The European Union is preparing the world’s most ambitious climate goal: to reduce emissions by about 55 percent over the next decade and to become the world’s first carbon neutral economy by 2050.  Climate policy will again take centre stage in Europe in 2021.  The European Commission is expected to table a mammoth package of green laws in June, in time for the COP26 UN climate summit in Glasgow, Scotland.

A new European Climate Law is being negotiated, which is just a start of a massive programme of legislative reform.  ‘Fit for 55’ is the Commission’s nickname for this massive package of EU legislation which aims to conform European laws to the bloc’s new climate objective for 2030.  Almost all EU laws on energy and climate are likely to be revised as part of the package, ranging from the renewable energy directive to EU legislation affecting energy taxation and the crown jewel of EU climate policy – the Emissions Trading Scheme (ETS), which regulates the world’s biggest carbon market.

The ‘fit for 55’ package will include a brand new addition to the EU’s climate policy arsenal: the much-awaited carbon border adjustment (CBA) mechanism , which aims to re-establish a level playing field between European industries and manufacturers with those in other parts of the world which do not face the same carbon costs.  The proposal for the CBA mechanism (which is sometimes referred to as the carbon border tax) should be presented around June 2021 with a plan to implement it in late 2022.  However, there is considerable uncertainty surrounding the contours of the mechanism, which is supposed to preserve Europe’s competitiveness by preventing “carbon leakage”, where companies relocate to countries with lower pollution costs.

The Commission has promised that any new carbon-pricing mechanism will simultaneously level the playing field for European and foreign producers in carbon-intensive sectors and respect the EU’s commitments under international trade law.  As of yet, there are no drafts available in the public domain.  The CBA mechanism would reflect the amount of carbon emissions attributed to goods imported into the 27-nation region.  Producers in countries with carbon-pricing mechanisms that the EU recognizes as compatible with its own may be exempt.

Although the exact mechanics and timing of a carbon border tax must still be determined and be approved by the EU’s legislative bodies, it should be noted that the requirement to measure, report, and factor in the costs of a product’s carbon footprint is already in place in the EU.  It could soon become a requirement for companies that export to Europe as well.

A carbon border adjustment covering selected sectors

Previous policy discussions about a CBA mechanism within the EU have focused only on carbon intensive industries, in which aligns with the literature that a limited CBA mechanism is the most politically and legally feasible option, whilst also capturing the majority of any carbon leakage benefits.  A limited CBA mechanism is feasible because most industrial emissions stem from very few traded sectors.  Twelve sectors highlighted by the ETS as particularly pollutive accounted for approximately 55 percent of EU industrial process and product-use emissions in 2018.  Thus, applying a CBA mechanism only to these products would not require investigating complex value chains, and would avoid placing an additional administrative burden on all other products, which currently account for 98 percent of the EU’s imports in terms of value.

The main problem with such an approach is that it may have a more damaging impact on EU competitiveness compared to no CBA at all.  Putting a border-tax on specific carbon-intensive inputs (such as steel) could imply trade distortions for other parts of the value chain.  So if leakage is an issue, a selective carbon-border tax could result in a situation in which instead of importing steel from less-regulated countries, the EU will instead import downstream products from the steel value chain (such as nails) from those countries.  This would lead to a higher loss in terms of value added and jobs.

If the EU opts for a carbon tax on imports, most experts assume that ETS benchmarks would be used to calculate the tax.  In terms of compliance with World Trade Organization (WTO) commitments, two key principles apply: the most-favored-nation principle, under which different trade partners are to be treated alike, and the national treatment principle, which mandates that the goods of foreign and domestic producers should be treated alike.

WTO implications

A tax on imported goods would present several challenges. Depending on how it is designed, a carbon tax could run afoul of international trade law if it treats the imports of some producers differently on the basis of their country of origin, thus violating the WTO’s most-favored-nation principle. Attempting to tax goods differently on the basis of criteria such as production methods, carbon content, and the climate policies of home countries could be legally complex as well.  The WTO’s General Agreement on Tariffs and Trade (Article XX, “General Exceptions”) allows member states to impose measures “necessary to protect human, animal or plant life or health.”

