Introduction

"....Taxation is a key part of ESG, on one hand, as a useful tool to be considered by the economic actors in the structuring and setting up of ESG policies, and, on the other hand, as a relevant standard to assess if those economic actors are ESG compliant"1

Recent tax policy discourse has seen 'carbon taxes' becoming a popular tool to tackle climate change, especially as a part of environmental, social and governance ("ESG") initiatives. Carbon regulatory measures, especially carbon border taxes, have been under consideration by European Union ('EU') and the United States for imposition on imported goods.2 India too has adopted carbon-mitigation measures such as the 'Perform, Achieve and Trade' ("PAT") scheme, carbon cess, renewable purchase obligation and renewable energy certificates.3 The most recent carbon measure has been the Carbon Border Adjustment Mechanism ("CBAM") Agreement which is the culmination of negotiations between the European Commission, European Parliament and European Council to bolster the decarbonisation agenda of the EU.4 The need for EU's CBAM apparently arose from the problem of 'carbon leakage' that has supposedly been corroding its efforts under its 'Fit for 55 package' aimed towards reducing the EU's Greenhouse Gas ("GHG") emissions by 55% percent from the 1990 benchmark level by 2030.5

  1. Regulatory Design and Mechanism of CBAM

Towards the establishment of CBAM, the European Parliament adopted a resolution titled 'WTO-compatible EU carbon border adjustment mechanism' on 10 March 2021, promulgating a mechanism which directly links CBAM with the current EU Emission Trading System ("EU ETS") which works on a 'cap-and-trade' principle.6 Essentially, under a system following a 'cap-and-trade' principle, a cap is set on the total amount of GHG emissions that companies covered by the system can emit, and within the cap, these companies can buy or receive allowances that can be traded, as needed.7 In such a system, a carbon price could create a disadvantage for companies undertaking production in the EU, relative to production from jurisdictions without carbon price, in a process called 'carbon leakage.'8 To prevent such leakage, the EU freely allocates allowances to companies that are deemed to be at-risk of carbon leakage.9 However, the grant of free allowances diminishes the incentive for companies to reduce GHG emissions, especially when it can bank certificates to cover any future needs.10 To address this shortcoming, the CBAM is proposed to act as an import tariff on carbon-intensive goods imported from abroad.11

The CBAM system will work by following the carbon border adjustment mechanism.12 The EU importers will buy carbon certificates equivalent to the carbon price they would have been required to pay had the goods been produced under EU's carbon pricing rules. The price of the certificate would be computed based on the weekly auction price of EU ETS allowances expressed in ? / tonne of GHG emitted. Further, on 31st May each year, the EU importer would be required to make declarations regarding the quantity of goods covered by CBAM imported that year, and the embedded emissions in those goods. At this stage, the EU importer would also be required to surrender any excess certificate that they have purchased in advance. It is to be noted that this financial adjustment would not be payable in the transitional phase from October 2023 to December 2025. Although the CBAM mirrors the EU ETS, in the sense that the system involves the purchase of certificates, the importers would need to register with national authorities who would be required to not only facilitate the registration, but also review and assess the declarations made by the importers.13 In this regard, if the non-EU producer is able to establish (based on verifiable information) that the goods have already suffered a carbon price in a third-party country, suitable deductions would be permitted in CBAM.14 As such, the commonality between EU ETS and CBAM is restricted to price alone as it does not follow the 'cap-and-trade' principle.15 Nonetheless, the CBAM will be complemented with changes in the EU ETS towards phasing out of free allowances which will be enforced in a gradual manner.16 Until then, the CBAM would be applicable only to specified goods, and in direct proportion to the free allowances granted to those goods under the EU ETS.17 CBAM is proposed to be implemented in the same manner as EU customs law. This means that the EU importers of covered goods would be required to classify the imported goods as per EU's combined nomenclature codes and ensure accurate declaration of country of origin in accordance with the EU's customs rules on non-preferential origin.18

