By Kate Abnett

BRUSSELS (Reuters) – Brussels policymakers, about to unveil the world’s first carbon border levy, are caught between industry demands to twin it with free carbon permits worth billions of euros, and analysts’ warnings that doing so could expose the EU to legal challenges at the WTO.

As part of a package of climate policies, including carbon market reforms, the European Commission will next month publish its plan to impose a carbon border adjustment mechanism (CBAM) or CO2 tariff on polluting goods, forcing some companies importing into the European Union to pay carbon costs at the border.

The idea is to prevent carbon leakage – or the phenomenon of European firms relocating to countries with less costly climate standards – by levelling the playing field between production in Europe and potentially cheaper but more polluting manufacture of products such as steel and cement elsewhere.

But the European Commission has also said the levy will be an alternative to existing carbon leakage measures, which include giving free CO2 permits to industries covered by the EU carbon market to offset their environmental costs and encourage them to stay in Europe.

That has worried Europe’s steel, aluminium, cement and fertilisers sectors, all of which would be covered by the CO2 border levy, a leaked draft shows.

The EU expects to hand out more than 6 billion free permits this decade – worth 314 billion euros ($373.97 billion), at today’s CO2 price of around 50 euros. Estimates of how much the CBAM would raise are complex, but analysts say they would be far lower for the sectors affected.

“If there is no free allocation, we don’t want to be part of it (the CBAM),” Charles de Lusignan, spokesman for steel association Eurofer said.

A swift reduction in free CO2 permits would shrink the already-slim profit margins of European steel firms, he said. “That may, for some companies, lead to having no profits any more.”

“Only a combination of CBAM and free allowances will allow (the) fertilizer industry to remain competitive,” Fertilizers Europe director general Jacob Hansen said. Losing free permits could prompt companies to redirect investments outside Europe, he said.

The leaked draft, which could change before it is published on July 14, said the EU border levy would apply from 2026, after a trial period from 2023. It did not specify what would happen to free CO2 permits.

Koen Coppenholle, chief executive of cement body Cembureau, said Brussels’ plan to give industry free permits should remain unchanged until 2030, to provide certainty for long-term green investments.

Technologies such as carbon capture, deemed essential to cutting industrial pollution, are unlikely to be commercially viable this decade, he said, and added the body had received legal advice that it could be possible to combine the CBAM and free permits without breaking international trade rules.

Aluminium Europe said it did not want to be included in the CBAM before 2030.

‘YOU CANNOT HAVE BOTH’

The Commission has a policy of not commenting on unpublished drafts, but said its carbon border proposal will be compatible with World Trade Organization rules.

Some officials have said that means free permits will need to go for sectors covered by the border levy.

“It is very clear that the moment you start phasing in CBAM, you have to start phasing out free allowances,” Sabine Weyand, head of the Commission’s trade department, told lawmakers in European Parliament this month.

“From the point of view of WTO compatibility, you cannot have both.”

Former WTO chief Pascal Lamy agreed, telling Reuters Brussels would be vulnerable to legal challenges if it were seen to be compensating companies twice.

“The rule is very simple: no double compensation. No overlapping,” he said.

Simone Tagliapietra, senior fellow at think tank Bruegel, said the two systems could coexist temporarily, if importers’ CBAM costs were reduced to reflect the amount of free CO2 permits they would receive had they produced the goods in the EU. But he said free allowances must end by 2026, when the border levy applies in full.

Environmental campaigners have long called for a swift end to free CO2 permits, which they say remove the incentive for industry to cut emissions.

Sam van den Plas, policy director at Carbon Market Watch, said the EU should auction all CO2 permits and invest the revenues in cutting emmisions.

“In the middle of a climate crisis, no company should be allowed to pollute for free,” he said.

EU figures show emissions from EU industry decreased by roughly 9% from 2013-2020, with the biggest drop recorded last year when the COVID-19 pandemic curbed economic activity.

Emissions from power plants, which do not receive free CO2 permits, fell by 38% from 2013-2020.

($1 = 0.8396 euros)

(Reporting by Kate Abnett; editing by Barbara Lewis)

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