This could certainly be invoked by the EU in this case.  Regardless of the legal basis for the measure, verifying compliance with environmental criteria by so many companies in so many nations would require extensive administration.  To overcome these challenges, some experts propose that the tax vary only by sector.  Additionally, foreign producers could have their carbon tax reduced if they can prove superior environmental performance.

EU-wide carbon tax

There are also proposals to transform the EU’s current ETS into a carbon tax that is imposed on both domestic producers and importers.  Such a mechanism has never been implemented. Although an EU-wide tax would seem to comply with international trade law, the domestic response in Europe has been mixed.  Some EU producers that rely on imported inputs oppose it because their costs would rise.  Also, EU companies have already adapted their operations to comply with the ETS, so to now have to adapt to a new system for pricing carbon in parts of their operations further increases opposition.  An EU-wide carbon tax would also require many European manufacturers to forfeit special emission allowances that are granted to certain industries that are carbon intensive, such as steel.  Finally, some EU member states may object to the proposal, simply because they have historically been against EU-wide taxes.  Any measures involving tax harmonization must be adopted on the basis of unanimity, which make such measures difficult to pass.

ETS adjustment

An alternative to using carbon tax mechanisms is to impose a cap-and-trade system on imported products under the ETS to cover imported products.  This could be done in one of two ways:

Extend the ETS to European importers.  Under this scenario, the EU cap-and-trade system would be applied to domestic companies that import goods into the EU.  These importers would also have to surrender current emissions allowances.  Carbon caps would be allocated for the products.  Importers that exceed their emission caps would pay a fine; importers that do not use their full caps would be able to sell permits on the open market.  Although this scenario has never been implemented in practice, two French informal policy drafts had proposed this mechanism for the EU in 2009 and 2016, respectively.  Both these earlier attempts were met with significant opposition owing to legal uncertainties.

Extend the ETS to foreign producers.  The current ETS could also be extended to foreign producers that export to Europe.  In 2009, the EU proposed including foreign air travel providers in the carbon cap-and-trade system. This proposal was questioned on the grounds that it violated WTO rules regarding quantitative restrictions on imports and would therefore be incompatible with international trade law.  It has also provoked a strong reaction from the US, which saw it as an extraterritorial application of EU law.

WTO/GATT Legal Issues

The European Commission, under the current PresidentUrsula von der Leyen, has made it clear it wants a carbon border adjustment that is compatible with the rules of the WTO.  A CBA mechanism that is WTO-compliant is in principle possible, but rests on complex preconditions that will inevitably imply a trade- off between political feasibility and effectiveness.

In the event that a CBA mechanism was legally challenged and found to violate Articles II.2 or III.2 of the General Agreement on Tariffs and Trade (GATT), exemptions can be applied for tariffs that “protect human, animal, or plant life or health” or when they are related “to the conservation of exhaustible natural resources”. A CBA mechanism would likely meet these criteria, but explicit measures would have to be taken in the design of the tariff to highlight that it is implemented for global environmental purposes rather than to protect the economic competitiveness of EU firms.

Furthermore, the United Nations Framework Convention on Climate Change (UNFCCC) rests on the principle of “common but differentiated responsibilities and respective capabilities”. This implies that less-developed countries (and possibly countries that contributed less to the current stock of greenhouse gases in the atmosphere) should not face the same mitigation burden as richer, developed countries.

A CBA mechanism which gives preferential treatment to clean domestic and foreign producers might unduly affect developing countries.  Tensions between developed and developing countries in international climate negotiations have long existed and there is concern a CBA might significantly exacerbate this.  The EU might therefore wish to design a CBA mechanism which excludes developing countries to some extent.  This would again raise the trade-off between overall effectiveness and addressing the concerns of developing countries.

Currently, the Commission is digesting the approximately 220 responses that it received as part of its public consultation on a proposed CBA mechanism and a first draft of its proposed directive is due before the summer 2021. Its publication will mark what is only the beginning of an exciting year for energy and climate law in the European Union.

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