This is a guest post by trade lawyer Victor Crochet of Van Bael & Bellis
The European Commission just unveiled its proposal for a carbon border adjustment mechanism (“CBAM”) (available here).
The proposal provides for a new system where importers must purchase CBAM certificates to cover direct and indirect carbon emissions embedded in certain products imported into the European Union (“EU”) (including, steel, iron, cement, fertilisers, aluminium and electricity). Unlike allowances for carbon emissions under the EU’s Emissions Trading System (“ETS”), which are auctioned or freely allocated and subsequently traded between EU producers, CBAM certificates would be purchased from a CBAM authority at a weekly price that is set at the average of the closing prices of auctions of EU ETS allowances. In addition, CBAM certificates cannot be traded. They can only be resold to the CBAM Authority, who can purchase back up to a third of the total yearly CBAM certificates purchased by an importer, or are otherwise cancelled at the end of each year. A reduction in the number of CBAM certificates to be surrendered for imported products corresponding to the carbon price paid in relation to the imported product in the country of origin is also provided for. Importers can thus claim that the amount to be paid under the CBAM be reduced pro rata in accordance with any carbon tax or price paid under an ETS in the country where the goods were manufactured.
Taking into consideration the far-reaching implications of the European Commission’s proposal, there has been quite some discussion on how to implement a carbon border adjustment mechanism that would be WTO-compatible (see here, here or here…). Recently, the European Parliament itself stressed that any CBAM proposal should be WTO-compliant and commissioned a study on how to achieve this (see here).
One element of the current CBAM proposal seems to have escaped scrutiny in these discussions. Most of the WTO-related literature on the issue, which I refer to above, discusses the WTO-compatibility of either a carbon tax collected at the border for imported products or the extension of an ETS to imports (so that importers would have to purchase and surrender ETS allowances at the time of importation). While the idea of pegging CBAM certificate prices to the EU ETS price had been touted by the European Commission (see here), it surprisingly did not attract much scholarly attention. Yet, in my opinion, there is a fundamental flaw in adopting such a pricing mechanism as it imposes a price for carbon emissions onto imports from other countries that is inherently linked to the EU’s own carbon emission levels and decarbonisation commitments.
The CBAM proposal fails to appreciate that the price of ETS allowances under an ETS is set by the market in each country or region, whereby it essentially depends on two factors. The first factor is demand for ETS allowances which is based on how much carbon the industry emits when producing goods (carbon emission per output multiplied by total output). For example, if the industry emits more carbon to produce a ton of steel or produces a greater quantity of steel, it will need more ETS allowances, causing the prices of allowances to increase. The second factor is the supply of ETS allowances (which is set by the authorities on the basis of a country’s target emission reduction). The price of ETS allowances would thus be different in every country even if they shared the same decarbonisation goals.
By creating a hybrid system in which the price of carbon emissions for imports is tied to the EU ETS, the current CBAM proposal fails to take into account the existence of these market-specificities thus discriminating between imported and domestic products. This may stand in the way of the CBAM being justified under Article XX of the GATT as this discrimination cannot be reconciled with the CBAM’s stated policy objective, namely the avoidance of carbon leakage to countries which do not share the EU’s level of climate ambitions.
As discussed above, even between WTO Members with similar climate ambitions, the prices of ETS allowances in their systems could still differ depending on the demand for emission allowances of their industries. However, under the current CBAM proposal, imports from trading partners who share similar climate ambitions and work towards them through their own ETS will still need to pay CBAM certificates to make up for the difference between the price paid in the country of origin and the CBAM price. Hence, the EU will “gold-plate” the value of carbon emissions embedded into products that are imported in the EU as carbon emissions for these imports cannot be valued lower than the carbon emissions under the EU ETS. This seems to indicate that the objective of the measure is not avoiding carbon leakage to countries which do not share the EU’s level of climate ambitions but, rather, that foreign producers do not pay less for their carbon emissions than EU producers.
At the same time, the proposed CBAM would not prevent carbon leakage but merely put a price tag on it hinting that the hybrid pricing mechanism is aimed at levelling the playing field rather than avoiding carbon leakage to countries which do not share the EU’s level of climate ambitions. Indeed, under the current CBAM proposal, there is no cap on how much carbon embedded into products can be imported into the EU. A better option to avoid carbon leakage may have been to extend the EU ETS to imports, as initially envisaged by the European Commission. Under this option, the number of EU ETS allowances would have been increased and imports would have competed with EU products for these allowances. In this way, the total number of EU ETS allowances would have capped the total carbon consumed in the EU (instead of total carbon produced in the EU under the current EU ETS) thus taking away any benefit from moving production abroad.
Taking the above into account, if the European Parliament is true to its word and remains committed to making the CBAM WTO-compatible (see here), it would be wise to rethink the current pricing mechanism for CBAM certificates.
