Between India and the EU: A Carbon Gap and the FTA Bridge

Syllabus

GS 2 ● India-EU ● Carbon Border Adjustment Mechanism

Why in the News

The article highlights how India’s election regulations lag behind digital campaigning realities. Using the Bihar Assembly election as a case study, it shows that third-party actors outspend official parties, achieve higher visibility, and escape accountability. The absence of disclosure norms for surrogate campaigners creates opaque financial flows, undermining transparency and fairness in digital democracy.

Introduction: CBAM as a New Trade Barrier

• From January 1, Indian steel and aluminium exports to the European Union (EU) face a significant cost shock.
• The cause is the EU’s Carbon Border Adjustment Mechanism (CBAM), which taxes imports based on carbon emissions generated during production. This mechanism, in some ways, mirrors the concept of environmental clearances in its aim to regulate industrial activities for environmental protection.
• While presented as a climate action, CBAM is reshaping global trade competitiveness, especially for developing economies like India. It represents a shift in environmental jurisprudence on an international scale.
• In the absence of a nationwide carbon pricing mechanism in India, exporters are exposed to the full CBAM burden, threatening margins, contracts, and market access. This situation draws parallels to the challenges faced in obtaining retrospective environmental clearances or ex post facto approvals in domestic contexts.

What is CBAM and How Does It Work?

1. Concept and Objective

• CBAM extends the EU Emissions Trading System (ETS) to imports.
• Its stated aim is to prevent carbon leakage—the shifting of production to countries with weaker climate regulations. This aligns with the precautionary principle often applied in environmental law.
• It covers steel, aluminium, cement, fertilisers, electricity, and hydrogen, with more sectors likely to be added.

1. Emissions Accounting Rules

• CBAM calculates liability using: ○ Scope 1 emissions: Direct fuel use in production. ○ Scope 2 emissions: Electricity consumption.
• Excluded: ○ Mining, transportation, logistics, and product-use emissions.
• Crucially: ○ Only plant-level emissions count. ○ Company-wide or national averages are irrelevant.

This approach to emissions accounting shares similarities with environmental impact assessment processes, focusing on specific project-level impacts.

Why Indian Exporters Are Disproportionately Hit

1. Absence of Carbon Pricing in India

• Unlike the EU, India does not yet have a national carbon tax or emissions trading system.
• As a result: ○ Indian exporters cannot offset CBAM liabilities with domestic carbon payments. ○ They must pay the entire EU carbon price, currently around €80 per tonne of CO₂.

1. Carbon Price Asymmetry

• EU carbon price: ~€80 per tonne ● China’s carbon price: ~10% of EU levels ● India’s future carbon price (expected): Significantly lower
• Applying rich-country carbon prices to developing economies: ○ Raises production costs ○ Hurts exports ○ Slows industrial growth ○ Has negligible impact on global emissions

This asymmetry in carbon pricing reflects broader challenges in achieving a pollution-free environment while balancing economic development needs.

The Hidden Reality: Who Really Pays the CBAM Tax?

• Officially: ○ CBAM is paid by EU importers, not Indian exporters.
• In practice: ○ Costs are passed back to Indian producers through: ■ Lower purchase prices ■ Contract renegotiations ■ Reduced bargaining power
• Indian exporters: ○ Earn less ○ Absorb the economic shock ○ Lose competitiveness despite not being the legal taxpayer

This dynamic echoes the polluter pays principle, albeit in a complex international trade context.

Quantifying the Impact: Steel and Aluminium Under Stress

1. Cost Calculation Example

• Coal-based BF–BOF steel production emits ~2.4 tonnes of CO₂ per tonne of steel.
• At €80 per tonne of CO₂: ○ CBAM cost = €192 per tonne of steel
• Importers are estimated to pass 50–70% of this cost to exporters.
• Result: ○ Exporters lose €95–€133 per tonne ○ Sale price falls from €600 to €467–€505 ○ Margin erosion of 16–22%

1. Trade Exposure

• EU absorbs about 22% of India’s steel and aluminium exports.
• Even modest price pressures risk: ○ Contract cancellations ○ Supplier switching ○ Long-term loss of market share

The Default Value Trap: A Silent Margin Killer

• If exporters fail to provide verified emissions data: ○ EU applies default CBAM values.
• These defaults are: ○ 30–80% higher than actual emissions ○ Sometimes nearly double
• Importers will not absorb this risk.
• They will: ○ Demand deeper price cuts ○ Or shift to alternative suppliers
• Avoiding default values is critical to protecting margins.

