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The EU’s CO2 Border Adjustment: Climate or Fiscal Policy?

Point of View, 05.08.2020 Forschungsgebiete

The EU plans to use a CO2 border adjustment on imports to improve its budget. In so doing, it risks eroding the instrument’s credibility as a response to climate change, argues Susanne Dröge.

The heads of state and government of the European Union propose introducing a “carbon border adjustment mechanism” from 2023, to charge imported goods according to the CO2 emitted during their production. At their recent summit, they decided to use the ensuing revenues to boost the EU’s budget. This gives a fiscal twist to an instrument actually designed for climate policy.

Commission President Ursula von der Leyen had already announced in 2019 that she would like to introduce a “carbon border tax” as part of her European Green Deal. In spring 2020, the Commission launched a roadmap process to prepare concrete legislative proposals by 2021. The Commission’s proposal also responds to fears that higher European CO2 costs caused by EU emissions trading (EU ETS) could cause companies to relocate activities outside the EU, causing carbon leakage. Outsourcing would contribute to reducing European emissions – but not to tackling the global problem. To date, the Union has addressed the risk of relocation by allocating free emission allowances to sectors at risk of carbon leakage. A CO2 border adjustment could create an alternative with a global impact.

There is rising support for the idea, after years of resistance from many member states and business associations. And the pressure is set to grow, with an increase in the EU’s climate target for 2030 – and anticipated higher CO2 costs for EU businesses – expected this autumn. Furthermore, a CO2 border adjustment for foreign products will be widely interpreted as a clear message, especially to Washington and Beijing, that the EU intends to implement the Paris Agreement. When designing the instrument, it will be important to comply with WTO rules and to get important trading partners on board. 

WTO-compatible design

The Commission proposes three ways in which a “carbon border adjustment mechanism” could be implemented: “a carbon tax on selected products, a new carbon customs duty or the extension of the EU ETS to imports”. From a trade law perspective, any of these options could be designed in accordance with WTO rules. The crucial aspect is the principle of non-discrimination: that a CO2 border adjustment must not differentiate among like products or between WTO members. If it were necessary to depart from the principle, for example where a trading partner or individual company is able to demonstrate that it is already taking care of emissions reductions, the rules for exceptions would need to be observed.

An EU-wide CO2 “product tax” and its implementation by the EU member states would be the most straightforward approach from a trade law perspective. To do this, the EU would first have to levy a CO2 tax on goods manufactured in the European Union; then it would be unproblematic to apply this tax to imports as well – the value added tax for example follows this approach. Imported “like” products would be treated the same way as domestic products, which is WTO-compliant. Extending the EU ETS to industrial imports would be more complex. The task for the Commission would be to demonstrate that under trade law the CO2 allowance price is ultimately equivalent to a “product tax”. Failing that, the Commission could argue that it was acting to protect a global resource, i.e. that avoiding carbon leakage was the central aim of the EU legislation. The “conservation of exhaustible natural resources”, which includes the earth’s atmosphere, is a valid ground for violating WTO principles, subject to certain conditions. Such an exemption would also have to be claimed for a new CO2 customs duty.

However, the European Council decision has exacerbated the risk that WTO dispute settlement panels will regard the new instrument as a means of generating income, rather than a means to protect the climate. This would make a difference if trading partners challenged the new tool. The climate focus, which would be taken into account in WTO rulings, is currently slipping into the background.

Don’t underestimate the diplomatic effort

A CO2 border adjustment mechanism will need extensive explanation given the many open details, and it can only promote international climate policy cooperation if trade partners are informed at an early stage and regularly consulted. For this, the EU should use WTO forums and the climate regime as well as other international organizations. In 2012, the European Commission was made painfully aware of the difficulties involved in going it alone, after seeking to include international aviation in the EU ETS. Major partners put political pressure on the EU, even threatening sanctions, and the EU decided to backtrack and reduce the coverage of the ETS to flights within the European Economic Area.

Trust can only arise if the EU adheres to multilateral climate and trade agreements, i.e. supports the Paris Agreement and the troubled WTO, and expresses this clearly and often. This task has probably become much more difficult after the European Council decision, because a fiscally motivated border adjustment cannot be convincingly attributed to these multilateral concerns – especially as the revenues would flow to the EU rather than to funds supporting climate protection, for example in poorer countries. If a CO2 border adjustment specifically targeted cement, steel and other energy-intensive industries, as has already been discussed, producers from emerging and industrialized countries would be especially affected. The Union should start discussions with these countries without delay. A good opportunity will arise at the meeting of G20 finance ministers in Saudi Arabia towards the end of the year. In addition, the EU should insist towards Washington that this initiative is not intended as a provocation in the smoldering customs dispute. Ultimately, the climate policy success of a CO2 border adjustment will depend on how the world’s major economies react to it.

This text was also published at fairobserver.com.