EU’s ‘Carbon Border Adjustment Mechanism’: How will it impact trade?

Introduced in 2023 by the European Union, the ‘Carbon Border Adjustment Mechanism’ will apply a carbon price on emissions embedded in the production of carbon-intensive goods imported to the region. In this post, Gupta, Pandey and Sapatnekar contend that the initiative can impact trade competitiveness and profitability of exporters, favouring nations with faster decarbonisation ability and robust carbon pricing systems.

The European Union (EU) has enhanced its climate commitment to achieve at least a 55% reduction in its net greenhouse gas (GHG) emissions by 2030 (compared to 1990 levels), and achieve climate-neutrality by 2050. To meet these ambitious climate commitments, the EU brought into effect the Carbon Border Adjustment Mechanism (CBAM) in May 2023, as one of the initiatives under its ‘Fit-for-55’ legislative package.

When completely implemented, the CBAM will apply a carbon price on emissions embedded in the production of carbon-intensive goods imported to the EU. Essentially, a non-EU producer would be required to purchase a CBAM certificate for every tonne of CO₂/CO₂e (carbon dioxide or equivalent) emissions at a price that mirrors the carbon price under the EU’s Emissions Trading System (EU ETS). By doing so, the EU aims to ensure that both imported and domestic goods are subjected to similar carbon pricing rules, thereby creating a level playing field.

The underlying rationale for CBAM stems from the risk of ‘carbon leakage’ – that is, the risk of EU-based producers relocating to countries with relatively lax environmental standards to circumvent costs associated with stringent climate policies within the EU. Therefore, the EU asserts that CBAM will reduce the risk of emissions shifting to non-EU countries and of carbon-intensive goods flooding its economy, while encouraging other jurisdictions to enhance their decarbonisation efforts as well.

The ‘transition period’ of CBAM has already been underway since October 2023, requiring non-EU producers to regularly furnish verified emissions data related to their exported goods. CBAM’s ‘definitive period’ will begin from 2026 onwards, requiring exporters to face a financial obligation by purchasing CBAM certificates for their reported emissions. Over the period 2026-2034, the CBAM’s financial obligation will be phased-in progressively as the system of free allowances for emissions under the EU ETS is phased out. Consequently, exporters’ carbon liability is expected to gradually increase as the free allowances decrease under the EU ETS for CBAM-covered sectors.

In recent research (Gupta, Pandey and Sapatnekar 2024), we discuss how CBAM can impact trade competitiveness and profitability of exporters, favouring nations with faster decarbonisation ability and robust carbon pricing systems. This article presents key takeaways and potential pathways from our analysis.

Disparities in export dependence, emission intensity, and carbon pricing

Currently, the scope of CBAM extends to imported goods and their relevant input materials (precursors) pertaining to six sectors. These sectors – namely, cement, fertilisers, aluminium, chemicals (hydrogen), electricity, and iron and steel – are deemed to be emission-intensive and at a high risk of carbon leakage under the EU ETS. Producers of goods covered under these sectors with a high degree of export dependence on the EU will be particularly vulnerable to the impacts of CBAM, in terms of complicated monitoring, reporting, and verification (MRV) processes or fluctuations in the EU ETS carbon price. At present, the main exporters of CBAM commodities fall in Central Asia, Europe, North Africa, and the Middle East (Brenton and Chemutai 2021). Over time, CBAM’s scope is expected to widen, potentially causing further uncertainty and transition risks for exporters to the EU.

Given that CBAM’s financial obligations for exporters will directly depend on their emissions intensity of production, relatively cleaner exporters are likely to gain trade competitiveness at a global scale. Therefore, the adoption levels of decarbonisation and energy-efficient technologies of an exporter vis-à-vis their competitors can be a significant factor in determining trade competitiveness moving forward (Asian Development Bank, 2024).

An Asian Development Bank brief also notes that although the overall impact of CBAM for Asian economies is limited, some economies can face significant cost increases at a sectoral level (Park, Yamamoto and Doong 2023). For instance, Kazakhstan in aluminium, Georgia in fertiliser, and India in the iron and steel sector, are likely to be impacted considering both emissions intensity of production and export dependence on the EU.

The additional cost from CBAM implementation for India, relative to average EU production, is expected to be US$3.01 per tonne of carbon emitted. At a sectoral level, India’s iron and steel sector is expected to incur the highest additional cost of US$4.36 per tonne of emissions, relative to an average EU producer of the same output. In comparison to India, countries facing lower additional costs for CBAM products stand to gain a competitive advantage.

The impact of CBAM on trade competitiveness will also depend on the existence or level of development of carbon pricing systems in exporting countries. Jurisdictions with a carbon pricing system, or those that move faster towards setting up one, are likely to benefit in the long run. This is because such jurisdictions can claim a deduction from CBAM’s financial obligation corresponding to the carbon price already paid domestically. Therefore, exporting countries that can obtain a relatively larger deduction because of their domestic carbon pricing policies stand to gain under CBAM. However, given the non-existent or nascent stage of carbon pricing systems in emerging economies in comparison to the EU’s ETS (which has been active since 2005), the issue of carbon pricing disparity adds another layer of complexity.

Lack of technical capacity in emissions monitoring and reporting

An apparent challenge facing non-EU producers, especially in developing economies, is the lack of infrastructure and technical capacity to monitor and report accurate emissions data. In the absence of reliable emissions data, default values would be used to calculate the emission intensity of exported goods, based on the EU’s calculations. As the technology and energy mix in production can vary widely across countries, the use of default value can lead to misrepresentation of data (Brauch et al. 2021). Moreover, if the default values are higher than the actual emissions, an exporter might end up overpaying for their emissions.

Concerns regarding CBAM in climate and trade-related discussions

The implementation of CBAM raises the bigger issue of fragmentations in the climate policy and trade discourse. Developing nations, including India through the BRICS platform formed along with Brazil, Russia, China and South Africa, have argued that EU’s CBAM is a protectionist and discriminatory measure that also violates the United Nations’ ‘Common But Differentiated Responsibilities’ (CBDR) principle by ignoring the specific climate action trajectory adopted by countries. Further, such concerns have been extended to challenge CBAM’s compatibility with WTO (World Trade Organization) rules. Additionally, CBAM revenues, which are primarily intended to serve the EU’s own decarbonisation efforts, bring up the question of fairness amidst the international discussion around climate justice and the need for climate finance from developed to developing economies.

Potential pathways for India in a changing global trade landscape

Despite contentions, EU’s CBAM is an indication of a changing global trade landscape – one that is increasingly considering the emission intensity of production. Developed economies like the UK, Australia, Canada and the United States (Gangotra, Carlsen and Kennedy 2023) have also expressed interest in implementing their own versions of CBAM, citing the risk of carbon leakage as the reason.

In this light, it is imperative to focus on adaptation measures at entity and government levels, especially in terms of strengthening emissions MRV capacities and domestic carbon pricing mechanisms. At present, there is no explicit carbon tax or emissions trading system in India, although India’s Carbon Credit Trading Scheme (CCTS) is under development. The CCTS could consider CBAM-related impacts, international standards, and insights from other jurisdictions to strengthen its carbon market.

Additionally, the Indian government could consider changing the nomenclature of the coal component under GST (Goods and Services Tax) Compensation Cess to a ‘carbon tax’, which could help reduce the potential carbon liabilities of industries under CBAM. Moreover, a taskforce could be established to inform public policy on the interrelated and evolving issues of climate commitments, development goals, carbon markets, and the changing global trade landscape.

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