EU carbon tariffs on the horizon – what Australian trading businesses need to know

The impact could be significant 6 min read

The European Union's Parliament (EP) has adopted a resolution supporting the introduction of a Carbon Border Adjustment Mechanism (CBAM) to tax carbon emissions embedded in foreign imports entering the EU. The EP has resolved to implement by 2023 a regime (eg a carbon tariff) that is compliant with World Trade Organization (WTO) rules. The European Commission is expected to put forward a detailed plan in June.

In this Insight we discuss the policy objective of the proposed CBAM, whether it would comply with WTO rules and the impact it may have on Australian trading businesses.

Key takeaways

• The EU is taking steps to implement its goals under the European Green Deal by incentivising its foreign trading partners to de-carbonise. It is also seeking to level the playing field for European producers paying a carbon price under the EU's emissions trading scheme (ETS).
• Compliance with WTO rules requires that the CBAM be aimed at reducing carbon emissions globally, and is not merely a protectionist trade instrument that discriminates against foreign imports or particular foreign countries.
• If legislated, the CBAM will likely affect Australian exports such as aluminium, steel and chemicals. Moreover, the CBAM may set a global precedent for other states, including the US and UK.

An EU carbon tariff: who, what, when, where and why?

Policy objectives and design of the CBAM

On 10 March 2021, the EP passed a resolution for 'a WTO-compatible EU carbon border adjustment mechanism'.

The EP's resolution states that the purpose of the CBAM is to 'level the playing field' for locally produced goods that are subject to the ETS, and to facilitate the EU's progress toward its climate objectives under the European Green Deal and global de-carbonisation, in line with the Paris Agreement objectives.

The effect of the CBAM will be to put a price on carbon emissions from commodities and products imported into the EU, including emissions embedded in intermediate or final products. This is intended to support the EU's ETS, which is a 'cap and trade system' regulating the EU's domestic carbon emissions. However, the ETS does not cover emissions embedded in imports and it does not stop EU companies shifting operations to countries with less onerous restrictions on carbon emissions, which the EP is concerned results in 'carbon leakage' to other jurisdictions. Currently, the EU estimates that net imports represent more than 20% of the EU's domestic carbon emissions. It is expected that the CBAM will first cover the energy sector and industrial sectors such as steel, aluminium, cement, paper, glass and various chemical products.

The EU is currently assessing different options for the implementation of the CBAM, including a tax or tariff on imported goods linked to the ETS. The CBAM is expected to require foreign exporters of carbon-intensive products to show that the carbon content of their products is not greater than the ETS 'free allocation benchmark' for the relevant industry. That is, the carbon content of the imported product must not be greater than the benchmark amount permitted for the product under the ETS. If it is, using a tariff mechanism as an example, a tariff will be applied on the carbon content above the benchmark equivalent to the market pricing under the ETS. The proposed mechanism contemplates credits or exemptions for imported products from countries already taxing carbon.

There are several significant implementation issues to be worked through, including how ETS free allocations would be translated into an equivalent tax or tariff for each imported product and what the relevant technical criteria should be to assess foreign carbon reduction regimes, and to value the carbon price of imports.

WTO compliance issues

The EP has resolved that the CBAM must comply with WTO rules, including the General Agreement on Tariffs and Trade (GATT).

Under the GATT, states may generally impose measures that are necessary to achieve environmental goals, provided they do not violate the 'national treatment' or 'most-favoured-nation' principles.¹ This means the CBAM cannot discriminate against imports (ie it cannot preference products from domestic sources) or between different sources of imports (ie it cannot preference products from certain countries). Accordingly, the CBAM must be a mechanism to reduce carbon emissions globally, not a disguised protectionist restriction on international trade.

Impact for Australian trading businesses

The impact of the CBAM on Australian trading businesses could be significant. Australian aluminium, steel and chemical industries are among those that are likely to be most impacted by the foreshadowed mechanism.

The CBAM seeks to incentivise Australian businesses trading in relevant commodities and products to reduce their carbon emissions, or otherwise be forced to absorb the carbon price imposed by the CBAM (or pass it down the supply chain) – challenging their ability to remain competitive.

Companies will likely need to undertake complex calculations to determine and certify the carbon footprint of an affected product, including emissions generated by shipping the product. Measuring, reporting and factoring in the costs of a product's carbon footprint may involve significant compliance costs.

The Australian Government is opposed to the tax burden imposed by the CBAM. Trade Minister Dan Tehan recently announced that the Government will push back against the CBAM via the WTO. Instead, it will argue for a plan to eliminate tariffs on certain environmentally friendly products and services.

Timeframe and next steps

The EU is expected to engage with the WTO and trading partners to assess the legal and technical feasibility of different forms of the CBAM. The European Commission is expected to put forward a more detailed legislative proposal in June this year, with implementation by 2023. Although the legislative proposal is expected to be politically contentious amongst some EU Member States, the EP's resolution indicates that it has broad-based political support within the EU.

The CBAM may become a global precedent for carbon tariffs. Despite indicating some initial resistance to the proposed CBAM, the US has indicated a long-term plan to follow the EU in enacting carbon border tariffs. Commentators have suggested the UK will also likely follow this path. Ambitious environmental targets set by Australia's key trading partners Japan, China and South Korea last year may also indicate a growing appetite globally for the implementation of carbon tariff regimes.

Actions you can take now

• Monitor developments in relation to the CBAM, including engagement between the EU, its trading partners and the WTO.
• Consider how best to be in a position to reduce and calculate the carbon embedded in products to be exported to the EU.
• Consider the impact on EU exports if carbon taxes or tariffs are introduced.