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The CBAM Under the Microscope: Navigating the Waters of WTO implications (MFN Principle)

Part I. The Bedrock of Discrimination: The WTO Most-Favored-Nation (MFN) Principle applied to CBAM

The European Union’s Carbon Border Adjustment Mechanism (CBAM) as delineated in Regulation EU 2023/956, aims to equalize the carbon costs between EU and non-EU entities, establishing a realm of carbon pricing on imports. This measure, while aimed at addressing climate change and fortifying EU industries, spirals into a debate concerning its alignment with World Trade Organization (WTO) regulations. This essay-series delves into the potential inconsistencies of the CBAM with WTO rules.

Under the aegis of Article I of the General Agreement on Tariffs and Trade (GATT), the MFN principle mandates equal treatment of imports from all WTO member states. The Most-Favored-Nation (MFN) principle is a cornerstone of the World Trade Organization (WTO) trading system. It requires WTO members to treat all other WTO members equally, in terms of both tariffs and non-tariff barriers to trade. This means that any trade concession that one WTO member grants to another WTO member must also be extended to all other WTO members.

The MFN principle is important because it helps to prevent discrimination and promote fair trade. It also helps to reduce the costs of trade and investment, by making it easier for businesses to predict and understand the trade rules that will apply to their products and services.

The CBAM, by attributing a carbon cost based on carbon intensity, potentially embarks on a path of discrimination. A differential application of CBAM based on the varying carbon policies across nations could ostensibly infringe the MFN principle, laying the groundwork for legal contestation.

The EU's Carbon Border Adjustment Mechanism (CBAM) and the phasing-out of free EU allowances could potentially infringe on this principle.

1. Phasing Out Free Allowances and Introducing CBAM:

The EU is in the process of transitioning from free allocation of allowances under the EU Emissions Trading System (ETS) to the CBAM certificate costs. This transition is expected to occur from 2026 to 2034, aligning the phase-out of free allowances with the phase-in of CBAM​.

2. Overallocation of EU Allowances:

Overallocation in the EU ETS has been observed in the past, where emissions were around 3% lower than the allocated allowances during the first two years of the first trading period​​. Another analysis showed a surplus of up to 19% (for Poland) in allowances for certain installations, leading to an overall surplus of more than 4% when extrapolated across the EU​. This overallocation potentially created financial advantages for EU firms, particularly in internationally competitive sectors like steel​.

3. Potential Discrimination Through CBAM:

The CBAM could potentially discriminate against imports from countries with less stringent carbon emissions standards or those that didn't have the benefit of free allowances. The EU operators, having benefitted from the overallocation of allowances, had time to adjust to emissions costs, possibly even profiting from it. In contrast, the CBAM might impose abrupt costs (even when applying a phase-in) on non-EU producers, contrasting the gradual adjustment-time EU producers had. This may be viewed as discriminatory under the MFN principle.

4. Comparison to EU Operators:

The phasing in of CBAM certificates is planned to occur in tandem with the phasing out of free EU allowances from 2026 to 2034. During the transitional phase, which begins on 1 October 2023 and lasts until the end of 2025, affected companies will have reporting obligations but no carbon pricing will apply. Carbon pricing, through the obligation to buy CBAM certificates, will start from 1 January 2026​.

This structured approach allows both EU and non-EU operators to have a transitional period to adjust to the new CBAM regime. The parallel phasing in and out of these systems could be argued to provide a balanced transition for all operators, mitigating abrupt cost impositions on non-EU producers. The argument for discrimination under the MFN principle might be weakened by the phased introduction of CBAM certificates, providing a structured transition similar to the one EU operators had with the phased-out free allowances.

5. Setting of Carbon Price for CBAM Certificates and Allowances:

Price Determination:

The price of CBAM certificates is set based on the weekly average auction price of EU ETS allowances, which is expressed in €/tonne of CO2 emitted​. The setting of carbon prices could pose a challenge under the MFN principle if the pricing mechanism is perceived to favor or disfavor certain countries or regions based on their carbon intensity or emissions policies.

Consistency in Pricing:

The consistent application of carbon pricing across EU and non-EU producers is crucial to ensure adherence to the MFN principle. Any inconsistencies or perceived biases in how the carbon prices are determined or applied could potentially invite legal challenges under the MFN principle.

Transparency and Fairness:

Transparency in the determination of carbon prices and the process by which CBAM certificates and allowances are allocated is paramount to mitigate challenges under the MFN principle. Lack of transparency or perceived unfairness in the pricing mechanism could be argued as a violation of the MFN principle, as it may lead to discriminatory treatment of imports from different countries.

Comparative Analysis:

A comparative analysis of carbon pricing in the CBAM and in other international or regional carbon pricing mechanisms might reveal disparities that could be challenged under the MFN principle. If the CBAM’s carbon pricing is found to be restrictive or discriminatory when compared to other mechanisms, it could be a ground for legal challenge under the WTO framework.

6. Difference in labor costs, production costs, and currency exchange factors

Variability in Labor and Production Costs:

Different countries have varying labor and production costs which naturally affect the cost of production and, consequently, the price of goods. The WTO acknowledges the economic advantage of low-wage countries and emphasizes that core labor standards should not be used for protectionism​​. When assessing the CBAM under the MFN principle, it may be argued that the mechanism doesn't account for these inherent disparities, possibly leading to a less favorable treatment of imports from countries with higher labor and production costs.

Comparative advantage theory underscores the natural labor-cost advantages certain countries possess and the implications this has on international trade​2​. A legal examination could scrutinize whether the CBAM unduly negates these advantages in a manner inconsistent with the MFN principle.

Currency Exchange Factors:

Currency exchange rates inherently affect international trade by influencing the prices of exports and imports​​. The variability in exchange rates among countries could thus affect the comparative costs of CBAM certificates and allowances.

The WTO's framework, notably the Agreement on Implementation of Article VII of the GATT, highlights the importance of a positive system of Customs Valuation based on the price actually paid or payable for the imported goods​​. A legal argument might explore whether the CBAM's pricing mechanism sufficiently accommodates currency exchange rate variations in a manner consistent with the MFN principle.

Potential Legal Scrutiny:

The interplay of labor costs, production costs, and currency exchange rates with the CBAM's pricing mechanism could be scrutinized under the MFN principle to ascertain whether it inadvertently discriminates against certain countries. Past WTO rulings and jurisprudence could provide a framework for such legal scrutiny.

The transparency and fairness in the determination of carbon prices, considering these economic factors, could also be a focal point in assessing the CBAM's conformity with the MFN principle.

6. Precedents and Past Challenges:

  • Past WTO rulings and jurisprudence provide a framework for examining the compatibility of environmental measures like CBAM with the MFN principle. For instance, the Reformulated Gasoline case highlighted the issue of discrimination, which is pivotal to MFN discussions​.

  • The WTO's "tool-box" of rules relating to environmental issues, including GATT Article XX, processes and production methods (PPMs), and the definition of a 'like product,' play a significant role in evaluating climate change measures like CBAM under the MFN principle​.

  • The case law between the European Court of Justice and GATT/WTO rulings on trade and environment could shed light on the current tension between trade and environmental protection objectives. These precedents might help in understanding how the CBAM could be viewed under the MFN principle, especially if similar cases arise in the WTO disputing the CBAM's conformity with the MFN principle​.

In light of these points, the CBAM’s alignment with the MFN principle under WTO rules could be called into question. The past overallocation of allowances provided a cushion for EU operators, potentially placing non-EU operators at a disadvantage with the introduction of CBAM. This argument could form a basis for challenging the CBAM’s consistency with WTO’s MFN principle.

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