Navigating the carbon-tax era in trade

The EU's carbon tax is set to shake up world trade, but through careful preparation, India can turn this to its advantage

The process for the EU’s Border Carbon Adjustment Tax (Border-CAT) is set to start in October this year when firms exporting to the EU will start sharing emission data with their eurozone counterparts. The carbon tax will kick in from January 2026 and initially cover steel, aluminium, cement, fertilisers, hydrogen, and electricity. The list of products will expand rapidly to cover all products by 2034. 

The idea of a carbon tax has found acceptance in the developed world. The UK will soon introduce it and countries like Canada, Japan, and the US are talking along similar lines. 

Developed countries, which currently account for 65 per cent of global trade, have an average industrial tariff of 2-3 per cent. Imagine the trade disruption when they start charging carbon tax in the range of 20-35 per cent over and above import duties. Soon, the world will be divided into countries charging carbon tax and the rest of the world (RoW).

World Trade Organization (WTO) commitments on tariffs will become meaningless for countries charging a carbon tax. A ceiling tariff or bound duty for a product represents the uppermost level that a government can impose without violating WTO commitments.

Free trade agreements (FTAs) with developed countries charging carbon tax will become one-sided. Suppose India and the EU agree to eliminate tariffs on all products through an FTA. Once Border-CAT is implemented in full, EU products will enter India at zero import duty, while Indian products will still attract a tax of 20-35 per cent. 

The carbon tax will also lead to a few unintended consequences for the EU and other developed countries. For example, it may reduce the EU’s exports to RoW markets, where cheaper products will be available from countries that do not charge a carbon tax. The EU firms must either invest in cleaner production or pay the carbon tax to become compliant. In both cases, their products will be expensive. Firms from countries with no carbon tax have no such limitations.

China may surprise by becoming the lowest-cost supplier of clean energy-compliant products, achieving this through a combination of hydroelectric and green hydrogen-led production of steel, aluminium, cars, and other industrial products. Green hydrogen produced using electricity generated by hydroelectric power costs just one-third of the price of hydrogen made using wind or solar energy, on which most of the EU and US strategy is based. So the EU’s home market may see more Chinese products. On the industrial side, car makers in the EU may find Chinese green steel to be cheaper. A similar fate may await the markets of the US and UK. 

The EU will not stop dirty imports; it will just tax them. So carbon tax will have an insignificant impact on the reduction in global emissions. 

While computing its net-zero goals, the EU only counts what it produces, not what it consumes. This means EU consumers can continue to happily consume items made in China and elsewhere without feeling guilty about global warming—such hypocrisy. Developed countries indulge in high consumption, and there is no discussion on reducing consumption levels, which alone will lead to a reduction in emissions. 

What should India do to prepare for this scenario?
 

Actions by government: Set up a carbon trading mechanism, similar to the ones already in use in 45 countries. It should re-designate customs, excise duty, and cesses charged on petroleum, coal and other items as carbon tax. This will reduce the amount of tax to be paid to the EU. The government should also start to work towards setting product embodied-carbon standards in end-use sectors. 

Since less than 2 per cent of the production-linked incentive (PLI) funds have been spent so far, the government may consider a new PLI for low-carbon trial projects. Additionally, it should provide capital expenditure subsidies on installations and prioritise green products in public procurement.

On trade, the government must devise a WTO-compatible carbon tax retaliation mechanism. It should sign new FTAs with developed countries after resolving the carbon tax issues with the EU or UK. Simultaneously, it must create a cadre of energy auditors to help firms with emissions data, ensuring their accreditation by the EU system. Additionally, it may also start an industry awareness programme. 

Actions by industry: Each firm must know its unit’s current state of baseline emissions and calculate the monetary impact associated with them. They should set internal targets to decarbonise and evaluate the costs of adopting renewables. 

As the emissions data is to be shared with the EU starting October 1 this year, firms should hire an auditor to prepare documents. Large firms may consider setting up two production lines — one for carbon tax markets, and the other for the RoW. 

Large firms must develop strategies to enhance their competitiveness in the new trade regime. They must consider if it is possible to grab market share from competitors, replace the EU’s home production, or their export market share. Firms should also watch out for cheaper imports, which will be on the rise.

The world’s trade rules are shaken periodically. The US and EU take the lead, be it through the founding of GATT in 1947, or pushing globalisation via offshoring production and global value chains in the 1980s, or the founding of WTO in 1995. They plan meticulously, but the law of unintended consequence comes into play.

For example, the US promoted offshoring and WTO to make China its production base, but not as a competitor in high-tech products. The rising trade of developing countries also was never an intended consequence. Next, the EU pushed for the adoption of the Information Technology (IT) Act at the WTO in 1996 to become a leader in emerging computer, electronics and IT product manufacturing. But, the EU has lost its market share post-IT Act and is now a minor player in this product group. It remains to be seen if a similar fate awaits the carbon tax. 

For now, the carbon tax is a reality. Let’s play the game with full awareness, strategy and statecraft.

The writer is founder, Global Trade Research Initiative, a research group  focused on technology and trade