What Is Carbon Border Tax and How Will It Impact Developing Economies?

The imposition of a carbon border tax could pose challenges for emerging economies seeking to export to the European market.
This measure is poised to accelerate manufacturers' shift towards sustainable methods.
EU’s Carbon Border Adjustment Mechanism will be rolled out progressively, with the initial phase commencing in October 2023 and a complete implementation anticipated by 2026.

August 30, 2023 | Market Intelligence

Addressing climate change necessitates global solutions.

While the European Union (EU) scales up its climate goals, a potential issue of "carbon leakage" looms if less stringent climate regulations persist in non-EU countries.

Carbon leakage involves scenarios where EU-based companies relocate carbon-intensive manufacturing to countries with less rigorous climate policies than the EU, or when higher carbon imports replace EU products.

In this blog, we will delve into the concept of carbon border tax and examine its possible impact on the economies of developing countries.

What is Carbon Border Tax?

EU’s Carbon Border Adjustment Mechanism or CBAM is a tool aimed at equitably pricing carbon emissions arising from the production of carbon-intensive goods entering the bloc. It also seeks to promote cleaner industrial processes in non-EU nations. The phased implementation of CBAM corresponds with the gradual phasing out of free allowances distributed under the EU Emissions Trading System (ETS), a move aimed at decarbonizing industries in the bloc.

Through its verification of the payment for embedded carbon emissions produced in the manufacturing of specific imported goods, CBAM ensures parity between the carbon cost of imports and that of domestic production.

In doing so, it safeguards the integrity of EU's climate goals.

Importantly, CBAM's design considers compatibility with regulations established by the World Trade Organization (WTO).

In its first phase, CBAM will focus on goods most at risk of carbon leakage from cement, iron & steel, aluminum, fertilizers, hydrogen and electricity. Once fully in place by 2026, CBAM will work as follows:

EU importers of goods covered by CBAM will need to buy CBAM certificates. The price of the certificates will depend upon the weekly average auction price of EU emissions trading system (ETS) allowances expressed in €/ton of CO2 emitted.
The EU importer must declare by May 31 each year the quantity of goods and the embedded emissions in those goods imported into the EU in the preceding year. At the same time, the importer surrenders the number of CBAM certificates that corresponds to the amount of greenhouse gas emissions embedded in the products.
If importers can prove, based on verified information from third country producers, that a carbon price has already been paid during the production of the imported goods, the corresponding amount can be deducted from their final bill.

Potential Impact of CBAM on Developing Economies

India, in conjunction with other developing nations, has consistently voiced its resistance to the carbon border tax proposition put forth by the EU.

The BASIC bloc comprising of Brazil, South Africa, India, and China have labelled CBAM as "discriminatory." The apprehension stems from the fear that the carbon border tax could lead to higher costs for their products in the European market, potentially leading to decreased demand.

The U.K., Canada, Japan, the U.S. and several other countries are also bracing up to levy carbon border tax on imports. Nearly 40% of India’s merchandise exports go to these countries.

Effects of CBM on India’s Exports of Steel, Iron Ore, and Cement

The EU carbon expense might bring about expanded production costs for Indian steel, iron metal, and concrete exporters. The industries’ heavy reliance on fossil fuels such as coal increases carbon emissions and, as a result, carbon tax obligations. This could make Indian exports less competitive on the EU market. The possible impact can be categorized into following:

Market Access Difficulties: The imposition of a carbon tax could pose challenges for exporters seeking entry into the EU market. The increased costs linked to carbon-intensive manufacturing processes might lead to reduced demand for Indian steel, iron ore, and cement. To sustain their foothold in the market, exporters may have to reassess pricing approaches, explore more environmentally friendly production techniques, and engage in dialogues with EU counterparts.
Moving Towards Sustainable Manufacturing: The EU carbon tax offers enterprises an opportunity to expedite their shift towards sustainable operations. The exporters can choose to invest in technologies that advance the circular economy, amplify energy efficiency, and curtail carbon emissions. These actions not only align with the EU's stipulations but also enhance the long-term competitiveness and sustainability of Indian exports.

The transition towards sustainable manufacturing requires huge investment, which may not be viable for small- and medium-scale manufacturers.

For example, the production of hydrogen demands around 70% more wind and solar energy compared to the replacement of natural gas power plants with wind and solar setups. This nearly doubles the expense of manufacturing steel through the utilization of green hydrogen. The refinement of this technology is ongoing, with numerous startups involved in its development.

This could lead to technological advancements in energy efficiency, carbon capture and storage, and other environmentally friendly practices. Developing economies can benefit from these advancements by accessing and adapting such technologies.

The table below shows the impact of CBAM on India’s trade relation with EU, where carbon border taxation is estimated to be 20-35% tariff equivalent for most Indian products (the data is for calendar year 2022).

number-of-indias-tariff-lines-affected

Source: Ajay Srivastava, "EU’s green rules will derail trade", The Hindu Business Line, July 26, 2023

Conclusion

Although carbon taxes present a potent market-driven remedy for addressing climate change, their integration within developing economies necessitates thoughtful adaptation to the distinct socio-economic circumstances.

Developing economies should undertake several measures to address the complexities of carbon border taxation and its repercussions.

Potential actions encompass formulating and executing the carbon tax, fostering its industry understanding, and integrating it as a central element in the negotiations for new free trade agreements.

Author: Kartik Kulhari