This is a guest post from Reinhard Quick, Professor for International Economic Law, Saarland University, Dr. iur. (University of Mannheim), LL.M (University of Michigan)
The political guidelines for the next European Commission (2019-2024) are a victory for the proponents of the so-called "Border Carbon Adjustment" (BCA). The President-designate of the European Commission has declared that she “will introduce a Carbon Border Tax to avoid carbon leakage. This should be fully compliant with World Trade Organization rules. It will start with a number of selected sectors and be gradually extended”.
In formulating its proposal, the European Commission can rely on a considerable body of academic literature supporting the necessity, feasibility as well as WTO-compatibility of carbon border adjustment. These contributions discuss the complex legal, economic and environmental aspects of border tax adjustment and conclude that BCAs should be introduced because timely measures to protect the climate are needed.
In the following I will take issue with these arguments:
- The concept of border tax adjustment (BTA) is unsuitable for BCAs
Uneven climate efforts between countries will lead to a relocation of production and investment from countries with ambitious climates policies to countries with less stringent requirements. In order to avoid the displacement of CO2-emissions, i.e. ‘carbon leakage’, and to protect the competitiveness of domestic energy-intensive industries, it is proposed to have recourse to the GATT concept of border tax adjustment. The idea of BTA is appealing but carbon adjustment suffers from an environmental handicap. "Trade neutrality" is the basic concept for BTA: a domestic tax or a charge on products is levied on imports and reimbursed for exports. However, reimbursing a domestic carbon border tax on export is contrary to the environmental objective of the measure and even renders the strict domestic climate policies absurd. In fact, seeing the environmental illogicality of an export adjustment, most commentators suggest not to apply the BTA-concept to exports. In my opinion, such BCAs are not neutral; they are one-sided in so far as they only apply to imports and therefore pose a conceptual problem.
- What is adjustable?
Border tax adjustment might be considered in case of a CO2-tax which is levied both domestically and on imports, but even such a relatively straight-forward solution raises GATT-compatibility questions because of the non-inclusion of CO2 in the final product. The issue, however, becomes even more complicated when the tax is levied at the border to compensate a domestic emissions trading system. GATT rules allow for the adjustment of direct and indirect taxes only when they are levied ‘on products’. Presumably, the carbon border tax will be presented as the import component of the domestic emissions trading scheme. Yet can emission trading, in a domestic content, be regarded as a ‘tax’ or ‘charge’ levied on products?
In principle, the cost of a general environmental legislation, i.e. the cost incurred in complying with typical environmental laws (e.g. water, air, soil, waste), cannot be offset at the border. The costs of these laws are not considered as charges levied directly on products, but as indirect costs incurred by a law-abiding application of the regulation which must be borne by the domestic industry. The ETS-regulation is not a typical product regulation rather a law limiting the greenhouse gas emissions of installations. It introduces a ‘cap and trade system’ by which a cap on the total amount of greenhouse gas emissions is set for each installation. Within the cap, companies "receive" or "buy" emission allowances which they can trade. The regulation combines the aspects of a typical environmental command-and-control regulation with a market instrument to limit greenhouse gas emissions. It is undisputable that the ETS-regulation has an indirect impact on the cost of production, but so do all the other typical environmental regulations. Is the fact that ETS-certificates have a “price” or can be attributed a “financial charge” sufficient to argue that they can be treated as an ‘indirect charge’ on a product and hence adjusted at the border? As any legislation leads to an indirect burden on products, regardless of whether it is environmental or social, so, where do we draw the line? In the case of emission trading there is also a special feature indicating that it should not be regarded as a product legislation: it is up to the owner of the installation to decide on how to comply with the cap, i.e. switching to cleaner technologies, buying more ETS-certificates or producing less. This means that the financial charge varies from installation to installation and thus from product to product and cannot be calculated in advance. In conclusion, if the ‘indirect cost on a product’ of a domestic measure cannot be established in advance such a measure seems unsuitable for an adjustment process.
To solve the problem, some commentators interpret in a creative way the concept of ‘indirect charge on a product’ under GATT Article III:2 or they revert to GATT Article III:4 considering the border carbon tax as the import facet of the ETS-regulation. I disagree with both solutions. In my view the GATT rules on non-discrimination are not applicable. In answering the question of whether the measure is a border measure, or an internal measure applied at the border, the Appellate Body looks at the ‘centre of gravity’ of the measure. Given the specific features of emission trading it seems questionable to treat the carbon border tax as the import facet of ETS; to me it rather looks as a border measure in breach of GATT Article II.
