Carbon tax: Light at the end of the tunnel?

European Union ‘s proposed carbon tax, expected to operationalise in October 2023, has raised concerns in Indian metal industries, particularly steel and aluminium. IBT analyses the possible approaches that India can take towards addressing this emerging challenge.

• EU’s Carbon Border Adjustment Mechanism (CBAM) is a proposed border tax, which will be imposed on imported goods crossing EU border.
• Beginning with a transitional phase from Oct 2023, CBAM will be permanently applied from the onset of 2026 to selective products and by 2034 will be applied on every imported product.
• Indian metal exports (Iron and steel, aluminum) to EU, which account for India’s 27% metal exports might face significant challenges.
• The affected developing countries can involve in diplomatic talks with EU to meet the CBAM expectations in the short term.

European Union, in its ambition to become a driver of the global environmental agenda and frontrunner in climate protection, seeks to achieve 55% lower carbon emissions by 2030 (compared to 1990 levels) and intends to become the world’s first climate-neutral continent by 2050.

In supplement to its constant carbon monitoring through Emissions Trading System (ETS), the Union agreed on a preliminary deal for an EU Carbon Border Adjustment Mechanism (CBAM) on imported goods such as iron and steel, cement, aluminum, fertilizers, electricity and hydrogen on December 13, 2022. This mechanism, which is expected to be formalised in October this year, has raised concerns among exporters, particularly in the steel and aluminium sectors. Exporters will be required to declare their carbon content per tonne, and based on this data, taxes will be imposed from January 1, 2026.

Principles of ETS and CBAM

In July 2021, a set of legislative packages were submitted to the Council of the European Union (EU), focused on strengthening the current EU emission trading system (ETS) through a faster reduction of allowances and a phase-out of free allowances. The general approach of this proposal was approved in March 2022.

The world’s first carbon market, the EU ETS, was established in 2005 and is a cap and trade system. It monitors emissions from over 10,000 power stations, oil refineries, iron, steel, aluminium, cement, paper, glass factories and civil aviation.

The ETS system operates through European Emission Allowance (EUA) – a license or permit that allows one tonne of CO2 emission. The EU ETS sets a cap on the quantity of greenhouse gas emissions (mainly carbon dioxide) that each installation can release. Every participating firm gets a limited number of annual EUAs. If their emissions exceed the EUA allowance, they must buy EUAs through auction at ETS. Firms that have reduced their emissions have surplus EUAs. The EU-ETS system reduces the cap gradually to reduce emissions.

The CBAM, which is a supplementary measure to the EU ETS, operates by imposing a charge on the embedded carbon of certain imports, which is equal to the charge imposed on domestic goods under the ETS, with adjustments being made to this charge to consider any mandatory carbon prices in the exporting country.

The phenomenon of firms shifting to low cost countries due to rising EU carbon prices (from €30 per tonne of CO2 in December 2020 to €100 in Feb 2023) is termed as carbon leakage.

In other words, CBAM (carbon border tax) or a carbon leakage instrument is brought to eliminate the difference in carbon price paid by companies subjected to the EU’s ETS or its domestic compliance-based carbon market, and the price paid by companies elsewhere, whose manufactured goods are imported into the EU.

Following are the key elements of the CBAM

1. CBAM will initially apply to imports of certain goods and selected precursors, whose production is carbon intensive and at most significant risk of carbon leakage: Cement, iron and steel, aluminum, fertilizers, electricity and hydrogen.
2. The agreement will enter into force in the transitional phase as of October 1, 2023. During this period, importers of goods in the scope of the new rules will only have to report greenhouse gas emissions (GHG) embedded in their imports (direct and indirect emissions), without making any financial payments or adjustments.
3. The agreement foresees that indirect emissions will be covered in the scope after the transition period for some sectors (cement and fertilisers), on the basis of a methodology to be defined in the meantime.
4. The objective of this transition period is to serve as a pilot and learning period for all stakeholders (importers, producers and authorities) and to collect useful information on embedded emissions to refine the methodology for the definitive period.
5. Once the permanent system begins from 1 January, 2026, importers will need to declare each year the quantity of goods imported into the EU in the preceding year and their embedded GHG. They will then surrender the corresponding number of CBAM certificates.
6. The price of the certificates will be calculated depending on the weekly average auction price of EU ETS allowances expressed in €/tonne of CO2 emitted.
7. The phasing-out of free allocation under the EU ETS will take place in parallel with the phasing-in of CBAM in the period 2026-2034.

Impact on India

The EU is an important trade partner, accounting for around 17% of India’s exports. In the initial phase, CBAM can pose significant challenges for India’s metal sector (around 27% of metal exports go to EU). But as soon as CBAM covers all goods, India’s exports to the EU may face very significant stress.

