Recent weeks have witnessed three important developments related to trade and climate change — the Intergovernmental Panel on Climate Change (‘IPCC’) has again highlighted the grave reality that the world cannot wait any longer to combat the climate crisis.

The European Union (EU) has unveiled details of a Carbon Border Adjustment Mechanism (CBAM) as a replacement of its current Emissions Trading System (ETS). In a recent report on CBAM, UNCTAD has warned that India’s trade with the EU would be substantially impacted by the CBAM. Hence, the EU CBAM merits analysis.

With the objective of levelling the playing field for its producers who have to comply with stringent domestic carbon emission curbing regulations, since 2005 the EU has been implementing its ETS. The ETS operates on a ‘cap and trade’ system, where a total limit (cap) is set on the carbon emissions by industrial installations in identified sectors. There is a fixed number of emission allowances within this cap, for which installations are not charged. A part of these allowances are free — meaning that up to the free level, installations are not charged for their emissions. Beyond the free level, and up to the cap, installations have to pay for the incremental emissions. The ETS operates to gradually reduce free allowances under the caps, in order to make EU’s production and manufacturing more carbon-neutral.

Under the ETS, the onus of reducing carbon emissions is on the EU domestic industry. However, the CBAM seeks to shift this burden to the foreign entities who export to the EU. The implementation of the CBAM is proposed in two phases — the transitional phase between 2023-2025 and the full implementation from 2026.

What is CBAM?

CBAM is intended to be a tax on imports of certain predetermined carbon-intensive goods into the EU. Currently, this measure is proposed to apply to the following products: cement, iron and steel, aluminium, fertilisers and electrical energy. The amount of the CBAM tax will be based on embedded carbon emissions voluntarily declared by third country producers/exporters, who register in a central EU database. The voluntary declaration would need to go through a complex verification processes, before importation to the EU is allowed upon imposition of the relevant CBAM tax.

If a third country producer/exporter does not register with the CBAM system, or is unable to provide data for verifying the actual embedded emissions, then applying the default emissions calculation, the EU is likely to impose a high punitive carbon tax on imports from these foreign producers. Indian producers/exporters could also be exposed to this high tax.

Many concerns arise from the design and proposed implementation of the CBAM. First, compliance with this complex system will require considerable adjustment by foreign producers/exporters. Registration with the central EU system will also raise compliance costs for them.

Second, the EU would unilaterally judge the domestic climate responses of each exporting country. Given that the EU considers its own system to adequately address the emission crisis, this unilateral judgment of each exporting country’s domestic climate change response may lead the EU to conclude that foreign products require taxation for emissions, whereas EU’s domestic producers do not.

Third, the design of the CBAM suggests that with the exception of countries that participate in the ETS — Iceland, Lichtenstein, Norway and Switzerland — the EU is unlikely to recognise carbon cutting rules of other countries as being equivalent to its own measures. Hence, the EU seems to be attempting to impose its climate-related measures extraterritorially and in a discriminatory manner.

Fourth, the EU claims this measure to be consistent with the rules of the WTO. However, the registration requirements with the CBAM system and the carbon pricing methodology seem to raise troubling concerns regarding the consistency of the CBAM with rules of the WTO. To illustrate, as the CBAM is based on carbon emissions embedded in imported products, a potential discrimination may exist between imported goods from different countries, and between imported and domestically manufactured goods. Such actions could violate the non-discrimination mandates of WTO.

Further, the EU may find it difficult to justify the CBAM by invoking exceptions in the WTO rules aimed at conserving exhaustible natural resources, or protecting human life and health,. However, it is doubtful whether the CBAM will satisfy the requirements that the measure should not be arbitrary or a disguised restriction on trade. If it does not satisfy these conditions, it will violate WTO rules.

Fifth, against the EU’s professed goal of encouraging international cooperation on emission reduction, the CBAM appears to be an attempt by the EU to compel an extraterritorial application of only its own rules and emission curbing standards. This would also go against the principle of common but differentiated responsibilities (CBDR) as recognised under the UNFCCC.

CBDR is a principle under the UNFCCC which acknowledges that while all states have a shared obligation to address climate change, different countries have different capabilities and responsibilities to address these issues. Given that the CBAM attempts to impose the EU’s standard of curbing emissions, it is likely to violate the spirit of CBDR.

Hence combating climate change requires constructive collaboration by the international community. EU’s CBAM proposal in its current form raises important concerns from the perspective of WTO and environmental law.

Further, the UNCTAD report states that CBAM’s impact on climate change would be limited — only a 0.1 per cent drop in global CO2 emissions. On the other hand, it will raise trade costs for developing countries including India. The EU needs to address these concerns, if the CBAM has to be an effective response to climate change, which is also agreeable to other nations.

Das is Assistant Lecturer, Jindal Global Law School; Nasution is Assistant Professor of Legal Practice, Jindal Global Law School. Views expressed are personal