The EU Border Carbon Adjustment: how to make it viable?

A post by Isabella Alloisio

The ratification of the Paris Agreement and heterogeneity in ambition in climate policy with non-comparable carbon constraints have reopened discussions over Border Carbon Adjustments (BCAs) as an alternative approach to free allocation for addressing carbon leakage (Mehling et al., 2019). Following the European Commission Communication on the European Green Deal, BCA is experiencing an upswing in political attention in Europe. The Commission has stated that “should differences in levels of ambition worldwide persist” it will propose a BCA for selected sectors (European Commission, 2019). Von der Leyen’s position is that the BCA measure would allow EU companies to compete with international rivals on a level playing field.

The inception impact assessment report for the EU Green Deal considers a few policy options to reduce the risk of carbon leakage: first, a carbon tax on selected products, both imported and domestic. Second, a new carbon customs duty or tax on imports. Third, an extension of the EU ETS to imports, so that the type of instrument and the level of carbon constraints applied to imports would be aligned with the EU domestic approach. The first two options would require to revising the EU energy tax directive with the constraint of unanimity vote under article 113 of the Treaty on the Functioning of the European Union. The latter option, despite requiring a review of the ETS regulations, seems to be the most technically, politically and legally feasible. However, two main barriers exist: first, the EU ETS only applies to specific regulated sectors making the scope of the BCA too limited with respect to the whole EU economy; second, intra-EU competition issues since countries that already have a domestic carbon tax in addition to the EU ETS should be allowed to adjust the BCA upward to include both the domestic carbon tax and the EU-wide EU ETS (Falcão, 2020).

BCA applies tariffs or other measures to imported goods from countries that do not have comparable emissions pricing requirements for their emissions-intensive goods. BCA may also include rebates or exemptions for domestic producers when exporting to markets without comparable emissions pricing. By leveling carbon costs on embodied emissions, a BCA aims to avoid carbon leakage from vulnerable sectors while strengthening incentives for abatement across industrial value chains, both domestically and abroad.

The introduction of a BCA has been extensively investigated in Europe over the last decade but has never been implemented. A French non-paper was presented at the EU Council in 2009, in preparation of the COP15 in Copenhagen. The idea was to tax goods from countries that do not sign up to a global climate change agreement in order to ensure that the environmental costs do not put European manufacturers at a competitive disadvantage. Justification from a political point of view was solid, but weak from legal standpoint. In 2016 another proposal from France to introduce BCAs for sectors with lower trade impact but high emissions intensity, such as cement, received the support by the European Parliament, but failed to be implemented. More recently, in 2019, a new French BCA proposal aimed to start with steel and cement and to extend it to aluminum and refining was presented at COP25 in Madrid. The proposal consisted in a gradual phase out of free allocations foreseen for the EU ETS most vulnerable sectors to carbon leakage, and with a benchmark set at the average carbon intensity of EU producers, allowing for the possibility of a more stringent level than the world average for the product.

As recalled by ICAP 2020, designing and implementing a BCA is elaborate and politically challenging. It requires careful consideration of design features ranging from scope, to coverage and the selection of benchmarks to determine the levels of adjustment, as well as risks of legal challenges based on World Trade Organization (WTO) rules to which the BCA mechanism should comply. As for the sectoral scope, legally the BCA could not be broader than what is covered under the domestic carbon pricing system. Also, it should be determined whether the BCA applies to imports, exports, or both (full BCA). As for emissions coverage, it should be decided whether the mechanism applies to direct emissions only (scope one emissions) or to indirect emissions from energy-related inputs (scope two emissions) as well.

Ensuring a feasible and legally robust design may present a trade-off relative to the BCA’s effectiveness against carbon leakage and in driving decarbonization. An example of EU steel sector (Dröge et al, 2009), shows that a full BCA (imports and exports) applied to both direct and indirect emissions would lead to a negative leakage rate of -25%, meaning emissions reductions would occur in both the implementing jurisdiction and among importing countries. A more limited BCA covering only imports and direct emissions leads to a leakage rate of less than 10%, significantly better than no border levelling (39%), but far less impactful than the comprehensive approach.

