How global trade could fragment after the EU’s tax on ‘dirty’ imports

In Jiaxing, a manufacturing town on the outskirts of Shanghai, 400 steel industry executives and engineers gathered last November to tackle an enormous task: weaning the world’s biggest steel producer off coal-fired blast furnaces.

The subject is of burning political urgency. The Chinese government is trying to decarbonise a sector that relies heavily on coal — and quickly — or risk losing its dominance as countries with ambitious climate goals look elsewhere.

The source of China’s predicament can be traced to Europe where the EU — one of its key export markets — has imposed the world’s first ever tax on emissions of carbon-intensive imports starting with cement, iron, aluminium, fertilisers, electricity, hydrogen and, of course, steel. The levy will come into force in 2026, but the transition is already under way.

But there is a deeper concern. The EU’s decision could set into motion a wave of countries enforcing similar measures, and on a wider variety of products, delivering a devastating collective blow to Chinese industry. In December, the UK announced the introduction of its own carbon import tax by 2027.

“Companies are watching this keenly,” says Gao Liqun, partner in carbon tariffs research for Deloitte China. “They are concerned that there will be many other countries — [most importantly] the US and Japan — taking on similar measures.”

One guest at the Jiaxing event, organised by the state-owned Zhejiang Society of Metals, was feeling optimistic, however. Tan Weihan, chief executive of Xi’an Xinda Electrical Furnace Works, sees the challenge facing Chinese steelmakers as an opportunity for companies like his that are helping to create cleaner steel.

“The government is signalling the need for large-scale research and industrial co-operation,” says Tan. “We’re talking to the government and we hope to receive support.”

For Europe, the introduction of the Carbon Border Adjustment Mechanism (CBAM), has been heralded as a much-needed leveller for European companies in an increasingly fractious landscape for global trade.

But it is also a major step towards broader carbon pricing, a measure policymakers and environmentalists say is needed to cut emissions to 1.5C, the ideal goal of the Paris agreement.

Western politicians are acutely concerned about an over-reliance on China for the raw materials necessary to support the green transition. Steel, among the world’s most commonly used metals, is one of the most politicised sectors in that debate.

The EU, which is facing pressure from member states to regain its competitive edge, wants to ensure that the billions of euros being invested by steel heavyweights such as ArcelorMittal and Thyssenkrupp into their European plants to reduce emissions will not be undercut by low-cost competitors using dirtier energy sources.

Yet unease over the first measures of its kind abounds from all sides. Some European producers themselves worry that CBAM could lead to higher costs that will erode the region’s appeal and their own.

Further afield, officials and executives in countries including China, India Turkey and Brazil fear that CBAM will disrupt trade flows and create a two-tier system, with products made using clean energy sent to the EU and those produced with coal power being exported to poorer countries with less stringent climate laws.

To that end, CBAM offers an early preview of what happens when the race to decarbonise is taken at different speeds by different countries.

The EU defends its policy as a necessary measure to drive down emissions. But for Beijing, CBAM is an example of green protectionism, says Qin Yan, a carbon analyst at London Stock Exchange Group.

“The overall trend is towards trade fragmentation because of concern about supply-chain risks: everyone is afraid of being dominated by China,” she adds. “The carbon pricing mechanism gives Europe an opportunity to reshore its manufacturing.”

This shift could accelerate the deepening wedge between the Chinese economy and those in the west — and pave the way for retaliatory measures.

The cost of polluting

Persuading its trade partners of the benefits of the carbon border tax has required some effort on the EU’s part.

To win support, Brussels has been hosting a series of seminars and outreach sessions. At one such gathering of Chinese executives and officials in Beijing last November, the EU’s climate commissioner Wopke Hoekstra pressed his case: “You will see that CBAM, regardless of what people try to push for, is not a ‘penalty’ for importers to the EU, but an incentive for decarbonisation.”

He urged any Chinese exporters present “to take mitigation action and get ready to report the carbon content of their products”.

For EU officials, CBAM is the logical development of the bloc’s emissions trading system (ETS), through which European companies buy permits corresponding to the number of tonnes of Co2 they emit.

But since its introduction in 2005, the carbon price — which fluctuates according to demand — has steadily increased. As the cost of polluting rises, EU-based manufacturers already facing high energy prices worry that their greener, more expensive production will be undercut by low-cost imports from countries using coal power for fuel. EU heavy industries currently receive some free ETS permits in help them stay competitive but these will be wound down in coming years.

