What are the potential areas of conflict between the carbon border adjustment mechanism (CBAM) proposed by the EU Commission and WTO law?
Background:
The CBAM proposed by the European Commission sets out a common and uniform framework through which to ensure an equivalence between the carbon pricing applied in the EU’s internal market and the carbon pricing policy applied on imports. It will be based on the purchase of certificates by importers, to cover the embedded emissions in products being subsequently imported into the EU. The price of those certificates will be calculated depending on the weekly average auction price based on the EU Emissions Trading System (“EU ETS”) allowances expressed in € / tonne of CO2 emitted. Each year by 31 May, importers must declare the quantity of goods and the embedded emissions in those goods imported into the EU in the preceding year. Importers will have to register with national authorities, who authorise such registrations, sell CBAM certificates to importers, as well as review and verify declarations.
In this way, the CBAM system would incentivise non-EU countries to adapt their production processes and environmental regulations so that they take into account the cost of carbon in order to be more attractive to EU importers who could benefit from a deduction in price as a result. Given the disparity between environmental policies and regulation across the world, the European Commission wants to avoid a situation where EU member states and/or EU companies can benefit from less stringent environmental regulations in non-EU countries by relocating carbon-heavy production outside of the EU. This phenomenon is called ‘carbon leakage’ and it is one of the main reasons for the creation of the CBAM. The CBAM aims to (i) address the issue of production relocation which displaces the carbon footprint of a product outside of the EU and (ii) minimise the import of carbon-intensive products.
The CBAM will initially apply only to a selected number of goods at high risk of carbon leakage, namely: iron and steel, cement, fertiliser, aluminium and electricity generation. It will apply to direct emissions of greenhouse gases emitted during the production process of the products covered. From 2023, a reporting system will apply to goods in the covered sectors. From 2026, importers will start paying financial adjustments on imported goods within the scope of the CBAM.
The CBAM is intended to be complementary to the EU ETS, which which currently distributes free allowances to counteract the risk of carbon leakage.’ However, the European Commission has proposed to reduce the number of free allowances over time under the EU ETS and such allowances will eventually be phased out by 2035. Until such phasing out is completed, the Commission has stated that the CBAM will apply only to the proportion of emissions that does not benefit from free allowances under the EU ETS, ensuring that importers and EU producers are treated equally.
In principle, imports of goods from all non-EU countries will be covered by the CBAM. Certain countries which have an emissions trading system linked to the EU’s (such as certain EEA members and Switzerland) will be excluded[1] from the CBAM.[2]
Advice:
While the proposed CBAM is intended to be in compliance with World Trade Organisation (“WTO”) law, there are several areas where a conflict and potential challenge may arise. This advice sets out areas of potential conflict and explains the consequences and exceptions available in the event of a breach of WTO law:
Both the EU and its Member States are parties to the WTO and bound to comply with WTO rules (the “Rules”). The Rules do not have direct effect in EU courts, and can only be enforced by other WTO members under state-to-state dispute settlement conducted in Geneva. Breaches of the Rules can, therefore, only be challenged by countries (not private industries).
Although the European Commission has been careful to present the CBAM as WTO-compliant in its design, it is plausible that countries whose exports to the EU will be affected by increased costs will seek to challenge the measures on the basis of WTO law. Already, Brazil, South Africa, India and China, among others, have expressed concern that the CBAM could violate the Rules.[3] As explored further below, there are several ways in which the implementation of the CBAM could be in conflict the Rules and which could lead to challenges being brought against the mechanism.
Charge on imported products exceeding EU agreed customs duty ceiling
The General Agreement on Tariffs and Trade (“GATT 1994”), Article II (Schedules of Concessions) places an agreed limit on customs duties (‘tariffs’) and all other border duties or charges in connection with importation of products into the territory of any WTO member (‘tariff bindings’). By requiring EU importers to buy carbon certificates to offset the price of carbon involved in the production of imported goods, the CBAM could be interpreted as an additional border duty or charge (tax) on imported products in excess of the tariff agreed by WTO members. On this analysis, it seems that the CBAM may be in conflict with this key Rule if the imposition of a carbon adjustment causes the import duties on a product to exceed the agreed tariff binding for that product.
