Carbon tax's WTO test and opportunities for better India-EU trade terms

The change in political leadership in the US has signalled large-scale impairment of multilateral institutions. The World Trade Organization is of particular interest to Donald Trump. However, this will hit the developing world hardest at a time when these countries need it most to protect themselves from environmental regulations like the Carbon Border Adjustment Mechanism (CBAM).

 

The WTO does not have any specific agreement on environment. However, Article XX of the General Agreement on Tariffs and Trade (GATT) allows exceptions to free trade with adequate safeguards. The European Union (EU) claims it to be WTO-compliant. According to the EU, CBAM is non-discriminatory, as it does not violate the most-favoured nation (MFN) and national treatment (NT) clauses of the GATT. The EU has justified protecting the environment and restricting free trade under GATT articles XX(b) and XX(g). Article XX(b) is used to protect human, animal, or plant life or health, while Article XX(g) is applied for conserving exhaustible natural resources.

 

However, critics have opposite views stating that it violates the core provisions of the GATT, like Article I (relating to MFN treatment), Article II (tariff schedule), and Article III (NT). According to them, certain features of the CBAM — such as exempting some countries from its application, providing allowances for carbon prices paid in the country of origin, and estimating embedded emissions based on non-product-related process and production methods (NPR PPMs) — violate the MFN and NT principles.

 

Moreover, permits under the EU Emissions Trading System (ETS) are tradable, while CBAM certificates are not, which is seen as discriminatory. As a result, they believe the regulation will face numerous challenges at the WTO. The absence of an effective appellate body may have discouraged litigation for now. Further, if the existing free allowances continue even after CBAM becomes effective — as they are set to be fully phased out only by 2034 —it would be in gross violation of the NT clause of the GATT.

 

Although there is a provision for adjusting the free allowance for CBAM-covered commodities, how it will be implemented remains unclear. It would be equivalent to subsidising the EU domestic industry. So, the CBAM violates the core provisions of the GATT and cannot be shielded under Article XX.

 

Though the jury is still out on CBAM’s compatibility with the GATT, the balance seems tilted against it, primarily due to likely instances of discrimination at the implementation level — against non-EU countries compared to EU firms, violating the NT clause, and among exporting nations, violating the MFN principle of the GATT.

 

The top 10 countries worst affected by CBAM include China, Turkey, the UK, India, Russia, South Korea, the US, Serbia, Ukraine, and Japan, collectively accounting for nearly $68 billion in CBAM-covered goods exports to the EU in 2023.

 

Many studies have recommended exempting least developed countries (LDCs) from CBAM and applying special and differential treatment for developing countries, as permitted under the WTO’s Enabling Clause. Paragraphs 2(a) and 2(b) are most relevant in this regard. Paragraph 2(a) allows preferential treatment with respect to the agreed MFN tariff rates when trading with developing countries, administered through the Generalised System of Preferences (GSP). Paragraph 2(b) deals with non-tariff barriers.

 

If CBAM is regarded as an internal tax, paragraph 2(b) can be invoked to grant exemptions to less-developed countries. It is also possible to use paragraph 2(d), which allows LDCs to be treated separately from other developing countries while designing any blanket exemption for LDCs. Part IV of the GATT titled “Trade and Development” provides another set of relevant provisions to give exemptions to less-developed countries. It comprises mandatory obligations to reduce barriers on an urgent basis to products of particular export interest to “less-developed countries” and to refrain from imposing new barriers or increasing existing ones on such products.

 

Two important developments, however, cannot be ignored. One, it is unlikely that the WTO and its appellate body will revive soon. Therefore, any hopes that potential challenges will be finally resolved, have little substance. Two, climatic uncertainties experienced in the recent past have significantly altered the world view on climate issues. The palpability of the issue is real and it is unlikely that a decision-maker on the WTO panel will take a very generous view of such “non-compatibility” arguments.

 

As a more pragmatic alternative, developing countries need to adopt a unified stance on the challenge and initiate negotiations with the EU. Most developing countries may face pressures on their technical and resource capacities. It will be prudent to negotiate support for capacity development, technology sharing, pathways to come around non-tariff measures in this respect, and the development of appropriate standards to address technical challenges in a cost-effective and facilitative manner. Given the recent opposition to CBAM within the EU, this could be a worthwhile option.

 

The EU-CBAM could use different phase-in periods for various groups of less-developed countries based on objective criteria. This could involve providing different transition periods depending on their developmental status. Differentiated CBAM rates could also be considered for Annex I countries and non-Annex I countries of the United Nations Framework Convention on Climate Change, giving the most preferential treatment to LDCs. Paragraph 2(d) of Enabling Clause can be invoked for this purpose as it allows LDCs to be treated more favourably than other developing countries.

 

India-EU free-trade agreement negotiations are once again gaining momentum due to evolving geopolitics. It will be in India’s interest to take this opportunity to enforce a deal, hoping for the EU’s greater amenability for accommodation in view of the challenges it faces from the US on several issues and from within itself on CBAM’s rationale.

The authors are, respectively, distinguished fellow and consultant with RIS