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Border carbon adjustments revisited

The incoming European Commission is putting the fight against climate change at the heart of its action.

So, here we go again! The issue of ‘border carbon adjustments’ has been a hot topic for a decade among academics. It is now high on the political agenda.

Ursula von der Leyen, president-elect of the European Commission, announced that carbon border taxes are one of the measures she considers introducing in her coming five-year tenure.

The new European Union leader’s aim is to avoid ‘carbon leakage’ so that “our companies can compete on a level playing field”. Von der Leyen promises the measures to be “fully compliant with World Trade Organization rules”. She would “start with a number of selected sectors” and then see to it that the taxes are gradually extended.

‘To level the playing field’ – a legitimate ambition?

The first question is whether the ambition to ‘level the playing field’ is reasonable or even desirable. The concept in itself is suspect: trade and other interchange between nations are essentially based on differences in various respects.

Company or labour union calls for similar or ‘fair’ conditions for competition have often been made when low-priced imports have threatened domestic production. These claims have often ignored the fact that these imports simply reflect differences in productivity or education levels, for example.

It can be argued that preserving the climate – which is a global public good – is a higher goal. If tough climate-related policy measures are introduced in certain countries, these may become ineffective in stopping or reducing carbon dioxide emissions if this just leads to an increase in CO2 production in countries with more lenient or no climate protecting measures. For each ton of carbon dioxide which is emitted in the atmosphere, the negative climate effect is the same – regardless of whether the emissions come from Europe, Brazil or China.

Three ways to tackle ‘carbon leakage’

There are roughly three types of instruments that governments can use to avoid ‘carbon leakage’ – in other words to avoid the increase of carbon emissions outside a given country or region as a direct result of its mitigation measures. The three types of measures are:

– International agreements;

– Internal cost-reducing measures such as free allocation of carbon credits, exemption of domestic carbon taxes or tax rebates, or subsidies;

– Unilateral border carbon adjustments, either in the form of border taxes or mandatory requirements for importers to hold emission allowances.

The best way to arrive at a situation with no carbon leakage would of course be to reach a global binding agreement whereby the marginal cost for emitting carbon dioxide would be the same for the biggest emitters. In today´s world, this seems utopian for a variety of reasons – political, economic and institutional.

In the short and medium-term, this leaves only two options for governments to deal with the risk of carbon leakage: either internal cost-reducing measures or unilateral adjustments at the border such asborder carbon adjustments.

Internal or external adjustment mechanisms?

So far, the EU and other countries that have introduced cap-and-trade schemes – also known as emissions trading systems – have opted for internal adjustment measures instead of various types of unilateral adjustments at the border.

As for the EU emissions trading system – the ETS – the European Commission stated in 2014 that the method of distributing emission allowances for free would continue and that border carbon adjustments should be seen as an “option of last resort”.

Back then, the Commission thought that “it could be hard to implement a system which sought to define in detail the carbon content of each individual category of goods, but such precision might be required”.

This is a probably a gross understatement. It would be extremely difficult to calculate in a fair and objective way the carbon content embedded in imported goods. Carbon emissions may differ from company to company and even within the same company. In addition, this is a moving target: products, production processes and technology continually change.

A study by the Swedish National Board of Trade sheds further light on the practical difficulties that would arise in administering border carbon adjustments. As an example, the study shows that a country which intends to apply such measures has to put in place a system for border controls.

In 2014, the Commission also stated that a system of border carbon adjustments could at best only be envisaged for a limited number of standardised commodities, such as steel or cement: “For each category of goods an average EU carbon content would have to be defined. This could become an administrative burden, and require agreement on such an average. This is] likely to be a difficult and protracted process.”

The Commission further deemed it “challenging to verify the performance of individual installations in third countries without a highly sophisticated monitoring and reporting system in place at installation level”.

Carbon taxes, tariffs or other border adjustment mechanisms?

The Commission president-elect’s announced carbon border tax would presumably be set at the same level as a domestic carbon tax. But no such tax at EU-level exists.

The probability that such a tax will be introduced in the near future is low. If a carbon tax on imports is not accompanied by a domestic carbon tax, the measure would be contrary to the principle of national treatment in the World Trade Organization.

So, given the present EU emissions trading scheme, the EU would have to rely on a border adjustment mechanism that would charge imported goods the equivalent of what they would have had to pay for emissions caused by the production process, had they been produced domestically.

It is yet unclear whether the EU will ultimately opt for some form of a carbon border tax – which presupposes a common unitary carbon tax in the EU – or try to incorporate importers into the present EU emissions trading system.

Border tax adjustments can be introduced in order to avoid either double taxation or no taxation. However, only indirect taxes – product taxes – are eligible for international tax adjustment. It is legally doubtful whether carbon taxes may be classified as product taxes.

Academic literature is divided on whether a tax on an input – such as carbon – that is not physically incorporated into the final product can be adjusted at the border. Existing case law is not conclusive since the legal precedents do not specifically address the issue of inputs which are fully consumed in the production process – as is the case with CO2.

Expert commentary is similarly divided as to the applicability of border tax adjustment for emission trading schemes. Most scholars assume that a prerequisite would be auction allowances instead of freely handed-out permits as is currently partly the practice in the EU.

WTO legality?

It is an open question whether unilateral border carbon adjustments will create problems in relation to the WTO rulebook. Much will depend on whether such measures create substantial negative effects for the trade of other countries and – above all – if these countries find it worthwhile and consistent with their interests to notify other countries´ measures to the WTO and start litigation proceedings there.

The consistency of carbon border adjustments with WTO law is currently very unclear and would need more clarification. Scholars are divided.

Is it possible to expand principles of border carbon adjustments as they have been interpreted by the GATT Working Party fifty years ago to other fields like carbon taxes? According to the analysis made by the National Board of Trade, this is doubtful at the very least.

It is also not clear whether emission trading schemes can be seen as equivalent to an internal tax on domestic products, especially if emission trading schemes allocate allowances for free.

Alternatively a justification under the environmental exceptions of GATT Article XX would be needed to justify any discrimination against imported products. WTO case law is very attentive to uncovering measures that pretend to be for environmental reasons but serve in fact other purposes, such as protection for domestic producers.

Moreover, Article XX of the GATT requires taking into account local conditions in foreign countries. This may force the imposing country to consider whether other countries have adopted comparable measures and if developing countries should carry the same burden as other countries. This may entail that border measures could not fully be applied to developing countries.

In any case, the design of a carbon measure will be crucial.

 

Peter Kleen is Senior Adviser at Global Challenge in Stockholm, Sweden. He was formerly Director-General of the National Board of Trade.

Recommended reading: Climate measures and trade – Legal and economic aspects of border carbon adjustment, National Board of Trade, Stockholm, 2009, a study which this op-ed draws heavily upon.

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