This situation underscores the importance of accurate environmental impact assessments and data transparency in international trade.

Early Signs of Stress in India–EU Trade

• In FY2025: ○ India exported $5.8 billion worth of steel and aluminium to the EU. ○ This was 24% lower than the previous year.
• The decline began before CBAM became a tax.
• Key reasons: ○ Emissions reporting requirements introduced in October 2023 ○ Compliance costs ○ Data gaps ○ Verification challenges
• Many exporters reduced shipments during CBAM’s transition phase itself

Verification and Compliance Challenges

• From 2026 onwards: ○ Emissions data must be verified by auditors approved under: ■ ISO 14065 ■ Or EU-recognised systems
• Challenges for India: ○ Limited number of qualified auditors ○ High verification costs ○ Urgent need for institutional capacity building
• Delay in preparation risks: ○ Higher CBAM costs ○ Loss of EU buyers

These verification challenges mirror issues faced in domestic environmental clearance processes, highlighting the need for robust environmental governance structures.

Contractual and Structural Shifts in Trade

• CBAM is forcing a rewrite of export contracts.
• Likely changes include: ○ CBAM cost deduction clauses ○ Mandatory verified plant-level data ○ Price renegotiation if EU carbon prices change
• Emerging practice: ○ Two-price quoting: ■ Base price ■ CBAM-adjusted price
• This marks a shift where carbon becomes a trade currency.

Production Routes and Carbon Competitiveness

• CBAM strongly differentiates based on production methods: ○ BF–BOF (coal-based) → Highest CBAM burden ○ Gas-based DRI → Moderate burden ○ Scrap-based / Electric Arc Furnace (EAF) → Lowest burden
• Effectively: ○ CBAM rewards cleaner production ○ Penalises carbon-intensive industrial pathways

This differentiation aligns with broader goals of promoting a pollution-free environment through economic incentives.

CBAM: Climate Action or Industrial Protection?

• Steel and aluminium account for about 10% of global carbon emissions.
• Yet they are now among the most protected sectors in developed economies.
• Parallel developments: ○ US imposes 50% import tariffs ○ EU adds a carbon tax
• CBAM thus serves a dual purpose: ○ Climate regulation ○ Industrial protection and revenue generation

These developments raise questions about environmental democracy and the balance between climate action and fair trade practices.

Way Forward for India

1. Trade Diplomacy

• CBAM must be addressed urgently in India–EU FTA negotiations.
• India should seek: ○ Transitional relief ○ Mutual recognition of carbon measures ○ Fair treatment for developing economies

1. Domestic Preparedness

• Strengthen carbon accounting frameworks ● Expand auditor capacity ● Support cleaner production technologies ● Provide transition support to MSMEs

1. Strategic Adaptation

• Shift towards: ○ Lower-carbon production routes ○ Data discipline and transparency
• Competitiveness will increasingly depend on: ○ Emission intensity, not just cost efficiency

Conclusion

• CBAM is not a temporary compliance hurdle but a structural shift in global trade, reminiscent of how environmental clearances have reshaped domestic industrial practices.
• For Indian exporters, survival in the EU market hinges on: ○ Early adaptation ○ Accurate emissions measurement ○ Verified data ○ Contractual realignment
• As carbon pricing becomes embedded in trade regimes, economic competitiveness and climate performance are converging—reshaping the future of industrial exports and global environmental governance.

UPSC Mains Practice Question

Q:”The EU’s Carbon Border Adjustment Mechanism (CBAM) represents a structural shift in global trade rather than a mere environmental regulation.”Critically examine its implications for India’s exports and suggest policy responses. (15 marks)