Chairman’s Message

Tatsuya Terazawa

Tatsuya Terazawa
Chairman and CEO
The Institute of Energy Economics, Japan

Chairman’s Message
- Trade and Environment -

Message for April 2022

The idea to use trade measures to realize environmental objectives is getting strong attention.

The leading example is CBAM, the Carbon Border Adjustment Mechanism, currently proposed by the European Commission. If approved, it would initially require importers of electricity, cement, aluminum, fertilizer and iron and steel products to purchase CBAM certificates, their value calculated by multiplying the embedded carbon emissions of the imported product by the prevailing EU ETS auction carbon prices. The carbon price paid at the country of origin can be deducted from the necessary value of CBAM certificates. Another example canbe the “Climate Club” proposed by Germany. The current details of the concept are still unclear but based on the papers submitted to the G7 Finance Ministers’ meeting process last year, it appears that it was at the time requiring the participants to make commitments to adopt common level of carbon pricing/emission standards and to introduce a joint carbon border adjustment mechanism to protect against carbon leakage in relation to the non-members of the “Club”. Germany is trying to incorporate the “Climate Club” as the output of the G7 Leaders’ Summit this June.

The rationale behind these ideas is to avoid carbon leakage. They argue that if EU or the “Club” members put into place rigorous measures to reduce carbon emission, such as the EU ETS, companies outside of theregion or the “Club” would exploit laxer carbon measures to export products with high carbon contents at lower prices. Alternatively, companies might shift their operation out from the region to take advantage of weaker carbon policies in other regions. The result would be net growth in carbon emission globally.

From the environmental policy perspectives, the logic of these ideas is well understood. But these measures can have great impact on international trade. The current argument in support of these measures seen in EU has been discussed almost entirely from the viewpoint of environmental policy without thoroughly considering the trade policy implications. I strongly believe that ideas such as CBAM need to be comprehensively reviewed from trade policyviewpoints as well.

EU is stressing that CBAM is designed to be WTO rules compatible. But the consistency of CBAM with WTO rules deserves rigorous scrutiny. While avoiding getting into too much detailed legal arguments, let me share with you some of thequestions surrounding CBAM.

CBAM can be argued to be inconsistent with some of the major disciplines of the WTO rules. One of such examples could be the fundamental rule not to impose custom duties in excess of the commitments, which are called “concessions” made by the WTO members. It will probably be argued that the requirement to purchase CBAM certificates is not “custom duties”. But GATT Article II stipulates that products shall be exempted from “all other duties or charges of any kind imposed on or in connection with the importation in excess of” of the commitments. There are also other basic rules such as the National Treatment, the Most-Favored-Nations Treatment and the Elimination of Quantitative Restrictions which need to be satisfied.

As theconsistency with these basic rules can be questionable, the proponents of these ideas may have to invoke the General Exceptions stipulated in GATT Article XX. Measures introduced to protect the environment are generally considered as qualifying for exceptions. But it is important to stress that exceptions to the rules must be invoked with great caution and we should recall how the Security Exception, Article XXI, was abused by the former US President. Article XX requires the measures not to be “applied in a manner which would constitute a means of arbitrary or unjustifiable discrimination between countries where the same conditions prevail, or a disguised restriction on international trade”. CBAM as currently being proposed could be argued to be inconsistent with such conditions.

First, in a hypothetical case in which the imported goods have less carbon content than similar goods produced in the region,due to better technology, CBAM certificates will still be required. The argument is to provide level playing field for the producers in the region to protect them. But from the objective of trying to lower global carbon emission, it will be better to import superior goods with less carbon content without requiring the CBAM certificate which would add cost.

Second, the current CBAM proposal appears to be only allowing reduction for explicit carbon pricing payment made at the country of origin. Implicit carbon pricing, including regulatory measures for ambitious carbon reduction, FIT (Feed in Tariff), energy related taxation, do not appear to be included for reduction. If the objective is to avoid carbon leakage, the cost arising through implicit carbon pricing should also be included for reduction. In the leading WTO dispute settlement decision regarding environment related measures, it was determined that “it is not acceptable, in international trade relations, for one WTO member to use an economic embargo to require other Members to adopt essentially the same comprehensive regulatory program, to achieve a certain policy goal, as that in force within that Member’s territory, without taking into consideration different conditions which may occur in the territories of those other Members.” Based on this precedent, exclusion of implicit carbon pricing could be considered to be inconsistent with the WTO rules.

