The European Union announced a new emissions target that the bloc would seek to reduce its net emissions by 55 percent by 2030 from the 1990 levels. As part of the EU’s initiatives to reach this ambitious climate goal, it’s drafting a carbon border adjustment mechanism to protect European producers’ competitiveness and incentivize other jurisdictions to implement climate policies. The official carbon border adjustment mechanism proposal is expected to be released next month. However, the pending drafts of the proposal were leaked last week. There is nothing really surprising in the draft documents as the EU officials discussed possible design details over the last year. 

Here is a summary of what the proposal includes according to the draft documents:

Covered products?

The draft proposal seems to be expanding the EU Emissions Trading System to include certain carbon-intensive imported goods, such as steel, cement, electricity, fertilizer, and iron.

How would it work?

The draft proposal would levy an import tax on eligible imported goods. There is no mention of providing export rebates to European exporters, according to the draft documents. 

Importers would be required to purchase emissions certificates from a new carbon border adjustment mechanism (CBAM) authority to cover the carbon emissions embedded in the goods imported in the previous year. Targeted emissions in the proposal include both direct emissions from the production processes of the eligible imported goods and indirect emissions associated with generating the electricity used in the manufacturing processes. 

Emissions certificate prices are set based on the average closing prices for all ETS permit trading each week. The price would then apply to the CBAM emissions certificates purchased in the following week. By the end of May every year, importers would be required to report the total amount of emissions associated with the goods imported in the previous year and submit the total required number of emissions certificates they purchased.

Which countries would be subject to the import tax?

The proposal seeks to adopt a differential treatment on imported goods to account for the carbon pricing policies in the country of origin. Imported goods from countries with a carbon price could be fully or partially exempted from the import tax. Specifically, according to the draft documents, “An authorised declarant may in its declaration claim a reduction in the number of CBAM certificates to be surrendered corresponding to the carbon price paid in the country of origin for the declared emissions.” 

What remains to be seen?

Will the new carbon border tax replace the existing free allowances? It’s unclear how much longer the free allowances will continue to be issued to certain industries or manufacturers within the EU ETS.  If the carbon border tax is implemented alongside the existing free allowances, this would certainly be perceived as protectionism. Both policies aim to level the playing field between EU and foreign producers.

What carbon prices will count toward acceptable emissions mitigation outside of the EU? It also remains to be seen as to what type of carbon pricing policy would be deemed acceptable to warrant a credit for reducing the required amount of emissions certificates to be purchased. Though according to the language used in the draft documents, it would seem that only explicit carbon pricing policies such as an emissions permit trading scheme, or a carbon tax, would be acceptable. 

What changes might WTO compliance require? The biggest question mark that remains with the draft proposal is perhaps whether any design details of the proposal would be changed to ensure compliance with the WTO rules. A differential treatment approach would potentially violate the WTO’s most-favored-nation rule. Using the environmental provision in Article XX to justify the differential treatment approach is not without its challenges. 

Based on the leaked draft proposal, the EU carbon border adjustment would not look like a standard border adjustment used in other tax types such as a value-added tax, which combines an import tax and an export rebate with a domestic tax. The EU is under tremendous pressure from its industry to enact an import tax as the ETS permit prices have gone up significantly this year. It seems that the draft proposal is trying to kill two birds with one stone—to protect EU producers’ competitiveness and to encourage other jurisdictions to put a price on carbon. 

A well-designed carbon border adjustment coupled with a domestic carbon price would effectively and efficiently incentivize emissions reduction. However it is still too early to determine the potential impact of the EU carbon border tax until we know the finalized design of the policy.