Proposal being considered
September, 2021 in Issue 3 - 2021, Cover Story
In recent years, EU stakeholders have been considering the introduction of a carbon border adjustment mechanism (CBAM). The idea is that, since the EU is heavily investing in a greener economy – which will raise production costs for its manufacturers – companies could be faced with less ‘green’ but more competitive ‘like products’ from outside the EU, where environmental regulation may be less strict and production less costly. Therefore, the EU is considering a mechanism that would penalise imports of carbon-intensive goods in order to level the playing field.
In the EU, certain emissions are currently regulated through its Emission Trading System (ETS). This is based on the ‘cap-trade system’ principle, where a limit is set on the amount of certain greenhouse gas (GHG) emissions that may be emitted by defined industry sectors. Within the cap, companies can receive or buy allowances that can be traded with other companies.
The cap is then linearly reduced over time so that the total emissions decrease. The ETS covers the electricity and heat generation industry; commercial aviation within the European Economic Area; aluminium production; and certain energy-intensive industrial sectors like cement, glass and oil refineries. It does not apply to the agricultural sector.
A proposal for review of the ETS was published on July 14, 2021, as part of the EU’s ‘Fit for 55’ legislative package. The proposal extends its scope to the maritime sector and foresees the establishment of a separate self-standing ETS from 2025 for road transport, as well as for energy efficiency of buildings.
A main criticism of the ETS concerns the free allocation of allowances, which is used to safeguard ‘the international competitiveness of industrial sectors at risk of carbon leakage’. Carbon leakage refers to the situation in which EU production moves to non-EU countries that have less ambitious emission rules and lower production costs, due to less burdensome climate policies. Industries that receive free allowances are not obliged to reduce emissions at the same pace as industries that do not receive free allowances.
A 2020 report by the European Court of Auditors noted that industries receiving free allowances continue to represent 94% of EU industrial carbon emissions. In order for the EU to reach its target of zero emissions by 2050, free allowances would need to be reduced to zero. Therefore, the EU considers the CBAM as a key tool to address carbon leakage with a mechanism that seeks to ‘equalise’ GHG costs of imports with those of domestic production.
Last year, the European Commission (EC) invited the public to submit feedback on the legislative Roadmap on the CBAM, which is aimed at ensuring ‘that the price of imports reflects more accurately their carbon content’. The EC is also to design a new policy to reduce EU carbon emissions, addressing ‘carbon leakage’ and incentivising other countries to join emission reduction efforts.
The legislative Roadmap listed four options for the CBAM:
Until now, there has been no clarity on the design of the EC’s legislative proposal and on how the CBAM could work in practice. At the time of writing, a public consultation is being conducted, with submissions to be accepted up to Sept 10.
European Parliament’s stance
On March 10, 2021, the European Parliament adopted its position on the CBAM through a Resolution on ‘A WTO-compatible EU carbon border adjustment mechanism’. This position is to be taken into account by the EC, as it works towards the publication of its legislative proposal.
The Resolution underlines that the European Parliament supports the introduction of a CBAM ‘provided that it is compatible with WTO rules and EU free trade agreements by not being discriminatory or constituting a disguised restriction on international trade’; and that a CBAM ‘should be exclusively designed to advance climate objectives and not to be misused as a tool of protectionism, unjustifiable discrimination or restriction’.
Indeed, this should be the objective, but it remains to be seen if the EU will actually deliver on this or if the CBAM will protect EU businesses rather than the environment.
While the European Parliament assessed the four options being considered by the EC, the Resolution focuses on options 1 (import tax), 3 (which mirrors the ETS) and 4 (a ‘carbon tax’).
Most notably, the Resolution encourages the EC to pursue option 3 and to propose a CBAM based on the ETS. According to the European Parliament, while complying with WTO rules, the CBAM would need ‘to charge the carbon content of imports in a way that mirrors the carbon costs paid by EU producers’.
It should be noted that the option favoured by the European Parliament would not immediately affect the agricultural sector. In fact, under this option, the mechanism would mirror the ETS and its current coverage of sectors. The other options would not strictly follow the ETS sectors, which could mean that those options would cover a broader range of sectors, possibly including agriculture.
In its Resolution, the European Parliament recognised that products not falling under the ETS should be considered and that, in order to achieve the objectives of the European Green Deal, the CBAM mechanism should be accompanied by ‘necessary measures in non-ETS sectors’. Such measures could affect palm oil, as agriculture is a non-ETS sector.