However, should the BCA mechanism be an alternative to the EU ETS free allocation of emission allowances, as it reads in the EU Green Deal, a fierce opposition would trigger from cement, aluminium and steel producers which would like the new measures to be additional and not alternative protection against competitors with weaker climate policies. Nevertheless, the EU officials’ real challenge is designing a CBA mechanism compliant with the World Trade Organisation (WTO) rules. The WTO decides whether a BCA is allowed under the General Agreement on Tariffs and Trade (GATT) [1]. According to the GATT, the tax that is either applied at the border on import or credited back on export must impose an equivalent (“like”) burden on products that are produced domestically and on those that are imported. Therefore, for the BCA to be legally valid the tax cannot impose an undue burden on the foreign product under penalty of being considered as discriminatory measure under the GATT. Furthermore, the most important rule under the GATT is that the BCA is applied on a product and not on a process. Taxes applied on production processes are known as hidden taxes and they are forbidden under WTO rules.[2]

As reported by ICAP 2020, there are three options under which a BCA implemented by an ETS jurisdiction is more likely to comply with international trade law (Mehling et al., 2019):

  1. adjusting for an internal tax or other internal charge under GATT Article III.2[3];
  2. adjusting for an internal regulation under GATT Article III.4[4];
  3. as a general exception to GATT on environmental grounds under GATT Article XX[5].

The first two options would require that the BCA follows WTO rules of non-discrimination which require, as already observed, that imports are not charged more than “like” domestic products and that any advantages or exemptions granted to domestic products are also extended to imports. The third option of seeking an exception to GATT under Article XX on environmental grounds still includes the rule of non-discrimination, along with other likely constraints based on WTO case law. Based on past international environmental trade disputes, the jurisdiction implementing a BCA will likely have to demonstrate that its scheme substantively addresses climate change (Cosbey et al., 2019).

Other challenges to the implementation of an EU border carbon adjustment mechanism come from the inner difference between the design of the BCA mechanism and the architecture of the Paris Agreement, as supported by Peter Vis in a recent article by Bloomberg. The BCA is meant as an EU-wide import levy, which is in contrast with the voluntary pledges of the Paris Agreement represented by the Nationally Determined Contributions (NDCs). Moreover, as supported by Marroni from MRC consultants, another challenge is raised by issues of “eco-imperialism”, when BCA is perceived as a move to put the developed world on a collision course with China, India and other developing countries, seriously damaging the international trade system. In the case of an introduction of a BCA mechanism in the EU, this would prevent developing countries’ own right to benefit from the revenues derived from a EU carbon tax. Indeed, the EU would apply the BCA mechanism instead of a carbon tax in the country of origin and it would employ the revenues towards its own budgetary objectives (Falcão, 2020).

In conclusion, there are many challenges in the design and implementation of a BCA, both in theory and in practice. It is important that any BCA is not becoming purely a tax, a form of arbitrary trade discrimination between countries, nor a barrier to trade. A possible way is linking the BCA to the emissions trading system. However, the real problem is the practical feasibility. Although levies could be made WTO-compliant, in theory, it would be almost impossible to tailor them to individual imports without knowing the carbon emissions up and down the manufacturing process, and monitoring those emissions may be unfeasible, if not impossible. It would, therefore, be needed a standardized carbon footprint tracking methodology applied to global supply chains with the aim to collect the data required for a BCA implementation.

[1] GATT is the General Agreement on Tariffs and Trade, a multilateral trade agreement aimed at the abolition of quotas and the reduction of tariff duties among the contracting nations, with the aim of stimulating free international trade.

[2] An example in the energy sector is a tax on fuel versus a tax on energy consumption or production.

[3] The products of the territory of any contracting party imported into the territory of any other contracting party shall not be subject, directly or indirectly, to internal taxes or other internal charges of any kind in excess of those applied, directly or indirectly, to like domestic products.  Moreover, no contracting party shall otherwise apply internal taxes or other internal charges to imported or domestic products in a manner contrary to the principles set forth in par. 1.

[4] The products of the territory of any contracting party imported into the territory of any other contracting party shall be accorded treatment no less favourable than that accorded to like products of national origin in respect of all laws, regulations and requirements affecting their internal sale, offering for sale, purchase, transportation, distribution or use.

[5] Subject to the requirement that such measures are not applied in a manner which would constitute a means of arbitrary or unjustifiable discrimination between countries where the same conditions prevail, or a disguised restriction on international trade, nothing in this Agreement shall be construed to prevent the adoption or enforcement by any contracting party of measures: (…) (g) relating to the conservation of exhaustible natural resources if such measures are made effective in conjunction with restrictions on domestic production or consumption. (…)