In December 2022, the EU finalised an agreement on the regulation governing the much-discussed Carbon Border Adjustment Mechanism (CBAM), which is expected to come into force later this year. The CBAM forms a part of the EU’s larger climate strategy and is to be accompanied by a slew of other reforms. The CBAM’s stated purpose is to prevent the risk of carbon leakage, which can arise when producers shift base to jurisdictions with less stringent climate policies.

The CBAM will become operational from October 2023 whereby initially the CBAM would apply with reporting obligations only aimed at data collection. A full-fledged CBAM would be phased in along with a phasing out of the free allowances granted to European industries under its emissions trading system. This will provide exporters with an additional period to fully understand the CBAM prior to its implementation.

The EU is India’s third largest trading partner, accounting for €88 billion in goods trade in 2021, or 10.8 per cent of total Indian trade. Understandably, concerns over the possible impact of this measure on Indian exports to the EU are palpable. The imposition of the CBAM is likely to affect a significant share of India’s exports to the EU. In fact, the UNCTAD forecasts that India will lose $1-1.7 billion in exports of energy-intensive products such as steel and aluminium.

Primarily, aluminium and iron and steel exports seem to be at risk. In addition to the quantum of the “carbon border tax” itself, the CBAM will increase compliance costs by requiring companies to monitor, calculate, report, and verify emissions. However, as the CBAM is expected to be expanded to other sectors in the future, its impact could be significantly greater in the years to come.

From a developing country perspective, the CBAM also raises several policy issues. In effect, the CBAM constrains developing countries to either expedite their climate targets under the Paris Agreement or face a disadvantage in the EU market.

Indeed the BASIC (Brazil, South Africa, India and China) countries have criticised an EU CBAM saying that it would be coercive and/or punitive, violating both the UNFCCC CBDR principle and the nationally determined spirit of the Paris Agreement.

A joint statement “expressed grave concern regarding the proposal for introducing trade barriers such as a unilateral carbon border adjustment”. Further, the CBAM may also be discriminatory under WTO rules as it differentiates between the like products coming from different countries solely based on their carbon footprint.

Risk of domino effect

The CBAM also poses the risk of creating a domino-effect, whereby carbon border measures may become commonplace, with countries such as Australia and the US already looking at such measures.

India too has taken the first steps towards addressing such trade related environmental measures with the announcement of a Green Credit Programme to be developed under the Energy Conservation Act as announced by the Finance Minister in this year’s Budget. At this stage although the Green Credit System remains unclear, this may serve as a starting point for India to address measures such as the CBAM.

Currently, under the CBAM the embedded emissions are subject to a carbon price in the country of origin, the importer may claim a deduction in the charge (in the form of CBAM certificates) to be incurred. The introduction of Green Credit System in India may therefore help mitigate the financial impact of the CBAM to a certain extent.

Further, the proposed regulation exempts imports from certain third countries from the CBAM. The exemptions will be granted only to those third countries subject to the EU ETS or that have a domestic emissions trading system linked to the EU ETS under an agreement with the EU.

India may consider utilising the negotiating forums of the ongoing India-EU Free Trade Agreement to discuss issues such as equivalence, mutual recognition and exemption with respect to the CBAM.

From an economic perspective, the direct consequence of CBAM is going to be, at least in the early stages, increases in prices of the targeted commodities in the EU, insofar as these taxes and/or abatement costs are passed through the prices, while keeping profits intact.

Economy-wide impact of this would mean a slump in demand in not only these commodities but also others, via forward and backward linkages. Such a slump may severely affect the economic fortunes of the poorer countries despite their much lower per-capita emissions. This may also mean a trade diversion of exports from India as well as many other developing countries away from the EU towards other countries, resulting in an excess supply situation, thereby reducing the global prices of these commodities.

However, in the longer term, many countries may start complying with the CBAM related regulations to the extent that the marginal cost converges to zero.

Nevertheless, at least two questions arise that need to be addressed: Firstly, how long would it take to achieve this harmless longer-term equilibrium and what are the developing countries expected to do to mitigate economic losses to be suffered from until then, given that EU is a major trading partner to most of them.

And, secondly, how are we going to accurately measure the emissions at a firm-level and product-level particularly in a developing country, given the practical difficulties involved therein.

Notani is the Senior Partner and Head of International Trade and Customs Practice, Economic Laws Practice; Gopalakrishnan is Fellow, NITI Aayog. Views expressed are personal

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