  1. Applicability and scope of CBAM

In principle, imports from all non-EU countries would be covered under CBAM.19 However, exclusions from the CBAM system will be allowed to EU ETS participant countries, or countries that have an equivalent system linked to EU ETS, such as Switzerland, Norway and Iceland.20 Initially, during its specified transition phase between the years 2023 to 2025, CBAM is proposed to be applicable to a specified set of carbon-intensive and hard-to-abate industries viz., aluminium, cement, electricity, fertilizer, iron and steel, and also hydrogen.21 Towards the end of the transitional period, based on the evaluation of the efficacy of CBAM, a decision will be taken on the expansion of its scope to more goods and services - including goods that are down the value chain; and whether to cover 'indirect' emissions such as GHG emissions from the electricity used in production of goods.22 Further, after end of the transitional period, a decision will also be taken on whether any exemptions would be granted to non-EU countries.23 The grant of such exemption, however, would likely be subject to strict adherence to specified obligations and commitments, which the EU will revise in 2030, at which point the non-EU countries are expected to have adopted the decarbonisation measures which include establishment of an emission trading system equivalent to that of the EU.24 Besides, with respect to the expansion of the covered goods under CBAM, priority would again be given to goods that are at a high risk of carbon leakage.25 It is expected that chemicals, plastics and some other sectors, that were initially considered for transitional coverage would be included in the expanded scope.26

  1. Limitations of CBAM

On the surface, the CBAM seeks to perform the function of an economic remedy, with each imported product having to bear the same carbon price that is borne by EU businesses through the operation of EU ETS.27 By virtue of this, CBAM purports to create a level playing field between EU and non-EU companies, with exemptions being granted in cases where an 'explicit' carbon price has already been imposed by countries due to the operation of jurisdictional emission trading schemes or cases where the countries are participants of EU ETS or directly linked to it.28 However, from an environmental integrity perspective, the CBAM may face criticism for its myopic economic rationale as it fails to consider non-price based GHG emission reduction polices adopted by non-EU countries.29 The stringency and effectiveness of such non-price-based policies that may be in force in different jurisdictions have also not been considered.30 For example, while India does not impose an 'explicit' carbon price, it does have an array of mechanisms and schemes that put an 'indirect / implicit' price on carbon.31 The PAT scheme, goods and services tax compensation cess and fuel excise taxes, etc. are examples of implicit carbon pricing measures.32 Practically, the CBAM imposes a carbon price on companies from developing countries, especially Least Developed Countries ('LDC') who probably had very limited contribution towards climate change.33 Examples of such LDCs include Zimbabwe for its iron and steel, Mozambique for its aluminium exports, Morocco and the North African countries for their fertilizers, etc.34 The embedded GHG emissions from the imports made from such countries constitute an insignificant portion of the GHG emissions embodied in the total imports to the EU.35 Further, the requirement for producers to declare the embedded GHG emissions in goods can impose a substantial technical and administrative cost on the suppliers from the LDCs, who may not have the capability or capacity to make a fair calculation for the purpose of CBAM.36 Thus, the application of CBAM could adversely erode the LCDs opportunities for export-led development.37