However, the European Commission might contend in response that the CBAM is not strictly a border regulation but a requirement of internal regulation, and so would not be subject to the limits on customs duties as agreed by WTO members. It is questionable that such a stance would be successful; the need to purchase a certificate under the CBAM accrues by virtue of the importation of that product, and so it is difficult to see how the CBAM is not a border / import measure.[4]
Alternatively, Article II:2(a) GATT 1994 explicitly allows for a border tax adjustment for goods (‘a charge equivalent to an internal tax imposed consistently with the provisions of paragraph 2 of Article III* in respect of the like domestic product or in respect of an article from which the imported product has been manufactured or produced in whole or in part’), but only if the adjustment relates to the imported product itself. The CBAM could be classed as a border tax adjustment if it could be construed as an internal tax or charge applied directly or indirectly to the product by reason of something physically in the product (e.g. carbon in steel), rather than a tax or charge applied to address an issue external to the product (e.g. general carbon emissions in the product’s country of origin).
Non-discrimination between domestic and foreign (non-EU) products
GATT 1994, Article III (the “national treatment rule”) prohibits protectionism in the form of discrimination against imported products in favour of domestic products. Under the current CBAM proposal, free emissions allowances in respect of products falling within the CBAM would continue to be allocated to EU producers under the EU ETS[5] for a number of years before being phased out. Although the CBAM proposal states that the CBAM will only apply to the proportion of emissions that do not benefit from free allowances, in practice, this may be difficult to apply with precision.
If a WTO member can prove that EU products are able to continue to benefit from free emissions allowances, where importers will need to purchase CBAM certificates for like imported products, this could lead to a conflict with the national treatment rule. This is due to the fact that the comparatively higher cost for imported carbon-heavy products places them at a competitive disadvantage in comparison to domestic products which also benefit from free emissions allowances.
On a more general level, there could be potential for the CBAM to breach the national treatment rule if it could result in a higher duty being placed on imported products which are identical to domestic products, save for the fact that the process of producing the imported products generated more carbon emissions. On the other hand, the CBAM could also be seen as a way to give priority to lower-emission imports based on their competitiveness with the EU domestic product.
Non-discrimination between foreign (non-EU) products
GATT 1994, Article I (the most favoured nation rule, or the “MFN rule”) prohibits discrimination between different WTO members / trading partners. Essentially, the MFN rule requires that any advantage granted to the imported products of one WTO member must also be granted to the same products originating from other WTO members.
There is potential for the CBAM to conflict with the MFN rule, if the CBAM purports to discriminate (based on carbon content) between imported products originating from different WTO member countries. As such, by individually assessing WTO members based on the stringency of their climate standards and thereby determining for which products importers will have to buy emissions certificates, the EU could be seen as discriminating between WTO members in the free trade of like-for-like products.
Limitation on imports
GATT 1994, Article XI prohibits any restrictions and prohibitions on imports made effective through quotas, import or export licenses or other measures (i.e. quantitative restrictions). Previous cases have considered minimum prices and reference prices within the scope of Article XI. If the CBAM is seen as a border restriction measure limiting imports, this could be a breach of GATT Article XI.
Reliance on an exception for non-compliance with the Rules
GATT 1994, Article XX sets out several ‘General Exceptions’ under which trade measures targeting certain imports but not others may be permitted. Article XX(b) of GATT 1994 permits trade measures that are ‘necessary to protect human, animal or plant life or health’ and Article XX(g) permits measures ‘relating to the conservation of exhaustible natural resources if such measures are made effective in conjunction with restrictions on domestic production or consumption’.[6]
To fall within exception XX(b), the CBAM must be considered necessary to achieve the stated environmental objectives (i.e. reducing carbon leakage). Necessity would be evaluated with reference to whether the same objectives could be achieved with less trade-restrictive measures. Some commentators argue that the CBAM would not be considered necessary to protect human, animal or plant life or health because a carbon tax could achieve the desired level of climate protection in a manner less restrictive to trade.[7] Whether the WTO would reach the same conclusion if presented with a challenge to the CBAM remains to be tested.
It is more likely that the EU will seek to justify the CBAM under exception XX(g),[8] on the basis that the CBAM relates to the conservation of exhaustible natural resources, i.e. breathable air at a liveable temperature. For this exception, a ‘close and genuine relationship’ between the measures envisaged by the CBAM and the conservation goal must be proven.[9]
Requirements relating to application of Article XX[10]
In order to benefit from either exception under Article XX, the CBAM will need to meet the following legal requirements in its application: The measure must not be applied in a manner which would constitute a means of arbitrary or unjustifiable discrimination between countries where the same conditions prevail.
