The carbon border adjustment mechanism would aim to prevent carbon leakage resulting from carbon pricing in the EU emissions trading system.

By Paul A. Davies and Michael D. Green

On 22 July 2020, the European Commission (the Commission) published a consultation on a carbon border adjustment mechanism (CBAM) that is open until 28 October 2020. According to the Commission, the CBAM would aim to ensure equivalent carbon costs between imports and goods produced in the EU. Notably, the Commission’s COVID-19 recovery fund includes the CBAM as a repayment option. (For more on the recovery fund, see this post.)

Background — The Green Deal and Carbon Leakage

The consultation follows on from the Commission’s Green Deal, which proposes a framework of legislation that the EU could use to achieve its goal of net-zero greenhouse gas (GHG) emissions by 2050. (For more on the Green Deal, see this post.)

The Green Deal emphasises that “should differences in levels of [climate] ambition worldwide persist, as the EU increases its climate ambition, the Commission will propose a carbon border adjustment mechanism, for selected sectors, to reduce the risk of carbon leakage”. Carbon leakage occurs when companies in energy-intensive industries relocate from the EU to jurisdictions with less stringent emissions regulations due to the costs incurred under EU GHG emissions reduction policies.

The Commission notes that “if this risk [of carbon leakage] materialises, there will be no reduction in global emissions, and this will frustrate the efforts of the EU and its industries to meet the global climate objectives of the Paris Agreement”. The EU currently sets a carbon price through its emissions trading system (EU ETS), whereby EU emissions allowances are traded under an emissions cap, limiting the total amount of emissions to a pre-defined level.

CBAM

The Commission consulted on a list of sectors in which carbon leakage is high, for instance the production of aluminium, iron and steel. The consultation suggests the CBAM could take one of the following forms:

  • Extending the EU ETS to imports, and obliging foreign companies to buy carbon permits at the border
  • Creating a separate pool of EU ETS permits for foreign producers
  • Establishing a border tax on imports, to be levied on selected carbon intensive products produced in sectors at risk of carbon leakage
  • Creating a carbon tax (VAT or excise duty) at the consumption level on products produced in sectors at risk of carbon leakage (this would apply to EU production, as well as to imports)

Next Steps

Determining Carbon Footprint

Determining how to calculate a product’s carbon footprint is uncertain. For instance, one question is whether regulatory authorities should consider a product’s entire value chain in their assessment (e.g., by including emissions from the international transport of goods, or those emitted due to electricity used during product production). Another question is which entity would be responsible for verifying the carbon content of imported products.

WTO Compatibility

CBAM legislation must comply with World Trade Organization (WTO) rules (in particular the General Agreement on Tariffs and Trade (GATT)), as well as the EU’s other international obligations. In principle, WTO rules do not allow for discrimination between domestic and imported products that are directly competitive in the eyes of the final consumer because of the way they are produced (including the amount of carbon dioxide emitted during a product’s production).

However, supporters of the Commission’s plan state that the CBAM may be justified under an exceptions regime to GATT, which allows for measures on the grounds of human health and natural resources protection.

Political Agreement

The CBAM must be agreed politically both within the EU and amongst international trade partners. Certain industries and EU governments have begun lobbying for double safeguards, in order to support the bloc’s competitiveness while reducing its carbon footprint. However, trade partners such as Russia, China, and the US have suggested that they may challenge the CBAM under WTO rules.

In addition, EU policymakers may decide to exempt certain countries from the CBAM if their environmental goals and policies align with the EU’s. This decision is likely to be politically sensitive. WTO rules will again be relevant in this scenario as, under the “most-favoured-nation” principle, all imports into the EU should receive equal treatment.

In any case, EU regulators will be required to demonstrate that the CBAM seeks to reduce GHG emissions globally, rather than protect the EU’s own industries.

Latham & Watkins will continue to monitor developments in this area.

This post was written with the assistance of Emilie Cornelis in the London office of Latham & Watkins.