Third, the current CBAM proposal applies to imports of target products from all the countries regardless of the import volume, with very limited exceptions for small volume imports of less than 150 Euros in value. However, 68-77% of the imports by EU of the four proposed target product sectors, i.e. cement, fertilizer, steel and aluminum, are dominated by only 5 or 6 exporting countries. Therefore, the imports from other countries would have limited impact on carbon leakage. On the other hand, the administrative cost of CBAM application is expected to be quite burdensome, deterring imports from countries with limited import volume. In this regard, requiring CBAM certificates to imports of the target products from all the countries, regardless of the import volume from them, could be considered to be excessive to qualify as an acceptable exception to the WTO rules.

I believe that this issue should not be limited to legal interpretations. The larger policy impactshould be discussed even more. As I have personally participated in trade policy for decades at the Ministry of Economy, Trade and Industry of the Japanese government, I am fully aware of the role of trade in realizing growth. The dramatic economic growthwhich has been achieved after the World War II has been driven by liberalization of trade. In particular, the impressive economic development achieved by many emerging economies and developing nations is unthinkable without international trade and participation in global supply chains. GATT, which was established in 1947, and WTO, which was established in 1995 to succeed GATT, and the many FTA’s have all been driving the trade liberalization with the ultimate goal of realizing a tariff free world.

If CBAMis applied to many sectors and countries, de-facto tariffs will be imposed on a wide range of international trade activities. The current European Commission’s proposal for CBAM is considering the four product sectors and the power sector as initial targets. There are already discussions at the EU Parliament to expand the list to include chemical products and EU is explaining that these sectors are just the beginning. Eventually, all the products subject to the EU ETS and the down-stream products could be covered. With pressures from the industries affected by the EU ETS, there seems to be no limits to the scope of the CBAM which may well be proliferating. As a result, the achievement of trade liberalization which has helped the global economic growth and development could be seriously undermined.

It should also be recognized that the introduction of CBAM may exacerbate the “North-South problem” as the developing countries may regard CBAM as an unfair measure hindering their aspiration for growth and prosperity. They may well view CBAM as being inconsistent with the spirit of “Common but differentiated responsibilities.” They may feel the unfairness of suddenly being penalized for the absence of an EU ETS type mechanism which is still under development evenfor EU after 17 years, since it was first introduced in 2005.

There is another emerging problem. As steel is considered as one of the target products under CBAM, we should be reminded that Ukraine is the second largest exporter of steel to the EU. If CBAM is imposed on steel exports from Ukraine, the reconstruction of its economy, following the Russian invasion, could be seriously constrained through the loss of its major exporting product.

We need to realize growth and development for those people and the world through expansion of international trade while protecting the environment. The question is “How”?

After having restructured CBAM to ensure its consistency with the WTO rules, I believe it is important to limit the target sectors within the scope which are absolutely necessary to protect the environment. The target products must have high carbon intensity and the volumeshould be large enough to substantially impact the environment. The target countries of origin of the imports should also be limited to countries with large import volume which can lead to substantial carbon leakage. The Least Developed Countries (LDCs) which depend on trade for development could be excluded while special consideration should also be given to Ukraine. The administrative burden should be minimized to reduce the impediments for trade.

I believe that there must be a global discipline on CBAM type measures to avoid proliferation and broad application which could seriously undermine international trade.

What about the“Climate Club”? While the concrete substance of the current idea is unclear, if it is concluded to include joint border adjustment measures, it could magnify the problems of CBAM. Rather than having EU alone introducing CBAM, the “Climate Club” may decideto extend the introduction of CBAM type measures to other countries. The “Climate Club” may also limit the domestic policy choices, constraining the flexibility to reflect the varied circumstances of countries.

On the other hand, some elements of the “Climate Club” could enhance the global efforts to jointly transform the energy-intensive industries’ responses to the climate issues by conducting joint R&D, creating joint lead markets and by setting common product standards.

In this regard, careful discussions need to take place in designing the “Climate Club” to strengthen the world’s response to climate issues without excessively limiting the flexibility and diversity in each country’s policies and without sacrificing international trade in an undue manner.

As such, the risk of expansion and proliferation of CBAM or the “Climate Club” and the impact on international trade need to be seriously considered. We need the integration of environmental policies with trade policies. A larger group of stakeholders, including the global trade policy experts and the emerging/developing countries, should have full participation in the discussion.

Without the discipline to limit the proliferation of trade restrictive measures, we may be opening a “Pandora’s Box”. If we are to open the “Box”, I strongly believe that we need to carefully scrutinize the measures before unlocking it.

We must ensure WTO consistency as well as ensure that the proliferation and the side effects would be minimized.We must establish a well-designed balance between the need to address the climate change concerns and the need to ensure continued expansion of international trade and development of global supply chain which are essential to realize growth and development for the world.