India exported a total value of US$ 64.96 billion in 2021-22, registering a 57% YoY growth. Out of India’s total exports of US$ 79.98 billion to European Union in 2022-23 (Apr-Jan), Iron and Steel (US$ 3.95 billion), articles of Iron and Steel (US$ 2.08 billion) and Aluminum (US$ 2.37 billion) form significant shares.

Source: Ministry of Commerce and Industry

India’s top export markets in the EU

Source: Ministry of Commerce and Industry

Netherland, Belgium, Germany, Italy and France were the top European export markets for India in 2021-22. Italy (US$ 2.14 billion) and Belgium (US$ 1.52 billion) had the highest Iron and Steel imports. Aluminium imports were led by Italy (US$ 493.8 million), Greece (US$ 485.29 million) and Netherland (US$ 434.17 million).    

Top exported metal products by India to EU

Source: ITC Trade Map

India’s coping mechanism

India can take three possible approaches to address this challenge. The first and most straightforward, of course, is shifting to greener ways of steel making.

But is it as straightforward as it sounds? Developing countries, backing their economies continuously with industrial growth are bound to emit carbon, and industries like metal, especially steel, are among the biggest producers of carbon dioxide. However, skipping this process of development, which comprises of significant carbon emissions and directly shifting to a stage with complete de-carbonization is a tedious task.

Metal industries might not be able to overhaul the entire production process, which is dominated by conventional carbon intensive ways. The process begins with heating iron ore, a process that consumes colossal amounts of energy in blast furnaces to extract pure iron. The resulting chemical reaction releases carbon dioxide. About 75% of steel is manufactured this way — mostly with coal.

According to the World Steel Association, every ton of steel manufactured in 2018 emitted on an average 1.85 tons of carbon dioxide, which equates to around 8% of global carbon dioxide emissions.

One way to switch to greener production is to ditch coal-fired blast furnaces and proceed extraction with gas. Reaction with green hydrogen, the cleanest of all (as made with renewable energy), will release water instead of carbon dioxide. But producing this huge amount of hydrogen would require colossal amounts of green energy.

Another option for steel makers can be carbon capture out of steel plants and their storage underground. But the share of emissions that CCS can capture from steel is unclear — or at what cost. According to the industry, this process is likely to be more expensive than in industries like cement, because steel factories have multiple sources of pollution.

Recycling steel, which is one of the most effective way to limit future emissions, also comes with demerits. The industry is worried about feed stock and scrap availability if they shift to this low emission process, whereas the conventional ore extraction route has a huge scale.

Shifting to greener technologies is expected to eventually happen with better understanding of processes, increased economies of scale and a comprehensive policy framework. But it looks daunting for Indian industries to cope with new carbon taxes in short run.

The second option that comes to mind is winning concessions through trade negotiations. In the backdrop of resumed negotiations on Free Trade Agreement with EU, India can negotiate for a middle ground to provide a smooth transitional phase to their native industries. In this regard, it can also find common cause with other countries. In 2021, other BRICS nations (Brazil, China, Russia and South Africa) joined cause with India to protest against the carbon tax, calling it discriminatory. India’s stand in this regard is that rich nations need to act with principles of equity and common but differentiated responsibilities and respective capabilities (CBDR-RC).

Meanwhile, India needs to also explore the third option, which will push the industry progressively towards low carbon emissions. Other developing countries like Vietnam and Taiwan, China are also encouraging cleaner industrial productions by setting up domestic carbon taxes. Vietnam’s exports to Italy grew at a CAGR of 63% (2017-19) and a YoY growth of 823% in 2021 and for Belgium, the corresponding figures were 32% and 878% respectively. In the backdrop of these rising exports, the country experts suggested to the Vietnamese government to establish policies to monitor emissions and issue carbon certificates to exporters and producers.

Taiwan’s exports registered a 12% CAGR (2017-21) and a 371% YoY growth in 2021. The country aims to adopt EU’s border tax as an opportunity for implementing carbon pricing in their own nation. With this, EU would offer the country considerable compensation, in accordance with the cost of emissions that would have already been paid in Taiwan.

India is expected to launch a National Carbon Market Scheme in June, which correspondingly would imply implementing a ‘cap-and-trade’ system. That means the government would impose an emissions cap and issue a certain number of credits for members to trade amongst each other. Participation will be mandatory for energy, steel and cement, which are identified as high emitters.

Over the long term, carbon pricing will have to be factored into industry, and it needs to prepare itself for these costs. Even as it asks the EU for more flexibility along with other developing countries, the government will have to progressively tax carbon emitting industries to push them towards green processes, to ensure that they remain internationally competitive over the long term.