Carbon Border Adjustment as a Mirror of EU ETS: Contemplating WTO-Compliant Mechanisms for Reciprocal Protection

A centrepiece of the European Union’s Green Deal, the Carbon Border Adjustment Mechanism (CBAM) is awaiting formal proposals for its adoption in June as a new ambitious climate measure that would phase out the incumbent EU Emissions Trading System (ETS). Discussions surrounding the CBAM are opportune considering that Covid-19 has raised pressures on public finances around the world, calling for concrete dialogues in carbon taxes for post-pandemic restoration of tax revenue and incentivisation for a low-carbon transition.

Against this backdrop, last-minute lobbying efforts from some of Europe’s largest industry groups resulted in a narrow vote at the European Parliament on March 9 in favor of retaining free carbon emission allowances under the ETS, much to everyone’s surprise. The plenary vote evidences the long-standing divide between industries advocating for a continuation of free allocation and certain lawmakers envisioning a level-playing field for European markets.

Such developments raise technical and legal questions stemming from the interrelationship between the two climate measures with ramifications for the EU’s major global partners. First, is it feasible to replace the ETS with the CBAM amidst concerns that the latter may pose potential protectionist trade tensions? Second, how may the EU reconcile the two measures in a manner consistent with WTO regulations? This article attempts to answer these questions. It also argues that functional and legal considerations may render the implementation of the CBAM as a “mirror” of ETS highly feasible.

A Brief Overview of the CBAM

The CBAM purports to provide a linear economic incentive to reduce emissions under a uniform pricing approach across jurisdictions and economic sectors. It seeks to: (1) prevent carbon leakage (where businesses relocate to jurisdictions with lower carbon prices and free-ride other nations’ efforts to reduce emissions) and (2) ensure industry competitiveness. Under this mechanism, the predicted carbon prices required to achieve the target greenhouse gas emissions are approximately $34/ton of CO2 for China, South Korea, and Mexico, with smaller carbon prices ranging from $8 to $15 per ton of CO2 for the US, Canada, and India. Contrariwise, under the ETS, businesses receive or buy emission allowances within a cap on the total amount of greenhouse gases that can be emitted, trading allowances with one another as necessary.

Meanwhile, the CBAM has also raised concerns that levying carbon border taxes on imported goods may be deemed protectionist tariffs in disguise. India fears the mechanism would be challenged in the WTO dispute forum, while countries heavily reliant on the exportation of carbon-intensive goods such as Australia, China, and Russia perceive the CBAM as a measure to protect the European market rather than as a climate action instrument.

However, depending on how the CBAM instrument is structured, a smooth transition to low-carbon recovery in compliance with WTO rules may be feasible. The three options of implementing the CBAM under discussion are: the imposition of a carbon tax on selected products, a carbon customs duty on imports, and the extension of the ETS to imports. This article aligns with the increasing consensus of the third method as the more viable option.

Establishing an Explicit Connection with Existing Legislations                                                 

Designing the CBAM as an instrument complementary to the ETS will not only ensure stability for sectors already compliant with the ETS but would also facilitate WTO compatibility. The central principle undergirding the GATT is its prohibition of discriminating between “like” products originating in or destined for, any other party (Article I:1), and discrimination between imported products and “like” domestic products (Article III:4). Because the CBAM imposes a greater burden of compliance for carbon-intensive imports than less carbon-intensive domestic products, it is potentially discriminatory within the meaning of the GATT.

However, the CBAM may derogate from those principles, provided that it falls within the General Exceptions pursuant to Article XX. Exceptions are provided for measures (b) “necessary to protect human, animal or plant life or health”, or (g) “relating to the conservation of exhaustible natural resources if such measures are made effective in conjunction with restrictions on domestic production or consumption”.

Establishing an explicit connection between the existing climate change legislation and the EU’s goals of reducing emissions via the CBAM will strengthen its environmental justification excepted under Article XX. Additionally, the scope of the CBAM may be adjusted to limits its applicability to sector-specific goods at risk of carbon leakage. In determining whether a sector would be subject to the CBAM, the European Commission may consider factors such as: level of risk of carbon leakage; the complexity of the product supply chain; emission benchmarks and data established in the EU; trade volume of EU’s imports of the selected products. Taking into account existing product-based benchmarks within the ETS in carbon pricing would be another viable factor ensuring compliance with Article III.

Once a sector is identified as subject to the CBAM, the Commission should communicate with its trade partners to minimise potential adverse impacts, providing a sufficient transition period for the affected industries to make appropriate arrangements. Limiting imposition of border tax to selected products would ensure transparency and predictability for other nations while offering a strengthened environmental justification falling within the GATT exception. Thus, CBAM would be legitimised under the General Exceptions, alleviating potential risks of constituting a “disguised restriction on international trade”.

Fortifying Compliance with the Non-Discriminatory Treatment Policy

Moreover, recent research conducted by MIT and the University of Cambridge sheds further light on WTO compliance with respect to the GATT’s integral national treatment obligation. The research proposed a voluntary, Individual Adjustment Mechanism (IAM) within the CBAM. The mechanism would ensure greater symmetry in the treatment of domestic and foreign products by allowing offshore producers to demonstrate their actual carbon intensity relative to an established default value. Accordingly, producers with relatively low-carbon emissions will avoid being overcharged compared to their high-carbon counterparts. To avail themselves of the IAM, producers need only provide documentary evidence regarding their actual emissions from producing the imported goods, a process identical to that for domestic goods under the ETS’ annual compliance cycle requiring monitoring, verification and reporting of emissions.

Their proposal has meaningful implications as it is corroborated by relevant case law suggesting IAM as a means of improving prospects of the CBAM’s compliance with WTO principles. In particular, it relied on the United States – Taxes on petroleum and certain imported substances case, wherein a GATT panel examined a border tax adjustment imposed by the U.S. on petroleum and certain imported substances under the Superfund Amendments and Reauthorization Act of 1986. The Act contained a provision directing the Secretary of the Treasury to impose, by default, a rate equal to the predominant method of production in the U.S. if importers failed to furnish the requisite information to determine the amount of feedstock chemicals and tax to be imposed. Hence, the adjustment was upheld as being consistent with Article III:2 (“The products of the territory of any contracting party imported into the territory of any other contracting party shall not be subject, directly or indirectly, to internal taxes or other internal charges of any kind in excess of those applied, directly or indirectly, to like domestic products….”). Thus, incorporating an IAM would ensure non-discriminatory treatment of EU and foreign producers, while incentivizing the latter to reduce their carbon intensity.

Towards Building Reciprocity and Trust

In conclusion, the CBAM is a unique mechanism in Europe’s efforts to attain its long-term objective of climate neutrality by 2050 with broad-sweeping implications in international trade, economics, and the environment. Functional and legal considerations may render the implementation of the CBAM as a “mirror” of ETS highly feasible, thus serving as mechanisms for reciprocal protection both within the existing climate legislation and the WTO framework.

With the design of the CBAM targeted to be completed by the second quarter of this year, intermittent developments should continually be monitored. Notably, the UK is closely monitoring such developments as it seeks to forge a carbon price coalition post-Brexit as host of the G7 summit this year. Meanwhile, the EU should promote international climate policy cooperation via periodic dialogues with its trade partners, particularly engaging producers from developing nations whose industries will be heavily affected. Thus, the CBAM will not only function as a “mirror” of the current regulatory framework but also as a “mirror” of understanding and trust.

 

Bo Hyun Kim is a law student in her penultimate year at Handong International Law School in South Korea where she is studying the U.S. and international law. 

 

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