Asian economies ill equipped to meet EU cross-border carbon tax challenge

Asian economies are ill prepared for upcoming carbon market regulation by the European Union that proposes a levy on imports of carbon-intensive goods and makes goods produced in countries with weaker carbon pricing mechanisms highly uncompetitive, industry sources and analysts told S&P Global Commodity Insights.

Few countries in Asia have imposed any form of carbon tax and only China, South Korea and Australia have established nationwide emission trading schemes to price carbon. Most exporters in these countries also lack broader awareness about the impacts of the EU's move, and are yet to establish uniform, stringent emission accounting and reporting practices, industry executives said.

EU's carbon border adjustment mechanism, or CBAM, could be implemented as early as 2023 when European companies have to start reporting emissions of imported goods, although they will not need to purchase CBAM certificates until 2026-2027. The Council of the European Union and the European Parliament are yet to decide on the timeline.

This gives Asian governments some breathing room to put in emissions accounting frameworks, but decarbonizing supply chains could still take years to accomplish, analysts said.

The EU's governmental agencies all feel CBAM is necessary to protect EU businesses against cheaper product imports from lower carbon pricing regimes and replace [EU's] free allocations of emissions allowances, Michael Evans, carbon market analyst with S&P Global, said.

"It therefore appears not to be a question of whether to implement such a mechanism, but when, and to what sectors/products," Evans said. "We continue to forecast a medium-high likelihood that CBAM will be implemented by the EU, subject to World Trade Organization agreement."

Based on the EU Parliament's latest proposal, four of the top 10 CBAM-eligible regions that export CBAM-covered goods to Europe are Asian, led by China, its largest trading partner, and also includes India, South Korea, and Japan, according to Bixuan Wu, senior partner at law firm Hiways.

"What is the certainty that the CBAM legislation will be enacted? The answer is almost 100%. Regardless of the WTO consistency debate, CBAM's time has come," Wu said, referring to concerns that CBAM may violate WTO rules.

The policy challenge

"WTO rules were drafted at a time when climate change problems were rarely recognized, and the drafters probably did not envision climate-related trade measures like CBAM. Proponents and opponents of the CBAM alike can find a basis in the existing WTO rules, in particular, the rules of exceptions," Wu said.

Evans said that for CBAM to be WTO compliant, it needs to demonstrate it is an environmental measure, and not a trade protectionist measure. "This is something that is an ongoing discussion between the EU and WTO," he said.

China has been vocal in opposing CBAM, but other Asian countries have yet to take an official policy stance or negotiate collectively to mitigate trade risks stemming from the legislation. It remains unclear whether COP27 will be a platform for them to converge, underscoring their lack of preparedness.

Beijing has previously called CBAM "an act of unilateralism" that unreasonably expands the climate issue to the field of trade and violates WTO rules. "In the face of global challenges, all parties should reject unilateralism, geopolitical rivalry and green barriers," China's foreign minister Wang Yi said at the Informal Leaders' Roundtable on Climate Action held in New York Sept. 28.

In May, the Biden administration launched its Indo-Pacific Economic Framework for Prosperity (IPEF) strategy to boost US reengagement in Asia that included Japan, South Korea, Australia, India and Southeast Asia.

The think tank Center for Strategic and International Studies (CSIS) recommended in a June report that the US should focus IPEF climate financing on middle- and low-income countries to decarbonize hard-to-abate sectors that would be impacted by CBAM like iron and steel, aluminum, fertilizers, and cement.

It said South Korea and India were the sixth and seventh-largest exporters of steel to the EU, respectively, worth around $5 billion. Vietnam was the third-largest cement exporter to the EU, and Malaysia the eight-largest, and were valued at roughly $27 million.

The European Commission's initial proposal in July 2021 said CBAM will cover steel, aluminum, cement, fertilizer, and electricity. In June, the European Parliament expanded this to include organic chemicals, plastics, hydrogen, and ammonia.

Other challenges

Still, Asian economies are likely to feel the disproportional impact of CBAM.

There are concerns that a unilateral EU CBAM will not only distort international trade, but also shift the burden of addressing climate change to developing countries, the Task Force on Climate, Development and the IMF of Boston University's Global Development Policy Center said in a March study.

Its simulation assumed a carbon price of $75/mtCO2e and resulted in sharp decreases in trade flows from developing countries like China, India, Russia and Ukraine.

"CBAM widens the gap between developed and developing countries in terms of GDP and welfare, may worsen the unequal income and welfare distributions between rich and poor economies, and further erode the capacity of some low-income countries to decarbonize their economies," the study said.

CBAM also faces unresolved issues in its scope, and recognition of carbon pricing instruments.

"A key question is the potential inclusion of indirect emissions to the CBAM, which is technically challenging but may be deemed necessary to guarantee the environmental stringency of the measure," Evans said.

"The role of the voluntary carbon market remains unlikely to be accepted towards CBAM obligations despite ongoing work to develop the integrity of the VCM market and quality criteria for credits. This will likely add pressure on the EU from trading partners," he said.

Evans said it was plausible that CBAM certificate costs are passed through to the commodity prices of affected products.

More broadly, the objective of CBAM is to avoid carbon leakage, where industries move production to countries with weaker emissions restrictions, and to incentivize trading partners to decarbonize, he said.

TABLE 1: Top exporters of CBAM products (First proposal)

*Note: Norway and Switzerland exempted from CBAM, Electricity excluded

Source: Hiways Law Firm

TABLE 2: Top exporters of CBAM products (Expanded scope)

*Note: Norway and Switzerland exempted from CBAM, Electricity excluded

Source: Hiways Law Firm