The Many Problems of EU’s Carbon Tax Regime

The first wave of environmental, social and governance (ESG) regulations across the world focused on disclosures and transparency. The later ones are not only directed towards more specific outcomes but are also multi-jurisdictional in reach. This is especially true with the European Union Carbon Border Adjustment Mechanism (CBAM) and the recently approved Corporate Sustainability Due Diligence Directive of the European Union. Both these regulations will impact business operations in many countries across the world.

CBAM is an import tax regime based on embedded emissions and covers six emission-intensive sectors. It is expected to significantly impact iron and steel and aluminum sectors in India because of the high export revenue they generate and the high level of embedded carbon in the Indian products. According to the Ministry of Commerce and Industry, in 2022, India exported steel and aluminum worth $6 billion and $2.3 billion respectively to the European Union. It further states that Indian exports to the region grew significantly, from $41 billion in 2021 to $65 billion in 2022. With a global export target of $770 billion in FY24, India will be eying further growth in exports to the European Union in coming years. Therefore, CBAM could act as a roadblock to India’s export growth plan.

CBAM is built on the premise that stiff emission caps on the European Union businesses will lead to emission leakage, or, in other words, production and, therefore, emissions will move outside the region where the caps are less stringent or do not exist. Emission leakage is a legitimate concern for the region, considering the significant level of decarbonisation it has already achieved and its commitment to further decarbonise.

As part of the new “fit for 55 in 2030 package”, the European Union plans to reduce emissions by at least 55% by 2030 compared to the 1990 levels, while emissions in the EU Emission Trading System (ETS), within the sectors covered by the compliance carbon market, will be cut by 62% by 2030 compared to 2005 levels. Therefore, CBAM represents a mechanism to achieve a legitimate goal, but through the wrong means, when viewed through the lens of a developing economy.

CBAM Not an Incentive

According to Mohammed Chahim, the European Parliament’s lead negotiator of the CBAM deal, “CBAM will be a crucial pillar of European climate policies. It is one of the only mechanisms we have to incentivise our trading partners to decarbonize their manufacturing industry.” However, as a new tax regime, CBAM is a hard sell as an “incentive” programme. How is the European Union imposing a carbon tax and keeping the money to itself going to incentivise an exporter to decarbonise its product? If decarbonisation must happen in the exporting country or facility, this carbon tax money must be invested back in that country/facility to improve efficiencies, switch to new fuels or deploy new technologies.

ETS Carbon Price Not a Just Transition

Since the beginning of the ETS in 2005, the European Union reduced emission covered under it by 43%, as per an article on the European Commission website, Increasing the ambition of EU emissions trading. Along this journey, the average carbon price has stayed well below €20 for almost 16 years. Only during 2020–22, the price has shot up to touch €100. That means, the price of carbon is not uniform throughout the emission intensity curve. Therefore, for a developing country exporter, being forced to pay carbon tax at the prevailing ETS carbon price level goes against the spirit of just transition. The level of decarbonisation that the European Union has achieved over the last 18 years cannot be matched in two or three years, especially by a developing country like India. The provision within CBAM that allows exporters to deduct any local carbon price is not sufficient relief, because most developing countries do not have a carbon price, or, if they do, it is much lower than the ETS price.

Also, the tax collected under CBAM will accrue to the European Union budget under “own resource”. According to a Financial Times report in July 2021, the European Union expects CBAM to raise nearly €10 billion a year when it is fully underway. The report claims that the region has earmarked CBAM revenue to help cover the cost of its €750 billion recovery fund, money borrowed to help member countries post-pandemic. This is another confirmation that CBAM is not an incentive to the trade partners. It is just another tax regime—another revenue stream—where the imposing countries benefit, given their position of advantage.

Against the Principles of Global Convention

ESG regulations targeting climate action are particularly vulnerable to criticism if they do not acknowledge Common But Differentiated Responsibilities (CBDR), a reference to legacy emissions, of countries. CBAM undermines Principles 1 and 2 under Article 3 of the United Nations Framework Convention on Climate Change. Principle 1 states that the parties should protect the climate system for the benefit of present and future generations of humankind on the basis of equity and in accordance with their CBDR and respective capabilities.

Principle 2 states that the specific needs and special circumstances of developing country parties, especially those that are particularly vulnerable to the adverse effects of climate change, and of those parties, especially developing country parties, that would have to bear a disproportionate or abnormal burden under the convention, should be given full consideration.

It is clear that CBAM makes no such differentiation, and it does not give any consideration, let alone full consideration, to the disproportionate and abnormal burden that it will be putting on developing country parties.

Many affected countries are engaging with the European Union to reduce the impact of CBAM on their trade balance and economy. India is hoping to leverage free trade discussion with it to find a solution. In the next four months, leading up to October when CBAM comes into force, and even after that, in its transition phase during 2024–25, the European Union has an opportunity to make this transition just for developing countries. 

Bose Varghese heads ESG practice at law firm Cyril Amarchand Mangaldas