What is the Carbon Border Adjustment Mechanism proposed by the EU ?

Advice:

The EU proposal

The Carbon Border Adjustment Mechanism (CBAM) was proposed by the Commission to support the EU’s climate targets. It is a measure that should prevent the risk of carbon leakage and support the EU’s increased ambition on climate mitigation but must be in line with WTO rules.

The CBAM system will work as follows: EU importers will need to 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, where 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, that cost can be fully deducted for the EU importer. The CBAM will help reduce the risk of carbon leakage by encouraging producers in non-EU countries to green their production processes.

The proposed CBAM:

• is to be phased in gradually, over a twelve-year period;
• will apply to direct emissions from the manufacture of a limited number of high-emission goods: including steel, iron, cement, fertilisers, aluminium and electricity;
• will include a reporting system as from 2023 for those products, with the objective of facilitating a smooth roll out and to facilitate dialogue with third countries;
• will require importers of these kinds of product to purchase CBAM certificates to cover the embedded carbon emissions, beginning in 2026.

These imported products will attract the same carbon price as their domestically produced equivalents, with the CBAM certificate price mirroring the average EU carbon price under the EU ETS for the preceding week. Products with low embedded emissions or already covered by a carbon pricing scheme will have those factors taken into account:

• Products from countries that participate in the EU ETS or have linked their carbon markets to the EU ETS and where the carbon price has been paid will be exempt. (If there is no usable data for imported products from the manufacturer or from the importer, default values will be applied.)
• And sectors or corporations outside the European Union that have lower emissions in their production cycles or apply a similar system of carbon pricing will have that amount deducted.

The proposed CBAM and WTO law

Carbon Border Adjustment Mechanisms are already in place in some regions around the world, such as California, where an adjustment is applied to certain imports of electricity. A number of countries such as Canada and Japan are planning similar initiatives. In addition, the IMF and the OECD have recently carried out work to study how such measures could support international efforts to reduce greenhouse gas emissions. In the communiqué following their meeting of 9-10 July 2021, G20 Finance Ministers also mentioned the need for closer international coordination on the use of carbon pricing mechanisms.

WTO law compliance issues vary somewhat depending on the type of CBAM adopted but, essentially, they all come down to whether there is discrimination against certain imports ie whether some imports are treated less favourably. The rules on this are set out mainly in the GATT. [GM1] 

The prohibition on discrimination in GATT requires member countries to treat ‘like’ products equally. Interpreted literally, this means that when country A accepts, say, imported aluminium pipes from country B which have been produced using low emissions technology or where there is a price on the carbon emitted, it must not treat those pipes more favourably than ‘like’ aluminium pipes from country C which have been produced with high emissions and no price on the carbon. It also means that Country A can’t treat its own low emissions or carbon priced aluminium pipes more favourably than ‘like’ aluminium pipes from other WTO member countries.

The problem behind this is that the GATT prohibition on discrimination relates to like products and, although it remains somewhat unclear and is much debated, in WTO jurisprudence products have been held to be like where they are physically the same, have the same end uses, the same international tariff classification and buyers treat them as alike. But in our case, the only difference between the otherwise ‘like’ aluminium pipes is that:

• a price has been paid for the verified GHGs released during the manufacture of one but not of the other.
• or the emissions in the manufacture of one were much higher than those of the other.

Where a CBAM is in the form of a requirement to purchase and surrender emission allowances at the border for regulated products, as in the EU’s proposed CBAM, under GATT the imports must be accorded treatment no less favourable than that accorded to ‘like’ domestic products. The test is a little different where a CBAM is in the form of a carbon tax applied at the time or point of importation, as it is an ‘internal tax’ applying to imported products. It must be ‘equivalent to’ the internal tax applied to like, domestically produced products, must not be ‘in excess of’ the tax applied, either directly or indirectly, to like domestic products, and must not be applied so as to afford protection to domestic production.

Leading WTO law scholars believe that the EU’s proposed CBAM will unlawfully discriminate against certain imports.^[1] For example, against aluminium pipes made in countries without any price on carbon emissions in the aluminium sector, compared to otherwise identical (that is, ‘like’ under WTO law) aluminium pipes made in countries which do have a price on carbon emissions in the aluminium sector. But whether other WTO members will actually challenge the EU CBAM in the WTO is an open question. All we know at this stage is that Brazil, China, India, and South Africa have expressed ‘grave concern’.

However, the scholars go on the explain, even if the EU’s proposed CBAM is challenged in the WTO, it is likely to survive because it will fall within the general exceptions available in GATT Article XX. The EU will argue that the CBAM is a measure necessary to protect human, animal, or plant life or health, under Article XX(b), or is directed at the conservation of an exhaustible natural resource, under Article XX(g).

But whether it will enjoy the protection of these exceptions will depend most of all on whether the EU has met the requirements of the chapeau to Article XX, by:

• engaging in appropriate consultation with potentially affected WTO Member countries,
• pursuing good regulatory cooperation with trading partners, and
• taking particular care in the even-handed design of the CBAM.

The position of other WTO member countries

These requirements in the chapeau to GATT Article XX create extra pressure on the EU to negotiate with other countries in good faith before adopting the CBAM in its final form. If the EU does not do this, and there is a successful challenge, it may be ordered by a WTO panel to do so, as necessary to bring its CBAM into conformity with WTO law.

In the meantime, affected countries in the Global South will be considering what their options are for avoiding the negative trade and economic consequences of being outside the EU’s ‘carbon club’ and the barriers facing them when it comes to joining the EU’s ‘carbon club’ and securing the advantages, of membership. The joining path requires access to considerable technical and other support to establish and operate qualifying domestic ETSs or carbon taxing systems of their own.

[1] James Bacchus, ‘Legal Issues with the European Carbon Border Adjustment Mechanism’ (Cato Briefing Paper, Cato Institute, 9 August 2021; Robert Howse, ‘How to Begin to Think About the WTO Compatibility of the European Union CBAM’ (International Economic Law and Policy Blog, 14 July 2021), <https://ielp.worldtradelaw.net/2021/07/how-to-begin-to-think-about-the-wto-compatibility-of-the-european-union-cbam.html>.

 [GM1]I’ve rearranged this a little to avoid splitting up the two types of carbon pricing and their different GATT tests. I think it’s clearer now.