In order for an exception to apply to the CBAM, the European Commission would need to demonstrate that all imports from countries with similar conditions (i.e. similar emissions reduction policies) were being treated equally. As such, the European Commission will need to demonstrate how environmental standards in other countries are being taken into account in applying the border adjustment measure. Crucially, in order to prevent discrimination imposed by the CBAM from being classified as arbitrary or unjustifiable, the adjustment mechanism must be founded on an assessment of the emissions from the production of the individual product in question rather than on a country’s general climate and emissions reductions policies.[11] However, it is feasible that a country with limited climate regulation would not be considered a country where the same ‘conditions prevail’ and discrimination by reason of the requirement to purchase certificates to import the product may not be unjustified.[12]
The measure must not be a disguised restriction on international trade
Whether the CBAM would be considered a disguised restriction on international trade will depend on its implementation. The continued granting of free emissions allowances to EU producers under the EU Emissions Trading System (which are intended to be phased out during the implementation of the CBAM) is a risk factor in the determination of whether the CBAM measures are disguised restrictions on trade.[13] This could be addressed by applying price offsets to certificates purchased by importers of like-imported products to those benefiting from free emissions allowances.[14]
Consequences of breach
If a breach were to be found, remedies are purely prospective and exclude monetary compensation; at worst, the EU would have to change or abandon the CBAM (but would be permitted a reasonable period of time to implement changes, which could be several years). Alternatively, the EU could keep the CBAM in place in spite of any breach and conclude mutually agreed solutions with individual WTO members (including accepting equivalent trade retaliation). However, according to Article 22.6 of the Dispute Settlement Understanding (which outlines the rules for dispute settlement in the WTO), if the CBAM was found to be in violation of the Rules during a WTO dispute settlement procedure, the EU would be required to rectify the violation within a ‘reasonable period of time’ After this period, it would be permitted for the other country involved in the dispute to impose restrictions on EU exports.
To avoid successful challenges, care should be taken to ensure that the aforementioned criteria for the Article XX exception are satisfied in the implementation of the CBAM. Furthermore, ongoing dialogue involving key stakeholders during the CBAM’s implementation period (which itself will not begin until 2023), to iron out tensions with WTO law, will allow the EU Commission to adjust the CBAM as necessary and avoid a deluge of legal challenges once the measure comes into force.
[1] For further information on the removal of import restrictions where a foreign country operates a similar system, consider the following WTO dispute: WTO, United States: Measures Concerning the Importation, Marketing and Sale of Tuna and Tuna Products, WT/DS38.
[2] European Commission, 14 July 2021, Carbon Border Adjustment Mechanism: Questions and Answers, < https://ec.europa.eu/commission/presscorner/detail/en/qanda_21_3661>.
[3] Bacchus, James, ‘Legal Issues with the European Carbon Border Adjustment Mechanism’, CATO Institute, Briefing Paper No. 125, 9 August 2021, <https://www.cato.org/briefing-paper/legal-issues-european-carbon-border-adjustment-mechanism>.
[4] For a WTO dispute settlement which discusses this distinction between a border regulation and internal regulation, see WTO, China – Measures Affecting Imports of Automobile Parts, WT/DS342.
[5] ‘The European Union’s carbon border mechanism and the WTO’, 19 July 2021 <https://www.bruegel.org/2021/07/the-european-unions-carbon-border-mechanism-and-the-wto/>
[6] ‘Trade Related Aspects of a Carbon Border Adjustment Mechanism. A Legal Assessment’. <https://www.europarl.europa.eu/cmsdata/210514/EXPO_BRI(2020)603502_EN.pdf>.
[7] Bacchus, James, ‘Legal Issues with the European Carbon Border Adjustment Mechanism’.
[8] Beattie, Alan, ‘The EU’s technical tangle in making carbon border measures WTO-legal’, FT, 15 July 2021.
[9] Bacchus, James, ‘Legal Issues with the European Carbon Border Adjustment Mechanism’.
[10] Please see Charnovitz, Steve, ‘The Law of Environmental “PPMs” in the WTO: Debunking the Myth of Illegality’, The Yale Journal of International Law, Vol.27:59 2002, <https://core.ac.uk/download/pdf/72839238.pdf> for discussion on the legality of trade measures relating to process and production methods and the extent to which they are covered by Article XX.
[11] Bacchus, James, ‘Legal Issues with the European Carbon Border Adjustment Mechanism’.
[12] ‘Trade Related Aspects of a Carbon Border Adjustment Mechanism. A Legal Assessment’.
[13] Bacchus, James, ‘Legal Issues with the European Carbon Border Adjustment Mechanism’.
[14] Ibid.