What is a carbon border tax and what does it mean for trade? 

2021 has already left its mark on global discussions about trade and the climate change. In July, the EU proposed a levy on imported carbon-intensive products. For good or bad, what comes next will shape the role of trade in the fight against climate change.

1. What is a carbon border adjustment tax? What is driving the EU in that direction?

A carbon border adjustment tax is a duty on imports based on the amount of carbon emissions resulting from the production of the product in question. As a price on carbon, it discourages emissions. As a trade-related measure, it affects production and exports.

The idea of a carbon border tax has been discussed by experts for years. If designed unilaterally, it tends to be seen as unfair by trading partners. There is the risk that it becomes a protectionist device, unduly shielding local industries from foreign competition in so-called 'green protectionism'.

For the EU, however, risk of “carbon leakage” required action, even if unilateral. In proposing a Carbon Boarder Adjustment Mechanism (CBAM), the EU claims to be concerned with the relocation of production to countries with less ambitious climate policies, undermining EU’s and global climate objectives. For the EU, CBAM would be neither a tax nor a tariff, but a policy measure. Others see it differently.

The CBAM also has an economic driver. By 'equalizing' the price of carbon between domestic products and imports, the EU claims to promote fair competition, levelling the playing field between EU and non-EU businesses.

2. How would the EU scheme work?

If implemented as planned, EU importers will have to buy carbon certificates corresponding to the carbon price that would have been paid in the EU, if the goods had been produced locally.

The price of the certificates would be calculated according to the auction prices in the EU carbon credit market. The amount of certificates required would be defined yearly by the quantity of goods and the embedded emissions in those goods imported into the EU.

The CBAM would initially apply to imports of cement, iron and steel, aluminium, fertilizers and electricity.

3. How are other countries responding?

The EU’s CBAM proposal contains various controversial aspects. For example: how to fairly account for emissions related to the production of imported goods? How to duly consider the costs that companies already face in complying with climate regulations in exporting countries?

The United States, China, India, Brazil, South Africa and several others, including least-developed countries, have expressed concern over the EU’s CBAM.

Assuming that the bloc will move ahead with the proposed scheme, what are the options for EU’s trading partners? They may well adapt to the new reality – but other scenarios exist:

Partners may:

• choose to retaliate imports coming from the EU. Countries could decide to impose barriers on EU imports in response.

• adopt their own CBAMs. For climate reasons, economic interests or as a response to the EU, countries could start adopting their own carbon border taxes. Following the EU announcement, the US is now considering this. A similar scheme is in the making in Canada.

• challenge the EU CBAM. Trade specialists have been discussing the consistency of the EU proposed mechanism with multilateral rules. A WTO dispute against the EU is possible.

• choose to negotiate exemptions with the EU. Many seem reluctant, though. Some partners feel that they are being forced into negotiating with Brussels, as the proposed CBAM scheme allows for the EU to acknowledge the costs of climate policies on the production abroad. But negotiating exemptions with the EU ultimately means bowing to a scheme often seen as an imposition from Brussels on others.

4. How can all parties make the most of the EU’s move?

All the paths above fail to ensure optimal climate or trade objectives. A trade spat triggered by EU’s CBAM wouldn’t contribute to any of these causes. A proliferation of different carbon border measures would create unnecessary costs to trade, in addition to more room for discrimination and protectionism. Importantly, in the absence of coordination, only suboptimal climate results would emerge.

A more constructive way forward is possible. The EU proposed scheme should serve to trigger a serious global discussion about the role of trade in tackling climate change. For far too long, trade and environment regimes have evolved in parallel, and collaboration across the two communities has been unsatisfactory.

With the proposed CBAM, there is a new sense of urgency for a shared understanding on carbon-based trade policies. If countries believe a carbon border tax is the way forward, a global view on this topic should include an alignment of key parameters applicable to them, as well as agreed standards for measuring carbon that is emitted in the production of goods. Transparency and non-discrimination should remain key principles of any global understanding, and that should also ensure that carbon-related measures do not unnecessarily restrict trade. A shared vision should also recognize, in line with the Paris Agreement, that countries observe different approaches and speeds in their decarbonization efforts.

If Brussels was frustrated with inaction and decided to go ahead unilaterally, now it has the chance to foster global engagement around harnessing trade policy to accelerate climate action. On a different occasion, the EU wanted to introduce a digital tax, and other partners were seriously concerned. But that helped to create momentum for a real global engagement to redefine taxation on multinational companies, which previously looked extremely unlikely. Perhaps EU’s CBAM could play a similar role in the trade and climate discussions.

The EU proposal brings trade and climate decisively together. With civil society and businesses, leaders must seize this opportunity to promote coherence between climate and trade regimes, maximizing both environmental and economic benefits.