“The reality is that we pay for steel at a much higher price than some of our competitors,” says Luca de Meo, chief executive of French carmaker Renault. “We have seen a rise in the price of steel which is probably 8 to 10 per cent the cost of the car in Europe.”

Assofermet, the Italian steel industry body, warned at a conference in September that CBAM could push up the price of steel by 15 per cent.

But EU policymakers argue that the measure is essential to prevent “carbon leakage”, the risk that EU companies will outsource carbon intensive production elsewhere.

As she sought to win over business, European Commission president Ursula von der Leyen said last year that “making sure that a price is paid for the embedded carbon emissions generated in the production of certain goods imported into the EU” would mean their carbon price matches that of domestic production “ensuring that the EU’s climate objectives are not undermined”.

The seven sectors that policymakers have singled out as most at risk of carbon leakage will be subject to CBAM first, although the EU expects that the levy will ultimately cover a much larger number of industries.

Importers will be charged for the carbon emissions related to the production of their goods according to the EU’s ETS price with first payments due to be made in 2026.

During a trial period that started in October, companies must report their emissions to the customs authorities, but will not be taxed. The first reports must be made in January 2024 and those that do not report will face a small fine.

Countries that have a carbon price similar to that of the EU will either be exempt or will be charged relatively less according to their domestic carbon price.

China, for example, does have a rudimentary carbon pricing system covering a small number of products, but the cost hovers at about 60 renminbi (€7 to €8) per tonne, about 10 times less than the EU’s current carbon price.

Even though Beijing is considering extending this to steel and cement, Chen Zhibin, senior manager at Adelphi, a climate think-tank, says its carbon price will fall far short of the EU price come 2026.

“It won’t go up to €80 to €90,” he says. “Up to €20 is already pretty idealistic.”

Unfair trade

When CBAM was first proposed, a primary concern from some EU lawmakers was that it would fall foul of World Trade Organization rules and lead to a series of disputes.

Ahead of the first payments being made, however, worries have turned to whether the levy will work — or if it can be circumvented by earmarking lower carbon steel for the EU.

For steel, which makes up 22 per cent of the EU’s industrial carbon emissions and is the biggest CBAM sector, the risk of circumvention, or “resource shuffling”, is particularly acute.

“The steel sector entails a high degree of complexity for the CBAM,” the European Steel Association (Eurofer) warned in a paper on the topic. Not only does steel cover numerous product categories with more than 100 custom codes, it said, it also involves different production routes and emissions generated during production as well as large trade flows.

Adolfo Aiello, deputy director-general at Eurofer, says European steelmakers could face competition on multiple fronts: not just from “cheaper dirty steel” but also “greener steel from third countries”. The risk, he adds, is that the EU becomes “a demand centre for green steel” with dirty steel being diverted elsewhere. The result, he says, “would be a net negative impact on the climate”.

Some domestic producers, including Luxembourg-based multinational ArcelorMittal, welcome CBAM but believe the current scheme “has some flaws”. The levy, ArcelorMittal executives argue, should be expanded to cover a wider scope of products made with a large amount of steel, such as the components used in white goods or machinery.

Failing to do so risks pushing manufacturers in Europe — many of which build crucial green infrastructure such as solar panels and electricity cables — to offshore production.

“The margins of [some of] these industries which are our customers and which consume steel in Europe are already extremely compressed. Then you add another handicap,” says Laurent Plasman, chief marketing officer at ArcelorMittal Europe. “The big concern we have is that companies will simply decide this thing is too much and will localise production elsewhere.”

The wind sector, which requires large steel plates for its turbines, has echoed these fears. Only taxing raw materials “could distort the EU wind industry’s supply chain”, the industry body Wind Europe warned in a paper.

These are the kinds of knock-on effects that will be taken into consideration during the trial period “and we will try and understand if we need an adjustment”, one senior EU official says.

Some producers say it is in the interests of European industries to adapt in order to remain competitive — and ensure the CBAM is successful.

Jose Noldin, chief executive of start-up GravitHy, which plans to build the first green iron plant in France using hydrogen made from renewable sources, warns there is a “risk that European producers don’t embrace change and are outpaced by producers in other regions”.

“EU industry is naturally positioned for example to lead the harmonisation of green standards, definitions . . . and certifications, which is essential for CBAM to work properly,” he adds.

Playing defence

At an event in Brussels in November, Fu Cong, the Chinese ambassador to the EU, made clear his country’s feelings about the tax on carbon.

