There are rules, and then there are exceptions to the rules. The World Trade Organization (WTO) has both, as illustrated by the recent trade tensions over “carbon border adjustments”—the application of domestic carbon pricing policies to imported products. Much of the focus has been on whether the European Union’s “carbon border adjustment mechanism” (CBAM), which began its transitional phase in October, would be permissible under the WTO’s exceptions for environmental measures.
But carbon border adjustments don’t necessarily require justification under an exception, as demonstrated by the Clean Competition Act (CCA), recently reintroduced by Senator Sheldon Whitehouse (D-RI) and Representative Suzan DelBene (D-WA-1). The CCA would impose a “carbon intensity charge” on imports of certain products—including fossil fuels, steel, and aluminum—that mirrors a domestic carbon charge. The import charges could be waived for products from countries that implement similar emissions pricing policies. The CCA also includes a border adjustment on exports; charges imposed on domestically produced products that are subsequently exported would be rebated.
The CCA’s carbon intensity charges would likely qualify as permissible border adjustments rather than illegal tariffs requiring justification under an exception. The term carbon border adjustment is a variation on “border tax adjustment,” which refers to the practice of applying domestic “indirect” taxes on productsto imports. Border adjustments have long been viewed as necessary to preserve fair competition between imports and domestically produced products, as explained by the British economist David Ricardo in the early 19th century:
“A tax affecting [domestic producers] exclusively is, in fact, a bounty to that amount on the importation of the same commodity from abroad; and to restore competition to its just level, it would be necessary not only to subject the imported commodity to an equal tax, but to allow a drawback of equal amount, on the exportation of the home-made commodity.”
Accordingly, the WTO permits both the imposition of indirect taxes on imports and their rebate on exports of domestically produced products, as provided for in the CCA. The WTO’s rules on both import and export border adjustments follow the “destination principle” of international tax policy, which calls for products to be taxed where they are consumed rather than where they are produced.
Whether a tax may be border adjusted depends on whether it is classified as “direct” or “indirect.” The distinction is frequently characterized as turning on whether a tax is imposed on goods or services (e.g., a sales tax) or producers of those goods and services (e.g., income taxes). Using this definition, the CCA’s carbon intensity charge would presumably qualify as an indirect tax because would be calculated by reference to the total weight of the relevant goods that are produced or imported.
Even if the CCA’s carbon intensity charges were not deemed by the WTO to qualify as an indirect tax, it would still likely be found to be permissible. As I have written about elsewhere, there are WTO exceptions that permit a wide variety of approaches to carbon border adjustments and other forms of carbon import fees, including provisions for environmental measures, essential security interests, and intergovernmental commodity agreements.
The EU’s CBAM, unlike the CCA, will probably need to be justified under one of these exceptions. The EU insists that the CBAM will comply with the WTO’s rules but hasn’t provided much detail on why, and it appears unlikely that the CBAM will qualify as a permissible border adjustment of an indirect tax. Like the CCA, the CBAM is designed to apply domestic carbon pricing to imported products. But the relevant domestic pricing under the CBAM is the EU’s Emissions Trading System (ETS), which applies to facilities, not products, and therefore may not be considered an adjustable indirect tax.
The CBAM should still be found permissible under one of the relevant WTO exceptions. But the Clean Competition Act offers a reminder that carbon border adjustments can be entirely compatible with free trade rules, no exceptions needed.