As policymakers in Brussels search for the right format for a possible Carbon Border Adjustment Mechanism (CBAM), European stakeholders are searching for ways to shape the discussions. Fairness – a principle embedded in EU trade policy and top of mind of its trade commissioner – is set to become a key challenge for the Commission when proposing legislation. Whom to include and leave out? Will the measure comply with WTO rules, or will retaliation follow? And international criticism has not gone away – although some countries may be eying their own CBAM. The Commission estimates the mechanism could generate anywhere in the region of €5-14bn. H+K Strategies’ Niels van Velde ponders how to make it worth the trouble.

The idea of a carbon tax, imposed at Europe’s borders, has been floating around the halls of the Berlaymont, the European Commission’s HQ, for a long time. The French never let go of the idea, ever since then French president Jacques Chirac first proposed such a measure after his famous speech many years ago saying ‘our house is burning’. But discussions were only really revived after a two-page French white paper started circulating in the summer of 2019 and it has turned out to be one of the most debated files in the EU today.

With Executive Vice-President Frans Timmermans at the helm, Europe wants to leave behind the ‘slash-and-burn carbon economy’ and moving to a clean, innovative, inclusive, and circular economy. Bringing its industry to net-zero is among the biggest priorities. However, CO₂ emissions are typically measured on the basis of ‘production’ – meaning imported emissions are often not accounted for. This explains why France’s total carbon footprint – including imported products – is about 70% higher than its national emissions.

With such volumes of imported CO₂, a mechanism like ETS (Emission Trading System) cap and trade no longer suffices as the EU sets out to drive down emissions outside its jurisdiction as well. Terrified that its climate ambitions will damage EU productivity and competitiveness, the Commission’s directorate-general for taxation DG TAXUD has set to work. The notion is that a carbon tax – or mechanism as the Commission prefers to call it – should protect EU industry from ‘cheap’ and ‘dirty’ competitors. The idea is simple: goods from outside the EU with a higher environmental footprint will cost more so that EU-produced goods stay competitive as the EU embeds its climate ambitions.

Designing the mechanism

For now the Commission has left its options open in terms of the design of the mechanism, always mentioning that it will design a WTO-compatible CBAM. The EU’s trade commissioner Valdis Dombrovskis recently argued that the levy is likely to take the shape of a notional emissions trading system, while presenting an EU trade strategy that hinges on sustainability. Other options up for discussion are a CBAM that is structured as an import tax, excise duty or consumption charge (added-value type).

A notional or quasi-ETS could be relatively simple to implement. Where EU producers buy ETS allowances from one pot, non-European producers would buy from a separate one – preventing market distortions. Now the difficult part: this does not solve the problems of benchmarking and certification. No matter how the system is designed, the Commission will need to set up criteria to distinguish ‘dirty’ from ‘clean’ imports.

The most frequently mentioned option to make that distinction is to use EU producer emissions and carbon costs as a benchmark – a system closely related to the ETS. Foreign producers would then be classified via another benchmark (national, regional or otherwise), which would allow the EU to compare emission costs and tax those differences. This however leaves the question what the real cost of emissions is in the EU, as some producers currently receive free allowances, while non-EU producers do not.

But if designed too bluntly CBAM side effects could possibly actually increase emissions. A very clean foreign producer from a generally speaking polluting region would disproportionally be harmed by such a mechanism – sparking the need for individual adjustments. This would require foreign producers to prove that their environmental footprint is lower than the benchmark it is subjected to, resulting in a lower carbon border tax. But how importers would prove and certify these green claims remains unclear.

Who is in? Who is out?

From inside the Commission we hear that steel, aluminium, cement, and some chemicals are among top candidates to be in a CBAM pilot phase program – but it is clear we haven’t heard the last word on this. And even when it is clear what sectors are in, and out of scope, the debate will continue as more and more sectors will be included. What to think of textiles, with its long and complex supply chains – and what about sensitive topics like agriculture?

For most sectors the fact that they will be covered by a CBAM is not in itself their main concern. It’s the ETS free allocation that keeps them awake at night. Free allowances make it hard to calculate what the real cost of emissions is in the EU. On top of that there are serious questions about the legality of combining a CBAM and ETS free allowances under WTO rules. Industry stakeholders argue it should be possible to keep free allowances while importers pay extra for their emissions, but most WTO experts beg to differ.

Most sectors are not keen on being the EU’s guinea pig for a CBAM. The reaction of the European association for aluminium is indicative, calling a CBAM ‘not an adequate tool to achieve the main objectives EU policymakers would like it to achieve’. They argue aluminium should not be included among the pilot sectors for the measure. The European Cement Association notes  that a ‘full co-existence of CBAM and free allocation is essential to minimise risks for the industry, avoid distortions on the internal market, safeguard the competitiveness of exports, and provide certainty for investors’. In brief, that means free allowances and a CBAM.

A double remedy? It’s not so far from political reality in the European Parliament as Adam Jarubas (EPP, Poland), coordinator of the largest group in parliament, warned before its plenary vote: ‘we have to be very careful when stating that the CBAM is an alternative to free allowances. It clearly does not work the same way’.

MEPs set the tone

As Commission officials discuss the details of this new mechanism MEPs seemed none too keen to wait. Launching an own-initiative process, MEPs of the environment committee (ENVI) produced their own recommendations on the scope and design of an eventual CBAM. The ENVI committee concluded that the mechanism should include all energy-intensive industries covered by the EU ETS – and as a starting point indicates sectors like cement, steel, aluminium, oil refinery, paper, glass, chemicals and fertilisers. In a last-minute amendment and very close vote (only 10 and 15 votes difference), a majority on the right side of the Parliament (EPP, ECR, ID, parts of Renew) removed a controversial reference to the parallel phasing out of free allowances.

On 10 March the parliament’s plenary session adopted their non-binding vision on a CBAM, but it remains unclear if the European Parliament will even have a say in the matter. Depending on its design, the Commission could opt for a taxation procedure that would sideline EU parliamentarians. This would however require unanimity among EU member states – historically almost never achieved.

All eyes on EU?

It’s important the EU gets it right. Some third countries smart at the prospect of an EU perceived to be dictating climate rules. The fact that no concrete proposal has actually been published hasn’t prevented the US from claiming early-on that an eventual EU CBAM would hurt American businesses. Moscow has already cried foul over ‘attempts to use the climate agenda to create new barriers’. While the threat of retaliation probably won’t waylay the EU to from its sustainability path, it does raise questions about a CBAM’s eventual design.

There is however room for consensus with third countries. The Japanese Ministry of Economy, Trade and Industry (METI) is considering a similar mechanism based on a mix of an ETS, carbon tax, and subsidies, while the Biden administration is ramping up its own climate ambitions – which could also include a carbon border tax. It remains unclear what this legislation will look like, but despite efforts from the EU to collaborate on the design it is likely to be very different. It is already becoming clear that both blocs will try to build their version of a CBAM on existing emission legislation – and climate legislation in the EU and US are intrinsically different. Each bloc will have to create its own instrument and ensure its WTO compliance. There is one more question that stays unanswered: where does this leave producer-nations like China and Russia? Will they soon come out with tangible emission reduction legislation, or rather take the legal route, fighting a CBAM at the WTO level?

It’s going to be an interesting process, kicking off in June with the Commission’s proposal. We expect it will spark a lot of debate in Europe and internationally. European leaders will need to walk the fine line between protection and protectionism, to level the playing field while delivering on climate ambitions. The devil is in the details – and the details of a CBAM will be complex.