Europe’s Carbon Border Adjustment moves to trilogue: potential impact on trade and WTO compatibility still unclear

Introduction

On June 22nd, the European Parliament and Council of the EU submitted amendments to the European Commission’s proposal for an EU Carbon Border Adjustment Mechanism (CBAM). The final shape of the CBAM is to be negotiated during the trilogue, but the effectiveness of the package, and its impacts on trade and competitiveness remains ambiguous. These depend heavily on technicalities such as the timing of abolition of the free allowances under the ETS, the existence of export rebates, the industrial scope covered, the reference emissions and the allocation of revenues.

Another key amendment regards export rebates. The Parliament has recommended that EU producers should only continue to receive free allowances under the EU ETS for products destined for third countries that do not have similar carbon pricing schemes. The Commission’s initial proposal for CBAM raised a problem of acceptability: by replacing the free allocation of ETS allowances with CBAM, it will penalise ETS industries in their export markets. The CBAM only replaces the free allocations under the ETS for imports, putting EU producers at a competitive disadvantage in third countries without carbon pricing mechanisms. The European Parliament has thereby requested a study by the Commission to assess the WTO-compatibility of the proposed export derogation.

The proposed CBAM regulation raises the question of how to best combine an efficient ETS market with WTO-compatible border compensation, while also tackling the competitiveness issues faced by ETS sectors. The issue of WTO compatibility has become central, and the European Parliament has been careful to incorporate this message into its amendments wherever possible.

Can CBAM reduce carbon leakage? 

In a recent CEPII working paper, Bellora and Fontagné used a general-equilibrium model to uncover the effect of CBAM on emissions, welfare, and trade. They find that leakages offset 22% of the reduction in EU GHG with CBAM, compared to 41% with free allowances and 62% in the absence of  both CBAM and free allowances. CBAM would thus reduce leakages, particularly direct leakages, but is unfit to mitigate indirect leakages. 

In their study, the authors assume a CBAM that covers all industries in the EU ETS, aligning their hypothesis with the Commission’s long-term objective (i.e., extending the coverage of CBAM beyond raw materials). Their model tracks production movements between countries and sectors to account for carbon leakage. In this scenario, the emissions of the exporting country are chosen as the reference emissions, meaning that the average carbon-intensity value for any given product is based on the world average. This benefits high-polluting countries, in contrast to country-specific values, and reflects higher carbon content than the EU as a benchmark, portraying values closer to the carbon content of EU imports. EU carbon intensities should ideally not be used as reference values, or else the potential environmental benefits would be too low, reducing the incentive effect for importers to surpass the default value.  

CBAM can reduce indirect leakage if it succeeds in incentivising non-EU countries to significantly reduce their emissions. In the Parliament’s proposal, the amount of CBAM certificates required to be purchased by the importer takes into account the carbon intensity of the electricity consumed in the production process. This is a critical amendment of the Commission’s proposal, which only covers direct emissions. The Executive Vice-President of the EU’s Green Deal, Frans Timmermans, has previously said that “the rationale for the border carbon adjustment mechanism disappears” if countries go “in the same direction, even if they take different paths”. However, as green electricity is heavily subsidised in Europe, how will the subsidy quagmire in the event of a WTO panel be avoided?

Including indirect emissions in the CBAM would add considerable complexity to the mechanism and incur a major cost. Nevertheless, indirect emissions stemming from electricity consumption needs to be considered, as they represent an important risk of carbon leakage in electricity-intensive sectors. Accordingly, the inclusion of indirect emissions is key to reaching a low-carbon system and ensure a level playing field between EU products and non-EU imports. While the parliament is pushing to include those immediately, the Commission prefers to take a more cautious approach with a gradual introduction of indirect emissions in a later stage.

The design components of the CBAM therefore point in different directions. Approximating the actual carbon emissions for each imported product requires a trade-off between administrative feasibility and environmental friendliness. A product-specific approach, assessing the real carbon content and using ad hoc carbon intensity values, would increase the risk of retaliation, as one would differentiate between countries in the end. But such a mechanism could also allow importers to substitute a uniform carbon intensity if they can effectively show that their specific production is more carbon efficient, rewarding lower carbon intensity. On the other hand, closer consideration of each importer’s situation would ensure less discrimination between importers and European producers. Ultimately, a greener CBAM would also be easier to defend as an environmental measure under the article XX of the WTO rules. 