- WTO compatibility - The hurdle of GATT Article XX
If the carbon border tax is found to be in violation with one of the GATT obligations (e.g. Article II), the EU could still try to justify it under the public policy exceptions of Article XX. The problem will not be so much to fit the ‘tax’ to one of the specific exceptions of subparagraphs (b) or (g). Yet the EU will have serious difficulties justifying it under the chapeau of Article XX. The way in which the carbon border tax will be applied risks being considered as an arbitrary and unjustifiable discrimination between countries where different conditions prevail. The Commission will have to distinguish between countries and these distinctions could lead to discrimination. It is unlikely that the ‘tax’ will only be applied against ‘climate offenders’, i.e. those countries that are not parties to the Paris Agreement, rather it will probably also affect the signatories of the agreement.
As announced the system will start with some exposed sectors and will be extended to others. Most likely the Commission will establish a greenhouse gas emission benchmark for the specific products according to which the imports will be measured and eventually ‘taxed’ if the emissions are higher than the benchmark. This benchmark will correspond to the average of domestic greenhouse gas emissions of comparable products. Such a benchmark might be convenient from an administrative point of view, but it is by no means in line with the reality of the ETS regulation nor does it take into consideration the situation in the exporting country. At least, the Commission will have to led exporters to demonstrate that the greenhouse gas emissions of the specific product are below the benchmark. The practical application of a border carbon tax already seems rather complex thereby risking a finding of arbitrariness.
Moreover, the question arises as to whether this ‘tax’ constitutes an inadmissible means of coercion for other WTO-members. The supporters of BCAs do not see them as ‘sanctions’ but rather as an ‘incentive’ to take similarly strict climate measures. In the Shrimps/turtle-case the Appellate Body has ruled that the imposition of a national regulation is inadmissible if it does not take national specificities into account – and here the Paris Agreement comes into play.
The Paris Agreement allows for a heterogeneous and asymmetric implementation based on a "spirit of cooperation" and taking different national circumstances into account. The EU’s position to levy a carbon ‘tax’ upon importation is based on the idea that the specific climate protection policies of another country are not sufficient compared to EU policies. Yet, if the climate protection policies of an exporting country comply with the obligations of the Paris Agreement, it could be argued that, in wanting to levy the ‘tax’, the EU does not take the specific situation of that country into account. The exporting country has every freedom to regulate industrial greenhouse gas emissions of a product differently from the EU as long as it complies with Paris. Such compliance could therefore be used as a defense in the analysis of the “chapeau” of GATT Article XX. The carbon border ‘tax’ could be proven to be a protectionist measure rather than a measure to protect the climate.
- Retaliation
Notwithstanding the significant hurdles many commentators consider BCAs as WTO-compatible, which is theoretically possible. However, I personally think that it is more likely that an EU carbon border tax would be considered WTO-incompatible. In order to verify the compatibility, WTO members would normally refer the case to WTO dispute settlement and wait for a final decision by the Appellate Body before taking any authorized countermeasures. Unfortunately, the good old days of WTO dispute settlement are over, and the WTO’s ‘crown jewel’ has lost its shine. In times of trade wars and unilateral impositions of additional tariffs, it is not exaggerated to assume that the countries affected by the EU’s measure would retaliate. The EU will have to analyze whether the introduction of a carbon border tax outweighs the risks of likely retaliatory action of its trading partners (USA, China, India, Saudi Arabia and Brazil, to name just a few). One wonders therefore whether the existing policy instruments to combat carbon leakage (e.g. free allocation of ETS certificates - although also potentially WTO-incompatible) are not preferable over tough and provocative border measures.
A solution?
WTO-compatibility will be a tough nut to crack. Even the strong supporters of BCAs set conditions for such compatibility (e.g. the abolition of fossil fuel subsidies), which the EU will have great difficulties to implement politically. Saying it will not work is not acceptable as little as the wishful thinking that the carbon border tax will be made WTO-compatible.
There are solutions, however. In times of dwindling support for multilateralism it is daring to propose a multilateral solution which both increases climate protection and decreases the relocation of greenhouse gas emissions. The reason for a multilateral solution, however, lies in the rules of the WTO and of the Paris Agreement. The latter allows members to implement heterogeneous and asymmetric climate actions whilst the WTO considers it to be an unjustified discrimination if the specific conditions of the respective countries are not taken into account (Shrimps/turtle). Therefore, the signatories of the Paris Agreement should be the ones to set the criteria for BCAs. These conditions can only be negotiated within the framework of the Paris Agreement and can then be enforced in the WTO with a waiver.
The multilateral path may also have many hurdles but is seems the only walkable way to justify BCAs and prevent retaliation. If the European Union and its Member States want to defend the multilateral approach, then they should try to find a multilateral solution and not immediately give way to unilateralism. Moreover, the EU could seek a simple fiscal solution to the problem: A two per cent increase of VAT coupled with the obligation to use this additional revenue exclusively for climate purposes could help to achieve climate goals without causing border tax adjustment problems.
