CBAM changes trade rules: India needs carbon pricing, not exemptions

CBAM to penalise polluting exporters; India should push for deep EU trade pact and simpler carbon tax over complex cap-and-trade

Discussion on global warming has existed since the early 1990s. For decades, this remained in the domain of conferences, treaties, and corporate social responsibility reports. Practical people often ignored it. Climate-change considerations first impinged upon the real world through the changed behaviour of the global financial system. The mighty tycoons of the Indian business world moved away from fossil fuels because global finance showed them that the path to more wealth lay in renewables. And now, we are ready for the second big impact of climate-change considerations upon reality: The carbon border tax. This will accelerate global decarbonisation, it will fight global warming, and as India stands to suffer greatly from global warming, this is good news for us. In January next year, the Carbon Border Adjustment Mechanism (CBAM) begins implementation in the European Union (EU). The global trading system is thus at a regime change where polluting firms are directly affected. This requires a reset in how we in India think about business strategy and trade diplomacy. 

There is a misconception in some quarters that the CBAM is a form of protectionism. The analogy with value-added tax (VAT) is useful. VAT is a destination-based tax. It is levied where consumption occurs. There is tax neutrality: European producers and Indian producers are treated identically when selling in Europe. 

The CBAM applies this same logic to carbon. The EU has a domestic price on carbon. If an Indian firm exports steel to the EU, and pays no carbon tax in India, the EU imposes a levy equivalent to the difference between the EU carbon price and the Indian carbon price. This gives tax neutrality: European producers and Indian producers are treated identically when selling in Europe. This is not protectionism. 

As with VAT, the CBAM has virality. The United Kingdom has already signalled intent. We expect other nations of the Organisation for Economic Cooperation and Development will follow. Fighting this as a trade barrier is an intellectual failure. It is as futile as asking a trading partner to exempt its VAT-on-imports for Indian sellers into that country. 

This creates a new landscape for Indian firms. In the pre-CBAM world, a firm could be a “pollution hero”. This is a firm that generates high profits by utilising dirty energy and imposing negative externalities. Current balance sheets in sectors like steel, cement, and aluminium reflect this distortion. Indian firms look better than global peers partly because the cost of pollution is not reckoned correctly. 

 This outperformance is a trap. When selling into CBAM countries, this pollution arbitrage vanishes. On average, Indian exporters have a disadvantage when compared with Chinese exporters, while selling into CBAM countries, because the share of renewable energy in Chinese electricity consumption is about three times higher than that in India. This gives Chinese producers a natural lower embedded carbon footprint. The failures of Indian electricity policy now harm the Indian exporter.

The global trade system is absorbing two shocks. There is Donald Trump, the reduced state capability in the United States (US). The second is the CBAM. These two forces require deep thinking. The response to the first shock — US protectionism — is to diversify partners. The EU is an economy roughly the size of the US. The EU remains committed to the wise post-war policy paths. India needs a deep trade agreement with the EU. 

In trade negotiations, negotiating capital is a finite resource. In recent years, substantial diplomatic capital was expended in negotiations with the UK, with an objective to seek exemptions from carbon adjustments. This was a misallocation of effort. A deep trade agreement cannot be obtained when one seeks to carve out exceptions to fundamental fiscal principles like VAT or carbon border pricing. 

The resulting treaty with the UK gave headlines, but it was not a deep trade agreement. It did not integrate markets in a way that reduces friction for high-value exchange. As we turn our eyes to the EU, we must avoid this mistake. To achieve a deep free-trade agreement with the EU, we must accept the CBAM as a boundary condition. Asking the EU to drop the CBAM undermines respect for Indian policymakers. 

If the EU collects the carbon levy, the revenue goes to Brussels. If India collects the carbon levy, the revenue stays in New Delhi, and the exporter faces no additional charge at the EU border. The rational response to the CBAM is, therefore, the implementation of a domestic carbon-pricing framework. 

India has initiated steps toward a Carbon Credit Trading Scheme (CCTS). While the intent is correct, the instrument selection warrants caution. A cap-and-trade system is theoretically elegant but institutionally demanding. It is a solution suited for advanced economy-style intellectual capacity and state capability. If the government remains committed to the CCTS path, better implementation is required. Building a functioning carbon market requires deep knowledge in financial markets, public finance, economics, and international trade law. We should not assume that the notification of a scheme equates to the solution of the problem. 

The carbon tax is a superior alternative. It is administratively simpler. It can be made to integrate nicely with goods and services tax. It provides price certainty to firms planning capital expenditure. 

We in India should rejoice: The world is making progress on fighting carbon-dioxide emission. The first phase was the financial system, which turned away from fossil fuels, which restrained the most powerful business people of India. Now the second phase is the CBAM. This comes in a difficult global context characterised by the protectionist impulses of the US and the regulatory rigour of the EU. Navigating this requires intellectual clarity. We must stop viewing carbon adjustments as unfair trade practices and respect them at the level of VAT. This will interfere with the “pollution hero” model of corporate profitability. We need a trade strategy that embraces deep integration with the EU, and a domestic fiscal strategy that internalises carbon pricing through a simple, robust mechanism: The carbon tax.

The author is a researcher at the XKDR Forum