The Resolution highlights that the option of an excise duty (option 4) on the carbon content of all consumed products – domestic and imported – would not ‘fully address the risk of carbon leakage’. It notes that this would be ‘technically challenging given the complexity of tracing carbon in global value chains and might place a significant burden on consumers’.
The Resolution further acknowledges that a fixed duty or tax on imports (option 1) could be a simple tool and would provide ‘a strong and stable environmental price signal for imported carbon’, but that – if the CBAM were to be of a fiscal nature – unanimity would be required in the Council of the EU.
Importantly, the Resolution ‘stresses that the CBAM should ensure that importers from third countries are not charged twice for the carbon content of their products’ and that ‘Least Developed Countries and Small Island Developing States should be given special treatment’.
Legal uncertainties
While the objectives of the CBAM are clear, many legal uncertainties remain. Consequently, the legal viability of the concept has yet to be determined. The EU should strive to develop a mechanism that complies with relevant WTO disciplines. How the EU designs and applies the CBAM will be crucial in determining its consistency with WTO rules, especially if the EU were to apply a border measure that only targets imports.
The General Agreement on Tariffs and Trade (GATT) prohibits WTO Members from imposing tariffs and charges in excess of the levels committed in their respective Schedule of Concessions. In addition, the GATT prohibits levying internal taxes or charges in excess of those applied to ‘like’ domestic products.
The European Parliament proposes a CBAM based on the ETS so as to ensure that both domestic producers and importers pay the same carbon price. Notably, a difficulty arises when assessing whether the charge levied by a WTO Member on an imported product is equivalent to that applied to the domestic product – for example, where the importing country does not maintain a simple tax scheme, but a more complex scheme, such as the ETS.
With respect to the issue of ‘likeness’ under Article III of the GATT on ‘National Treatment on Internal Taxation and Regulation’, processing methods cannot currently be used to classify two products as different (or not ‘like’). EU policies that discriminate against imported products vis-à-vis ‘like’ domestic products, based on how they are produced, risk being incompatible with WTO rules, notably with the non-discrimination principle. Therefore, a CBAM would run the risk of being inconsistent with WTO rules.
Article XX of the GATT on ‘General Exceptions’ does allow WTO Members to adopt certain (otherwise discriminatory) measures, for instance when they are justified in order to protect human, animal or plant life or health, or when they relate to the conservation of exhaustible natural resources. Both exceptions are subject to strict requirements and, over the years, in the majority of disputes, WTO Members have failed to successfully justify their environment-related measures under Article XX.
In particular, the exception for measures to protect human, animal or plant life or health would need to pass the necessity test; this would determine whether such measures are ‘necessary’ to achieve the policy objectives being pursued.
To consider a measure ‘necessary’, a WTO panel would need to assess the extent of the measure’s contribution to the achievement of its objective; and its trade restrictiveness in light of the importance of the interests or values at stake.
Concerns expressed
While the EU may be pursuing legitimate objectives with its environmental policies that drive up its costs, such regulatory requirements should not be detrimental to businesses around the world which are already subject to domestic requirements.
Countries like Australia, China, India, Indonesia, Japan and Singapore have already expressed concern, indicating that they perceive the CBAM as a unilaterally imposed and potentially protectionist measure that would be discriminatory and negatively affect trade.
They point out that countries in Asia and the Pacific region have been developing or already have their own carbon pricing approaches, which the EU might not be taking into account. Therefore, these countries have asked the EU to create a CBAM that would take their measures and mechanisms into consideration.
More specifically, certain Asian countries and in particular Indonesia and Malaysia, have called on the EU to work with third countries and not to take a unilateral decision that would cause a situation comparable to the discrimination of palm oil under the EU’s revised Renewable Energy Directive (RED II). Additionally, several countries have said that the EU should use the revenues generated by a CBAM to help developing countries in their decarbonisation efforts.
Any CBAM introduced by the EU must be implemented in the least trade-restrictive manner possible. However, it can already be expected that any such mechanism, regardless of its design, will be challenged by other WTO Members.
Given existing EU policies, such as the RED II, it should also be clearly advocated that the CBAM should not apply to agricultural products, including palm oil.
On April 26, 2021, EC Executive Vice-President and Commissioner for Trade Valdis Dombrovskis stated that the proposal on the CBAM was only the beginning of the discussion.
Stakeholders, including those in Malaysia, should therefore ensure that their perspectives and positions are heard, in order to achieve a balanced and non-discriminatory mechanism – ideally one that is based on multilateral approaches and not on unilateral obligations.
Dato’ Dr Wan Zawawi Wan Ismail
CEO, MPOC
