In today’s Finshots, we offer a simplified explainer on why the EU wants to impose the world’s first-ever transnational carbon tax and why India isn’t happy about it

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The Story

Imagine you’re a manufacturer of steel — a darn useful commodity that’s used in industries across the world, right from cars to pharmaceutical appliances to building bridges. But steel manufacturing is an energy-intensive process. It emits a lot of carbon dioxide (Co2) and is responsible for 8% of global greenhouse gas emissions. It’s not a good thing for the environment.

And countries are aware of this. So they might decide to impose a special tax on everyone who manufactures this ‘dirty’ steel. It’s called the carbon tax. And the goal is simple — if you penalize ‘dirty’ production practices, manufacturers will innovate and find greener ways to produce steel. This in turn should reduce emissions. It’s all part of the quest to limit the rise in global temperature.

But not all countries in the world are on the same page. According to the World Bank, there are 47 national jurisdictions (think of it as countries?) that have imposed some form of carbon pricing. The others are still sitting on the fence.

Now, this creates a dilemma…it could result in something called carbon leakage.

You see, when a country imposes a carbon tax on domestic industries such as steel, it stunts its own industrial growth. Simply because the steel manufacturer’s costs rise (due to the carbon tax) while the margins take a turn for the worse. It can’t pass on the costs to its customer, say a car maker, simply because the car maker isn’t actively trying to source ‘green steel’. They’re trying to survive in a very competitive environment and they know that customers won’t shell out more for a car made of green steel. So, the carmaker simply sources ‘cheaper’ steel from a country where there’s no additional cost (without a carbon tax for instance).

The steel manufacturer loses its competitive edge. It’s outpriced by its peers in the global market. And before you know it, it might even have to wind up operations. And that’s not good for the country especially since it’s happened in the noble pursuit of combating climate change.

Or there’s another more extreme version of this.

Let’s imagine you are a steel manufacturer once again. If you believe that the carbon tax could hurt you, you might think that you’re better off setting up a steel manufacturing unit in another country. One that doesn’t impose such taxes. And then you can export the goods back to your home base. It’s a simple workaround. But it could save your business.

On the other hand, it doesn’t really reduce carbon emissions in any way. It’s merely transferred to a different location. Not only has the country lost its steel manufacturer, but it hasn’t helped climate change in any way too. It’s pretty disappointing!

Anyway, with that long introduction (or explanation!) about carbon tax and leakage out of the way, let’s turn to what’s happening in the European Union (EU). You see, the folks there have been paying close attention to this matter. And despite some evidence, including some evidence from the World Bank, showing that carbon leakage isn’t really prevalent, the EU is still worried that their carbon tax could hurt their domestic industry.

So, they now want to link trade policy with climate policy. And introduce what is probably the world’s first ‘transational carbon tax’. Or what’s formally known as the “carbon border adjustment mechanism” or CBAM.

The concept is simple. If a company in the EU is importing stuff that’s part of 5 industries — cement, iron and steel, aluminium, fertiliser and electricity — it’ll have to buy a carbon certificate first. This in turn will cost them money. How much money? Well, pretty much the same thing that they would have had to pay as carbon tax if they were producing the steel within the EU itself. It’s an equalization levy or an import duty to level the playing field.

And this could eliminate the price discount on steel between the EU and other countries. If the EU importer can prove that the original manufacturer has already paid some sort of carbon tax, then it can claim a refund.

This way, the EU’s domestic industry is protected. And EU companies won’t even think about setting up manufacturing units outside the country just to save on carbon taxes.

Anyway, all this is still in its early stages. They’re planning a test run from 2023 to 2025. And they’ll capture all the carbon-related data during this period. Once the calendar turns to 2026, the real tax will kick in.

But India is quite unhappy with this carbon tax matter. In fact, we even raised it at the recently concluded UN Climate Change Conference or COP27.

India exports over €5 billion worth of CBAM-related products to the EU. If EU importers have to pay taxes on these products now, it makes Indian goods more expensive. And they may choose not to deal with India anymore. Naturally, that would hurt India’s exports.

The question India has is — all these years, developed countries have not taken enough responsibility for their role in climate change; they’ve not contributed enough to climate change funds to help vulnerable countries; now, a carbon border tax is simply a protectionist move — saving one’s domestic industry — by hurting developing economies even more.

Anyway, there are still a lot of discussions pending on how best to implement this idea. So it isn’t happening overnight. But nonetheless, we would do well to protect the country against this exigency. After all, even the UK and the US are mulling over the idea. And these are big trading partners.

So yeah, hopefully, we figure out something quite soon.

Until then…

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