In July 2021, the European Commission finalised its proposal to introduce a Carbon Border Adjustment Mechanism (CBAM) by the end of the year. If adopted, the CBAM will impose a levy on imports in carbon-intensive sectors from countries with lower environmental standards than the EU by 2023. This is likely to directly affect Australian and other non-EU businesses from those sectors who export into the EU market.
The rationale for the proposal is the “profound climate crisis and the challenges of climate change”. The measure will almost certainly be challenged by EU trade partners through the WTO Dispute Settlement Mechanism (DSM), and potentially through other avenues such as investor-state dispute settlement.
What is the proposed CBAM?
The current proposal requires importers to purchase ‘CBAM Certificates’ to cover their carbon emissions at prices corresponding to the EU's current carbon price. In a press release dated July 2021, the European Commission describes the measure as follows: “EU importers will buy carbon certificates corresponding to the carbon price that would have been paid, had the goods been produced under the EU's carbon pricing rules. Conversely, once a non-EU producer can show that they have already paid a price for the carbon used in the production of the imported goods in a third country, the corresponding cost can be fully deducted for the EU importer”.
The EU is not the first to propose a CBAM. Similar measures are in place in California, where an adjustment is applied to certain imports of electricity. Canada and Japan have indicated that similar initiatives are being planned. The Biden administration has also indicated that the US may be poised to follow the EU with a similar proposal.
Doesn’t the EU already have a carbon trading scheme?
The EU already has an existing emissions trading scheme. The EU's Emissions Trading System (ETS) was the world's first international emissions trading scheme, touted as the EU's flagship policy to combat climate change. Like most emissions trading schemes, the ETS is a ‘cap and trade’ system. It sets a cap on the amount of greenhouse gas emissions that can be released from industrial installations in certain sectors. If a company’s emissions exceed the cap, it must buy allowances on the ETS trading market – companies with surplus allowance can trade. In order to prevent carbon leakage (where companies move their production abroad to countries with less ambitious climate measures), a certain number of free allowances is distributed.
According to the EU’s press release, that system has been effective in addressing the risk of leakage but it also dampens the incentive to invest in greener production in the EU and abroad. The CBAM is intended to progressively become an alternative to the ETS carbon leakage approach. For the CBAM sectors, the free allowances will gradually be phased out as from 2026. Unlike the ETS, the CBAM is not a ‘cap and trade’ system’. Instead, the CBAM certificates mirrors the ETS price.
When will the CBAM become law?
The proposal requires the approval of both the European Parliament and the Council before it comes into effect. At the First Reading, the EU Parliament will adopt its position and communicate it to the Council. If the Council adopts that position, the directive will become law.
The proposal will also be subject to international debate in terms of the proposal's compliance with the WTO. It is likely that climate and environmental activists will also argue that the measure does not go far enough given the limitation to certain sectors and its application to direct emissions only (and not emissions produced at a consumer level).
What does this mean for Australian and other non-EU Businesses?
Australian businesses who export steel, alumina and aluminium (for which the EU market accounts for around 10-20% of Australian exports) are likely to be the most affected by the proposed measure. It is estimated that levies imposed by the CBAM would increase the price of exporting coal to the EU by more than 50%.
Australia’s Trade Minister Dan Tehan has recently stated that the measures may contravene World Trade Organisation (WTO) rules. "Australia is very concerned that the EU's carbon border adjustment mechanism is just a new form of protectionism that will undermine global free trade and impact Australian exporters and jobs." The European Commission is likely to expect WTO challenge (formally or through dialogue) of the CBAM. Interestingly, the European Commission has asserted in its press-release that the CBAM is compatible with WTO rules. If the measure is found to be in breach of any international obligations (including those set out in the General Agreement on Tariffs and Trade (GATT)), the EU must demonstrate that a general exception to those obligations applies, for example, that it is ‘necessary to protect human, animal or plant life or health’ (GATT Article XX(b)). Is the CBAM, a measure designed to target climate change, necessary to protect human, animal or plant life or health? It is at least arguable that it is.
Non-EU companies from carbon-intensive sectors are likely to be similarly affected. A report prepared by the United Nations Conference on Trade and Development (UNCTAD) shows that Exports by developing countries across the targeted carbon-intensive sectors would be reduced by 1.4% if the CBAM is implemented with a price of $44 per tonne of embedded CO2 emissions, and by 2.4% if it’s implemented with an $88 per tonne price.
Whatever the outcome of the WTO dialogue, this development marks a significant new chapter in climate policies and, inevitably, climate law globally which Australian and non-EU businesses that export to the EU in particular should be keeping a close eye on.