  1. Compatibility with WTO Law and India's Proposal

Since its inception, it has been insisted that the CBAM would be compatible with the World Trade Organisation ("WTO") rules.38 However, the key litmus test for this determination is 2 (two) parameters, viz., whether it is non-preferential and reciprocal.39 Although the EU argues that the carbon price paid by the non-EU producer would be equivalent to the cost of allowances that EU producers would be required to pay under the EU ETS; by excluding non-price based 'implicit' carbon prices from its consideration, the CBAM fails to treat 'environmentally equivalent' goods in the same way as goods originating from countries that have an 'explicit' carbon price.40 However, from a WTO perspective, any challenge alleging failure to meet the primary tests under WTO rules, would be required to be made on a case-to-case basis.41 Further, a case can also be made out against the exclusions granted to non-EU producers to the extent of the 'explicit' carbon price paid in the country of origin, or even the blanket exemption to countries that are participants of EU ETS or are linked to it.42 It could be argued that the same violates the Most Favoured Nation ("MFN") principle.43 In fact, inconsistency with the MFN principle could also be claimed in relation to the discrimination between EU and non-EU producers based on embedded GHG emissions.44 Pertinently, CBAM being a charge on imported goods, would most likely also exceed the ceiling on customs duties and levies for customs clearance that have been agreed by the EU in its WTO commitments.45 This may prove to be another breach of a basic WTO norm. In response, while the EU may contend that the CBAM is an internal regulation, the fact the obligation to pay is accrued on the import of goods, the CBAM qualifies as an import measure that acts as a non-tariff barrier. Incidentally, non-compliance with the Paris Agreement could also be alleged as the CBAM departs from its 'common but differentiated capacities principle.'46 In this regard, India in its proposal titled 'Concerns on Emerging Trends of Ushing Environmental Measures as Protectionist Non-Tariff Measures' has claimed that the CBAM is a protectionist measure that cannot achieve any greening of the economy by stating as follows:47

"Carbon border measures (CBAMs) that are being considered (by the European Union and the United States) for imposition on imported products, effectively amount to prioritising a singular policy of the importing country over those of exporting countries and will amount to imposing a unilateral vision of how to combat climate change. ....Not only will such measures undermine the multilaterally agreed mandate of NDCs (Nationally Determined Contributions) of the country of export, but also create (a) distinct preferential treatment for domestic over imported goods".

In its proposal India has highlighted that environmental policy measures are being imposed without contextual risk assessment and absent any consideration for differences in climatic and soil conditions across the world. It also raised concerns regarding 'green tariff rates' that "seek to develop a methodology to assess the carbon content of traded commodities and provide specific tariff-free quotas to select Members".49

  1. Remedial action for Indian Exporters to EU

The EU is India's third largest trading partner, with trade amounting to USD 116.36 billion in financial year ("FY") 2021 - 2022.50 Further, despite the global disruptions caused by the COVID-19 pandemic, the bilateral trade with EU achieved an annual growth of 43% in the said year.51 In July 2022 India has even concluded the first round of negotiations for the 'India-EU Trade and Investment Agreements' in New Delhi.52 Although India had previously communicated its strong opposition to CBAM at the end of their April 2021 BASIC group meeting on climate change, and now in its proposal to WTO has even outlined alternative unilateral measures that may be adopted to combat climate change, it is unlikely that the EU or other states looking to adopt carbon borders measures such as the CBAM, will incorporate all or any of the recommendations made in India's proposal.53 Besides, the recent passage of the Energy Conservation (Amendment) Bill in December 2022, as a precursor to the establishment of a cap-and-trade system in India (similar to EU ETS), empowers the government to specify a domestic carbon credit trading scheme and requires covered business to meet certain non-fossil fuel energy use obligations.54 However, implementation of the measures prescribed therein would take some time. Consequently, at least for the upcoming transition period of CBAM, it is imperative that necessary representations are put forth before the Government to bolster the plea seeking consideration of 'indirect/implicit' carbon prices that are borne by goods exported by India for CBAM exclusions. Without strong objections from India and other aggrieved countries, the CBAM would severely affect relevant sectors that export to the EU. In any event, exporters of the sectors covered in the transitional phase would need to undertake the following processes to adapt to the CBAM mechanism:55

  1. At the outset, covered businesses would need to assess the implications of CBAM on their business model, considering it will impact not only customs declarations, but also its sourcing and supply chains.
  2. Exporters to the EU may be required to undertake an assessment of their global supply chain and also assess the potential for reducing GHG emissions and creation of a sustainable, environment friendly supply chain.
  3. As the importers are mandated to declare the embedded GHG emission in their imports, detailing both the direct and indirect GHG emissions and the carbon price paid in the country of origin, Indian exporters would need to undertake the necessary technical and administrative analysis beforehand to provide such information to their EU importers/customers.
  4. Accordingly, exporters will need to adopt processes and systems for carbon accounting to track the embedded CGC emissions associated with their products, and separately adopt mechanisms for independent verification of these embedded emissions as well.
  5. Further, exporters would also need to ensure that the data elements required for a global supply chain review conducted under the CBAM system is readily available and meet the quality requirements of EU. For this, a monitoring, reporting and verification system would also need to be adopted.

