM. While MFN requires that similar products should not be discriminated against if coming from different trade partners, NT calls for non-discrimination among domestically produced goods and “like” imported goods. The EU’s justification of differential (discriminatory) treatment of otherwise similar/ like products is based on differential carbon content of imports. This, however, is a complex issue as different process and production methods across countries can lead to varying levels of embedded carbon content in a “like” good, thus making CBAM a potentially discriminatory border tax and liable for frequent challenges at the WTO. 

Regarding NT, the EU’s argument of parity between domestically produced and similar imported goods is based on CBAM being an extension of the EU ETS that is already applied to domestic products. However, considering that as of April, 2023, there are 73 regional/ national/ sub-national carbon pricing mechanisms in the form of either ETS or carbon tax covering only 23 per cent of global green-house gas emissions (World Bank Carbon Pricing Dashboard), it is hard to imagine how CBAM can ensure “equivalence” in the case of imports from countries that have opted for different forms of climate regulation under their nationally determined contributions (NDCs). The implicit assumption or enforced compliance under CBAM in respect of all other countries is not just contrary to the spirit of “self-differentiation” under the NDCs, but also raises the more important question of extra-territoriality effects.

 In fact, even a justification using broad interpretation of general exception under GATT article XX may not be sufficiently persuasive to claim CBAM’s WTO compliance. It will still be required to prove that the CBAM is non-discriminatory in its application and that it is not a “disguised restriction on international trade”.

In the broader trade context also, the complexity of implementing the CBAM brings in an element of inequity. Given that there is a high likelihood of CBAM triggering retaliatory carbon border taxes from other countries/ regional blocs, global value chain (GVC)-led trade will necessitate establishing the rules of origin to account for carbon content for every part and component at the point of origin.  This will be a formidable task, particularly in complex GVCs (involving multiple border crossing of parts and components), which will be beyond the administrative and institutional capabilities of many developing countries and certainly all LDCs. 

 Lastly, and perhaps most significantly, the fundamental premise of “carbon leakage” for the CBAM stands compromised by available evidence. The broad inference drawn from extant empirical literature is that there is no conclusive evidence, thus far, of a significant level of carbon leakage to provide a fair rationale for the CBAM. In fact, it is pointed out that relative to the costs of environmental protection, factors like labour costs, other factors of production, transparent regulation, stable policy environment, protection of property rights are likely to have far greater weight in the investment location decisions even of polluting industries.

 Therefore, with CBAM now included for discussions in the India-EU Trade and Technology Council (The Economic Times, June 13, 2023), it is for India to seek corrective action from the EU to ensure that scarce diplomatic capital of developing countries and LDCs spent on ensuring fair outcomes of multilateral climate and trade negotiations is not rendered wasteful by the multipurpose CBAM.

The writer is professor of economics, School of International Studies, JNU, and author of India’s Trade Policy in the 21 st Century,  Routledge: London, 2022. The views are personal