Starting October 1 this year, the exports of cement, Iron, steel, aluminium, fertilizer, and hydrogen to the European Union (EU) will face extra scrutiny. After 27 months, from January 1, 2026, the EU will start collecting a carbon tax on each consignment of these products.

Welcome to the EU’s new regulation ‘Carbon Border Adjustment Mechanism (CBAM)’. CBAM will gradually cover new products. By 2034, CBAM will levied on all the goods exported to the EU.

The quantum of tariff is worrying. CBAM may translate into average taxes ranging from 20-35 per cent on iron, steel, and aluminium products. This is far above the average 2.2 per cent bound tariffs agreed by the EU at the WTO for manufacturers. High CBAM tariffs will render WTO and FTA commitments meaningless.

Let us understand why the EU implements CBAM and how India should prepare for it.

EU’s eco goals

The EU seeks to achieve 55 per cent lower carbon emissions by 2030 compared to 1990 levels. It wants to be carbon-neutral by 2050. Emissions Trading System (EU ETS) is the EU’s instrument for achieving these goals. It monitors emissions from over 10,000 power stations, oil refineries, iron, steel, aluminium, cement, paper, glass factories, and civil aviation.

The ETS system operates through European Emission Allowance (EUA). Call it a license or permit that allows one tonne of CO2 emission. The EU-ETS sets a cap on the quantity of greenhouse gas emissions (mainly carbon dioxide) each installation can release. Each participating firm gets a limited number of annual EUAs.

If their emissions exceed the EUA allowance, they must buy EUAs through auction at ETS. Firms that have reduced their emissions have surplus EUAs. The EU-ETS system reduces cap gradually to reduce emissions.

The firms are expected to achieve lower emissions by investing in better technologies, fossil fuel alternatives, and energy efficiency.

Thus the EU-ETS is a cap-and-trade system that uses market forces to reduce emissions. The system allows the market to determine a carbon price, and that price drives investment decisions.

While the EU ETS covers many industrial sectors for emission reduction, it allows the most polluting sectors, like steel or aluminium, a free run by giving them free emissions allowances or EUAs to cover all their emissions.

Any emission reduction target on such firms will result in EU firms relocating to cheaper destinations like China or India. The phenomenon of shifting polluting sector firms from high-cost countries to low-cost countries is termed carbon leakage.

Rising EU carbon prices (from €30 per tonne of CO2 in December 2020 to €100 in Feb 2023) make carbon leakage likely.

The EU was in a dilemma. Its most polluting industries must reduce emissions to reach its climate goals. But, if the EU permits free allowances and applied the emission reduction norms, most production may shift to low-cost countries.

One way to reduce carbon leakage was to apply CBAM only on imports from EU firms that have shifted production to low-cost countries. But the EU chose to tax all imports through CBAM at EU’s prevailing carbon prices.

It decided to gradually phase out the free allowances from most polluting sectors and simultaneously introduce CBAM to prevent the relocation of industries or carbon leakage in these sectors.

High CBAM tariffs on all products by 2034 will disrupt global trade. Soon the UK, the US, Canada, and many others may take similar measures.

Developing countries will suffer the most as they carry out the most carbon-intensive manufacturing. The developed country-led global value chains ensured that cleaner production takes place in developed countries while the polluting part of production takes place in developing countries.

CBAM will have a negligible impact on climate. The carbon content of the environment will come down as consumption comes down. CBAM has no plans to reduce consumption. EU has estimated that by 2030, global emissions in the CBAM sectors will decrease by 0.4 per cent.

CBAM violates the Paris Agreement’s core principles, vitiating the climate talks. Developed countries have generated 79 per cent of historical carbon emissions. That’s why it has been agreed they will bear more burden in climate mitigation. CBAM goes against the principle of common but differentiated responsibilities (CBDR) accepted in the Paris Agreement.

It imposes the environmental standards of developed countries on developing countries. Also, instead of helping, the EU will now collect revenue from developing countries through the CBAM mechanism. EU will use this money as a budgetary resource and not for helping developing countries with climate adoption.

Brazil, Russia, India, China, and South Africa, in April 2021, in a Joint Statement called CBAM discriminatory, against the principles of Equity and the United Nations Framework Convention on Climate Change (UNFCCC) principle of Common but Differentiated Responsibilities and Respective Capabilities.

Impact on India

CBAM will be a significant challenge for India’s metal sector. India’s 27 per cent exports of iron ore pellets, iron, steel, and aluminium products of value $8.2 billion in CY 2022 went to the EU. As soon as CBAM covers all goods, India’s exports to the EU may face stress. EU is an important trade partner, with 17 per cent of India’s exports destined for the EU.

The government may take the following two actions on CBAM:

One, set up a task force to prepare administrative ministries and industry to meet the CBAM challenge.

Two, factor impact of CBAM in FTA negotiations with UK and EU. Even if both countries agree to zero tariffs under FTA, CBAM will ensure while EU goods enter India at zero tariffs, Indian goods will pay very high CBAM tariffs.

The EU is unleashing CBAM as the Climate Trojan Horse. It may not improve the environment, but it surely will disrupt global trade in a big way.

The writer is founder Global Trade Research Initiative