Conclusion

The impact and reach of CBAM in EU should be a wake-up call for India, as also other countries, regarding the urgent need for a comprehensive and concerted effort towards decarbonisation. Even if the proposed form of CBAM is not adopted, it is still a harbinger of things to come - of tighter carbon regulations, standards, and taxes that could take various forms in the future. As stated by India in its proposal to the WTO, "shared global concerns need global solutions, and small clubs cannot achieve this."56 Without a concerted effort, measures such as CBAM will significantly weigh down trade partners, especially developing countries and LDCs, with tedious and costly compliances.57

As trade rules directly govern the global flow of goods and services, trade policies such a CBAM can offer substantial monetary reward for deeper decarbonization. It remains to be seen, however, to what degree the CBAM will succeed in incentivizing decarbonization and whether it will spur a reciprocal policy cycle among global trading partners or, if it will start another round of trade wars.58

Footnotes

1 See "ESG and taxation: a new challenge ahead" by João Miguel Fernandes as available at https://www.internationaltaxreview.com/article/2bft226iti7ozkcso7bwh/sponsored/esg-and-taxation-a-new-challenge-ahead

2 The Wire's Article dated 02 March 2023 by Ravi Kanth Devarakonda titled "Is India Serious About its Plans to Galvanise the Global South?: https://thewire.in/diplomacy/is-india-serious-about-its-plans-to-galvanise-the-global-south

3 Article by Mannat Jaspal in Observer Research Foundation's Occasional Papers September 2022 issue (Issue No. 368) titled "To Price or not to Price? Making a Case for a Carbon Pricing Mechanism for India."

4 European Commission Press Release dated 13 December 2022

5 Centre for Strategic & International Studies Brief, February 2023 titled "Analyzing the European Union's Carbon Border Adjustment Mechanism" by Emily Benson, Joseph Majkut, William A. Reinsch, and Federico Steinberg (hereinafter referred to as "CSIS Brief.")

6 European Commission Final Report of the "Study on the possibility to set up a carbon border adjustment mechanism on selected sectors" dated July 2021

7 ibid

8 ibid

9 CSIS Brief (n.4)

10 CSIS Brief (n.4)

11 ibid

12 European Commission's FAQs and Press Note on Carbon Border Adjustment Mechanism dated 14 July 2021

13 ibid. Also refer EU Proposal for a "Regulation of the European Parliament and of the Council Establishing a Carbon Border Adjustment Mechanism" | COM(2021) 564 final dated 14. July 2021 (hereinafter referred to as "EU CBAM proposal")

14 EU CBAM proposal (n.12). Also refer, European Commission's FAQs and Press Note on Carbon Border Adjustment Mechanism dated 14 July 2021

15 ibid

16 ibid

17 ibid

18 EU CBAM proposal (n.12), refer Article 6 and Article 7

19 European Commission's FAQs and Press Note on Carbon Border Adjustment Mechanism dated 14 July 2021

20 ibid

21 European Commission's FAQs on Carbon Border Adjustment Mechanism dated 14 July 2021

22 ibid

23 ibid

24 ibid

25 ibid

26 ibid. Also see, Dentons Report titled "EU carbon pricing goes global | Preparing for the Carbon Border Adjustment Mechanism" dated 27 May 2021

27 Research Note | Carbon Border Measures, Environmental Effectiveness and WTO Law Compatibility: Is There a Way Forward for the Steel and Aluminium Climate Club?" by Giulia Claudia Leonelli | World Trade Review (2022), 21, 619-632 (hereinafter 'Carbon Border Measures')

28 ibid

29 ibid

30 ibid

31 Article by Mannat Jaspal in Observer Research Foundation's Occasional Papers September 2022 issue (Issue No. 368) titled "To Price or not to Price? Making a Case for a Carbon Pricing Mechanism for India."