Competitiveness and CBAM: Green at what cost ?

Competitiveness is a crucial issue in the debate on climate agreements. As it is extremely difficult to reach a global agreement, sub-groups of countries with stricter environmental constraints risk seeing companies move to countries where emissions are not limited. CBAM is to be implemented at the same time as the gradual removal of free allocation in the EU ETS. This puts energy-intensive sectors in a difficult position and could lead to significant job reallocation costs. 

Originally, most allowances were given for free to maintain the competitiveness of regulated industries and to avoid carbon leakages. However, to meet increasingly ambitious environmental targets, auctioning has become the default method for allocation of allowances. The recent phase IV reform proposed by the European commission updates the criteria for access to free allocations, as recent research suggested potential over-allocation to firms that did not face a high leakage risk.

Bellora and Fontagné (2022) have studied the effect of a potential system of compensation for competitiveness losses for exporters. In their second scenario, CBAM is designed at “offsetting emissions and incentivising non-participating countries”. This type of CBAM entails collecting information on foreign emissions and offering different compensations to exporters—and has a serious risk of being challenged at the WTO. As expected, they report a decrease in European imports of EU ETS products, but they also point to a decrease in European exports. European exporters of final goods are losing competitiveness on the European and on third markets due to more expensive intermediate goods (whether imported or produced in Europe). The agreement reached on 15th March does not address this issue. 

Third-Country Impacts: CBAM’s WTO Compatibility

The EU remains committed to the bottom-up approach of the Paris Agreement, in which countries determine their own environmental commitments. However, this approach needs to be complemented by additional policies to accelerate the transition to low-carbon economies. 

By adopting this approach, the authors of the Paris Agreement aimed for broad coverage of commitments while acknowledging the differences between countries in terms of history, economic development, and natural resources. International partners are asking the EU to include this same differentiation in the design of the CBAM. In fact, the Paris Agreement can legally be used against CBAM. As a reference support of a Multilateral Environmental Agreement, it does not mention border measures and could disqualify CBAM having the general exception clause (GATT Article XX). The compatibility of the CBAM proposal with WTO rules is subject to many uncertainties. Especially if, as suggested by Bellora and Fontagné (2022), the EU benefits from a positive terms of trade effect after the implementation of CBAM. The issue of free allowances raised previously could be inconsistent with the WTO’s national treatment rule, that requires imported products to receive at least the same treatment as similar domestic products. If imports are taxed on their emissions while EU producers continue to receive free emission allowances.

Lastly, another compatibility problem with the WTO could be the lack of clear allocation of the substantial revenues generates by CBAM for environmental policies. To benefit from the WTO environmental exemption on which the CBAM could rely on, the revenues generated shouldn’t be allocated to the general budget. First, they should at least be used towards green and decarbonization projects in the EU. This could be done through the EU Innovation Fund, allowing all EU member to have access to this funding source. By coordinating green energy project spending at the EU level, it is possible to avoid the inefficiencies created by national stop-and-go policies, especially in the development of renewable energy sources. Furthermore, CBAM funds could be used to help developing countries transition from fuel-based technologies, such as Just Energy Transition Programme. The text adopted by the Parliament demands ‘full transparency about the use of those revenues (…) and for an increase in the EU’s contribution to international climate finance in favour of Least Developed Countries and Small Island Developing States’. 

The EU is charging all exporters with the CBAM (covered goods) and fail to consider the negative consequence on less and least developed countries. It does not foresee any exemptions for developing countries. Prior consideration of distributional impacts should be part of the multilateral coordination process. Currently, CBAM offers no exemptions under the WTO’s enabling cause. The CBAM fee is not presented as a tariff, nor has it been negotiated under GATT. 

Conclusion

In the long run, the “climate club” should materialise or the risk of carbon leakage will intensify, as the gap in competitiveness created by increasing carbon prices would only be reinforced. Different climate policies can achieve similar results, and the Brussels effect in CBAM seems non-existent in the near future. 

The next step should be to have a calculation of equivalency in national climate policy. This would enhance coordination of climate policy approaches and mutual recognition by putting a price on compliance costs with climate regulation with no CO² pricing mechanism (e.g. Japan and the US). An equivilancy calculation is supported by the OECD, IMF, World Bank, IEA, and WTO. Of course, the equivalency and exclusivity character of such “club” is an oxymoron.