He argued that the initiative was “another green trade barrier” — a view he warned was shared by “many other developing countries and by the US”. China is one of several countries still threatening WTO complaints.

China has already spoken out against other trade defence measures being taken by the EU and the US, such as the EU’s anti-subsidy probe into Chinese electric vehicles, which Beijing sees as a stealth form of protectionism. In response, China has launched an anti-dumping investigation into imports of French brandy.

Other countries opposed to the CBAM are using the growing discontent as an opening. Mehmet Fatih Kacir, Turkey’s industry minister, says that the EU should see his country as a reliable alternative to China for competitively priced solar panels, electric vehicles and wind turbines.

But there is a catch: because of its proximity to the EU and its inclusion in the customs union that allows such goods to enter the single market without tariffs or quotas, Turkey should be exempt from CBAM, he argues. “Clearly, we think that the border of the customs union should be the border of the carbon trade,” Kacir adds.

Meanwhile, the Indian industry minister Piyush Goyal has branded the CBAM an “ill-conceived” tax and says he expects EU companies to move production to India as a result.

The European Commission has pushed back strongly against any claims that CBAM is incompatible with WTO standards or will upset global trade.

“The EU lawyers who made CBAM are 100 per cent convinced that it is WTO compliant because we are applying the same levies to domestic producers as outside producers,” one EU official says.

What will the US do?

Further down the line there is another obstacle for CBAM. From 2025, only the EU method of emissions accounting will be accepted.

Japanese steelmakers are among those that have taken issue with Brussels over the detail of reporting required and the potential fines that could be incurred even during the trial period. Even the commission’s own impact assessment estimates that complying with CBAM could cost companies up to €27mn per year.

In the run-up to December’s COP28, the UN’s annual climate conference, ambitious western nations have stepped up their call for a global carbon price, pitching it as a way to incentivise businesses to cut emissions.

This approach, they hope, will prevent a fragmentation of global markets into “cleaner” and “dirtier” ones. The summit was the first to feature a trade day, a sign of the issue’s growing importance as a tool for climate action.

There are signs of a shift. Canada’s “carbon pricing challenge”, an initiative launched at COP26 in 2021 that aims for 60 per cent of global emissions to be subject to permits by 2030, has gathered momentum this year, with the EU signing up in November.

Countries with “strong carbon pricing systems must prevent carbon leakage and freeriding from low-ambition countries, or their own decarbonisation plans will not be politically viable”, warns Simone Tagliapetra, senior fellow at the Brussels-based think-tank Bruegel. “The EU is just the first to face this.”

But in lieu of a global carbon price, other countries including Canada and Australia are watching EU’s CBAM closely with an eye to introducing their own. Canberra’s review of whether it should implement a carbon border tax will be published next year. The UK government said its planned CBAM is subject to further consultation, including which products it will cover.

The biggest fear for Chinese companies, however, is the prospect of a carbon border tax in the US, says Li Shuo, director of China climate research at the Asia Society Policy Institute.

“For most of the Chinese analysts and government officials, when they talk about CBAM, what’s really on their mind is what the US will do,” he says. “Will the US impose its own carbon tax in the future? It’s reasonable for us to assume that [such a tax would] be less in line with any WTO-related considerations, more hostile, and harsher.”

On November 2, three Republican senators introduced the Foreign Pollution Fee Act, which would charge imports of certain products according to how “dirty” they are compared to US-made alternatives. A similar bill with a focus on domestic production as well was proposed by Democrats in December. But as the US does not have its own emissions trading system, analysts say such measures are more likely to fall foul of WTO rules.

The greater risk, however, is that CBAMs will eventually materialise throughout the world but without common definitions for minimum standards for products such as green steel or guidelines for best practice, according to the European Roundtable on Climate Change and Sustainable Transition. The outcome, their analysts say, would be ineffective climate policy — and confusion for producers.

Mohammed Chahim, a Dutch lawmaker who led negotiations on the CBAM proposal in Brussels, suggests there is a straightforward solution: other countries should simply align with the EU. “We [could] adjust ours a bit but at least we co-ordinate on how it is applied because otherwise it will fragment global trade,” he says.

But in an ideal world he would wish for the CBAM to “never be implemented”.

“That [would] mean economies outside the EU are cleaner or they have introduced their own carbon emissions system,” he adds. “And I’m OK with that.”

Additional reporting by Andy Bounds in Brussels

Data visualisation by Steven Bernard and Ian Bott