Climate Change: European Union’s Carbon Border Adjustment Mechanism and its impact on India

October 18, 2021 10:59 AM

Free riding and climate fairness are the two main issues behind the difficulties in reaching meaningful international agreements on reducing emissions.

climate changeFree riding and climate fairness are the two main issues behind the difficulties in reaching meaningful international agreements on reducing emissions.

By (Mrs) Amb Narinder Chauhan

Climate change is a global problem that needs a global solution. It is a given that while there is strong common interest in tackling climate change, the efforts required need to be reconciled with climate fairness i.e., the fact that countries have contributed differently to the cumulation of CO2 emissions and that those countries most likely to be affected by climate change would be those least responsible for it. Free riding and climate fairness are the two main issues behind the difficulties in reaching meaningful international agreements on reducing emissions.

The European Green deal sets the goal of a 55% reduction in carbon emissions compared to 1990 levels by 2030, and to become a climate neutral continent by 2050. The European Parliament has given the green signal to the European Commission’s plan to decarbonize its economy by 2050, by approving the proposed Carbon Border Adjustment Mechanism [CABM]. The CBAM proposes to reduce the risk of carbon leakage and to level the field for EU industries working to decarbonize their production processes. This will be done by imposing a carbon tariff on carbon intensive products such as cement and electricity, imported by the EU. The CBAM is likely to take effect in 2026 with reporting stated in 2023.

The stated argument is, as it raises its own climate ambition and less stringent environmental and climate policies prevail in non-EU countries, there is a strong risk of ‘carbon leakage’- i.e., companies based in EU could move carbon intensive productions abroad to take advantage of lax tax standards, or EU industry could be replaced by more carbon-intensive imports. Such carbon leakage can shift emissions outside of Europe and thereby seriously undermine EU and global climate efforts. The CBAM will equalize the price of carbon between domestic products and imports and ensure that the EU’s climate objectives are not undermined by production relocating to countries with less ambitious policies. The EU is thus pushing for the world’s first carbon border tax on imported goods. It plans to levy the tax in a phased manner from 2026. It directs non-EU companies exporting to Europe to pay the same price for their carbon footprint in Europe as European companies.

How does the mechanism work? It is stated that EU importers will buy carbon certificates corresponding to the carbon price that would have been paid, had the goods been produced under the EU’s carbon pricing rules. Conversely, once a non-EU producer can show that they have already paid carbon tax in their jurisdiction, the corresponding cost can be deducted for the EU importer. The stated aim of CBAM is to reduce the risk of carbon leakage by encouraging producers in non-EU countries to green their production processes.

To provide the businesses and other countries with legal certainty and stability, the CBAM will be phased in gradually and will initially apply only to a selected number of goods at high risk of carbon leakage: iron and steel, cement, fertilizer, aluminum and electricity generation. A reporting system will apply as from 2023 for those products with the objective of facilitating a smooth roll out and to facilitate dialogue with third countries, and importers will start paying a financial adjustment in 2026.

CBAM is purported to be an improvement on the Emissions Trading System (ETS) of the EU. ETS is the world’s first international emissions trading scheme and the EU’s flagship policy to combat climate change. It caps the GreenHouse Gas (GHG) emissions that can be released by certain industries. It also addresses leakage, but it also dampens the incentive to invest in greener production at home and abroad. The intention of the CBAM is to progressively replace ETS or provide an alternative. For the CBAM, the free allowances will gradually be reduced and phased out from 2026. Further, until they are completely phased out, in 2035, the CBAM will apply only to the proportion of emissions that does not benefit from free allowances under the EU ETS, thus ensuring that importers are treated in an even-handed way compared to EU producers. To clarify, importers already paying carbon prices in countries of origin will not be charged twice. In income terms, gains and losses from CBAM are small compared to the $53 b losses in real income that the EU experiences as a result of imposing a domestic carbon price of $44 per ton of CO2 emissions in their economies.

The increase of carbon pricing in the EU results in leakage of CO2. The higher the carbon price, the higher the leakage. With carbon taxes, emissions reductions and production losses are significant in the EU. Without CBAM, it is estimated the EU would experience substantial carbon leakage and export declines. With a 44% carbon tax, CBAM would cut leakage by more than half, from 13.3% to 5.2%. Although it reduces carbon leakage and enhances EU exports, CBAM’s value in mitigating climate change is limited. Whereas the potential EU domestic carbon price of $44 on all emissions reduces the global emissions by 13% – and by 21% in the case of a carbon price of $88 – the introduction of the CBAM adds another 0.8% to 1.3 % only. Therefore, ultimately, reduction of CO2 will come mainly from the domestic carbon pricing.

Several trade partners of the EU, particularly developing countries, including India, have already raised the impact on their exports and competitiveness. As per UNCTAD study, for most countries, this may not be the case. The simple average reduction in exports by developing countries in the targeted sectors is only 1.4 % when the CBAM is implemented with a $44 per ton tax, and just under 2.4% when implemented by an $88 per ton tax. The developing countries have, nevertheless, cried foul: while the ETS puts the burden on the domestic industry, the CBAM shifts the onus to foreign exporters raising fears of enhanced taxes and of incompatibility with WTO (World Trade Organization) rules.

True, without CBAM, developing countries as a group benefit from an increase of carbon prices in the EU and consequent production loss, by capturing part of the market and increasing their exports. This gain will be partially neutralized by the introduction of the CBAM (on the other hand, the exemption to LDCs and SIDS helps them slightly increase their exports, although starting from a low base). Therefore, while some countries will require support to incorporate green technologies, still others may require a smooth transition period. The UNCTAD study indicates, among the major G20 countries, Russia and China would be more affected due to high carbon intensity in the production, while Turkey and India would become more attractive due to low carbon production processes in this sector. This needs verification.

From a development perspective, CBAM promotes the reduction of GHG emissions of trade partners, but it would also do well to focus on how to pursue that endeavor. Reducing these emissions will require more efficient production and transport processes. This can be done by, inter alia, utilizing some of the revenue generated by the CBAM to infuse cleaner production technologies in the developing countries in the targeted sectors. Countries such as India may look to internalize carbon costs themselves rather than be subject to carbon taxes in other jurisdictions. This will require technology funding to incentivize developing country industries to adopt alternatives like solar power and hydrogen engines, which have lower impacts on the environment. These supplementary measures can narrow, and eventually eliminate, the gaps between developed and developing countries.

The sensitivity of production to carbon taxes is such that in an ideal situation, if a carbon tax is imposed globally, in all countries and all sectors, total global emissions would fall substantially, states UNCTAD. This would render CBAM superfluous and unnecessary. Going forward, the EU will understand that supplementary initiatives for cleaner production technologies are a sine qua non for a greener global economy and for a more inclusive trading system.

The EU is a major trade, technology and investment partner of India. India and the EU have a Strategic Partnership based on mutual interests and common values. We have a comprehensive dialogue framework across sectors. The EU approaches relations with India based on equality: it considers India equal to its 27 constituents, amongst the most developed countries in the world. Strict EU standards have helped raise the quality of Indian manufacturing. When I would argue with the European Commission on behalf of Indian industry, they would counter that the imports from India were no less in quality compared to German products! Let us sit down in a room with the Eurocrats, a highly professional body of diplomats, and work this out. The European Commission loves to negotiate a fair and balanced deal with its partners.

(The author is former Indian Ambassador. She also served as Counsellor/ Minister dealing with Trade Policy at the Indian Embassy in Brussels, accredited to EU, Belgium and Luxembourg. Views expressed are personal and do not reflect the official position or policy of Financial Express Online.)

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