32 ibid

33 Article by Rim Berahab titled "Is the EU's Carbon Border Adjustment Mechanism a Threat for Developing Countries?" published on 13 January 2022 and United Nations Conference on Trade and Development Report titled "A European Union Carbon Border Adjustment Mechanism: Implications for developing countries" dated 14 July 2021 (hereinafter "UNCTAD Report")

34 ibid

35 ibid. See also, "An EU Tax on African Carbon - Assessing the Impact and Ways Forward' by Samuel Pleeck, Fatima Denton and Ian Mitchell published on 10 February 2022

36 Article by Rim Berahab titled "Is the EU's Carbon Border Adjustment Mechanism a Threat for Developing Countries?" published on 13 January 2022

37 ibid

38 UNCTAD Report (n. 32)

39 CSIS Brief (n. 4)

40 CSIS Brief (n. 4)

41 ibid, See also: European Communities - Asbestos: https://www.wto.org/english/tratop_e/envir_e/edis09_e.htm

42 Carbon Border Measures' (n. 26); See also, G. C. Hufbauer et al. (2021), Can EU Carbon Border Adjustment Measures Propel WTO Climate Talks?, PIEE Policy Brief.

43 ibid

44 Briefing Paper No. 125, "Legal Issues with the European Carbon Border Adjustment Mechanism" by James Bacchus dated 9 August 2021 |CATO Institute (hereinafter "CATO Institute Briefing Paper")

45 ibid

46 ibid

47 The Wire Article by Ravi Kanth Devarakonda titled 'India Serious About its Plans to Galvanise the Global South? dated 02 March 2023 https://thewire.in/diplomacy/is-india-serious-about-its-plans-to-galvanise-the-global-south: See also, https://docs.wto.org/dol2fe/Pages/FE_Search/FE_S_S006.aspx?DataSource=Cat&query=@Symbol=%22JOB/TE/78%22&Context=ScriptedSearches&languageUIChanged=true

48 ibid

49 ibid

50 Ministry of Commerce and Industry Press Release dated 02 July 2022 by PIB Delhi

51 ibid

52 ibid

53 Business Standard Article titled 'India writes to WTO against Carbon border tax: here's all you need to know' dated 16 February 2023 https://www.business-standard.com/article/economy-policy/india-writes-to-wto-against-carbon-border-tax-here-s-all-you-need-to-know-123021601319_1.html#:~:text=India%20has%20written%20to%20WTO%20raising%20concerns%20over%20the%20selective,such%20measures%2C%20the%20report%20said.

54 Hindustan times Article by Jayshree Nandi titled: Energy conservation bill gets Rajya Sabha nod' dated 13 December 2022 https://www.hindustantimes.com/india-news/energy-conservation-bill-gets-rajya-sabha-nod-101670869864782.html

55 KPMG report: Provisional agreements in EU on emissions trading, carbon border adjustments, and climate funding dated 22 December 2022

56 The Wire Article by Ravi Kanth Devarakonda titled 'India Serious About its Plans to Galvanise the Global South? dated 02 March 2023 https://thewire.in/diplomacy/is-india-serious-about-its-plans-to-galvanise-the-global-south. See also, https://docs.wto.org/dol2fe/Pages/FE_Search/FE_S_S006.aspx?DataSource=Cat&query=@Symbol=%22JOB/TE/78%22&Context=ScriptedSearches&languageUIChanged=true

57 ibid

58 CSIS Brief (n.4)

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