Brussels' proposed Carbon Border Adjustment Mechanism risks controversy at COP26 and conflict in the WTO. Is the EU trying to leverage in global carbon pricing?

Together with other proposals in its 'Fit for 55' package to enact EU commitments to reduce its carbon emissions by 55% on 1990 levels, the European Commission has published a proposed Regulation (Proposed Regulation) to introduce the Carbon Border Adjustment Mechanism (CBAM). The aim is to avoid 'carbon leakage', where high-carbon production shifts to jurisdictions with laxer emission restrictions. Supporters argue the proposed complex system of levies on imports into the region will level the playing field for EU producers and provide revenue that can be spent on climate action.

We will summarise the EU's proposals and outline key issues this will raise at the World Trade Organisation (WTO) and, more immediately, the United Nations' COP26 climate conference in November.

The Proposed Regulation

The Proposed Regulation would require importers of certain goods to purchase electronic certificates (CBAM Certificates) covering the total embedded emissions (meaning direct emissions from their production) in goods imported into the EU. Annex I of the Proposed Regulation provides a list of goods whose import would be subject to the CBAM, including cement, electricity, fertilisers, iron, steel and aluminium.

Goods from countries and territories listed in Annex II would be excluded. At present these include Iceland, Liechtenstein, Norway and Switzerland but there is a mechanism for other countries to be added in future.

Registration

A person lodging a customs import declaration for covered goods, referred to as the "declarant", would require prior authorisation from the competent authority where the declarant is established. Obtaining authorisation requires the declarant to provide prescribed information, including its main economic activity, capacity to fulfil its obligations under the framework and a declaration that it has not been involved in any serious infringements of customs, taxation and market abuse rules during the previous five years.

Declarants must submit to the authority by 31 May each year (CBAM Declaration) for the preceding calendar year. This covers the quantity of each type of goods imported during the calendar year before declaration, the embedded emissions and number of CBAM Certificates to be surrendered.

CBAM Certificates

By 31 May each year, each authorised declarant would be required to surrender to the competent authority the number of CBAM Certificates corresponding to the embedded emissions in its CBAM Declaration.

Declarants would be able to buy CBAM Certificates from the authority where they are registered. CBAM Certificates would be sold at a price calculated by the Commission, based on the average closing price of EU ETS allowances on the common auction platform.

In its CBAM Declaration, a declarant can claim a reduction in the number of CBAM Certificates to be surrendered to account for carbon prices paid in their country of origin.

Transitional period

The Proposed Regulation envisages a transitional period of three years during which the framework would operate only as a reporting obligation with no requirement to surrender CBAM Certificates. The Commission is to report on the operation of the mechanism before the end of that period together with any appropriate legislative proposals.

Policy issues

Even by EU standards, the proposed framework is complex and ambitious and will meet opposition from third countries. The Proposed Regulation may therefore be substantially amended before adoption. It is also possible the purpose of the proposal is to provoke negotiation of a more satisfactory international regime on carbon pricing.

WTO issues

There are several ways WTO compatibility of the proposal could be challenged. These include:

  • as an import charge going beyond what the EU is allowed to impose under its Schedule of Concessions or as a discriminatory internal tax or levy;
  • violating basic WTO requirements of ensuring "most favoured nation" treatment since some countries will be exempt; and
  • violating basic WTO requirements of "national treatment" since EU producers will receive free allowances, resulting in better treatment than third country producers.

The EU will likely claim its model is not an import charge but rather a requirement to surrender CBAM Certificates to cover embedded emissions and that the measure is not discriminatory since all differences in treatment reflect varying circumstances. However, WTO obligations are expressed in terms of "no less favourable treatment" of "like products" and the WTO has traditionally required "likeness" to be assessed at the border, with no consideration of production processes and methods. On this basis, a tonne of foreign steel must be treated the same as a physically identical tonne of domestic steel, irrespective of how it was produced (and embedded emissions), subject only to payment of WTO authorised duties and other restrictions.

The EU would therefore have to justify the CBAM under the general exception in Article XX of the General Agreement on Tariffs and Trade as a measure necessary to protect "human, animal or plant life or health" or "relating to the conservation of exhaustible natural resources". This would require the EU to demonstrate that there are no reasonable alternatives that are less "trade distortive". It also requires that the EU's regime is not applied in a manner that results in "unjustifiable discrimination" against other WTO members and does not function as a "disguised restriction on international trade".

Crucially, the CBAM would have to be justified for all products and countries. The fact that the overall burden on imports is equivalent (or even less than that on EU products) would, even if true, not prevent a finding of incompatibility if one WTO member can point to discriminatory treatment of one like product. It will also be difficult for the EU to provide methodologies for the 'carbon price' that fully take account of the burden imposed in the country of origin, which may result from taxation, prices of inputs or regulatory measures.

The EU appreciates the fact that it grants free allowances to domestic industry will complicate justifying its reforms and so proposes the mechanism will be phased in while free allowances are phased out. This does not, however, solve the discrimination problem. A percentage reduction in free allowances to domestic producers will not have the same economic effect as the same percentage cut in the CBAM levy. Some imports will be more severely affected than domestic producers during the phase-in, which could form the basis for discrimination claims.

Issues under the UNFCCC and the Paris Agreement

The United Nations Framework Convention on Climate Change (UNFCCC) and the agreements negotiated under it, including the Paris Agreement, are all based on the principle that developing countries should bear less burden in reducing emissions than developed nations. Developing countries feel strongly that, since it is industrialised states that created the problem of climate change through their historic emissions, developing nations should not have to support the cost, or see their development impaired, as a result.

This is one reason why the Paris Agreement is based on nationally determined contributions and thus reduction commitments. The CBAM conflicts with these principles by providing for countries to align with the EU (or demonstrate plans equivalent to EU rules) or bear extra charges on their exports to the EU.

An additional source of incompatibility between the EU approach and UNFCCC principles is that many countries do not approve of using market mechanisms to cut emissions as the EU favours, arguing it disadvantages the poor, preferring a regulatory approach. Other countries that do not have the EU's difficulties with tax measures (which need unanimity in the EU) prefer tax as a means to incentivise emission reductions.

Developing countries also insist resources should be devoted to adaptation to climate change (benefitting such countries at the expense of developed nations) rather than mitigation of climate impacts through emissions cuts.

Trouble ahead?

The EU will have difficulty defending its measures at COP26 and the WTO. Moreover, arguments and concessions it needs to advance at COP26 and the WTO conflict. The first is based on lower burdens on developing countries while at the WTO the fundamental principle is equal treatment.

The way out is most likely through recognition that countries cannot increase their climate ambitions through policies that ultimately merely move emissions around the globe rather than cut pollution overall. A worldwide mechanism for addressing the problem will most likely have to be reached through negotiation. That the CBAM contains a transitional period, a blank section B of Annex II for exempted countries and that the methodology for calculating carbon prices paid in the country of origin is yet to be established all point to the reality that global talks are required to increase climate ambition. It is hoped that the CBAM proposals facilitate rather than hinder these negotiations. COP26 could be the occasion where this dialogue starts in earnest.