Climate Protection Tariffs: The New Trade War

On October 1, the European Union launched a new climate-linked tariff that has the potential to shake up international trade. For many, the new Carbon Border Adjustment Mechanism (CBAM) passed under the radar, perhaps because it applies to a limited number of goods or because it has phased implementation, delaying when businesses will feel the greatest impacts. However, as the first initiative to impose trade tariffs on greenhouse gas emissions, the EU is setting a precedent with CBAM that is likely to be mimicked by other countries and for other sectors, disrupting supply chains and creating a new trade barrier between greening economies and those lagging behind.

Carbon Board Adjustment Mechanism

CBAM imposes CO2 emissions tariffs on imported iron and steel, aluminum, cement, electricity, fertilizers and hydrogen. The tariffs seek to level the field between EU and foreign producers in these carbon intensive sectors. EU industries must buy permits from the EU carbon market (Emissions Trading System) when they pollute, and under the new system, foreign producers will pay tariffs based on emission lifecycles of their products, a move regulators hope will even the playing field for higher-cost EU producers and lower cost, but more polluting, foreign producers. The lower the emissions footprint, the lower the tariffs. Additionally, the EU system allows deductions from the rate for any carbon prices the foreign producer pays .

The EU states CBAM will encourage a worldwide shift to greener production and will prevent “carbon leakage,” i.e., the relocation of EU industries to countries with lower compliance standards for greenhouse gas emissions.

The first phase of CBAM went into effect on October 1. Phase 1 requires importers to collect emissions data and report them to a European Commission registry in order to continue sending their products into the EU. Starting on January 1, 2026, based on reported data, the companies will pay an “adjustment” fee to cover the carbon price gap between non-EU and EU products. According to the EU’s Economy Commissioner Paolo Gentiloni, CBAM will extend the same pricing principles as the Emissions Trading System to all carbon-intensive products imported into the EU. Because the EU will be treating foreign and domestic companies alike, the tariff will be compliant with World Trade Organization rules.

While CBAM sounds simple in theory, implementation will be complex and risks will create a new set of trade tensions.

Steel Sector: Wide Divergency in Carbon Footprints

China has responded negatively to CBAM, criticizing the EU for taking unilateral measures and urging other countries not to follow suit. This is not surprising, given the adverse impact CBAM will have on trade between China and the EU in carbon-intensive industries. A look at the steel sector provides an illustrative example.

China produces half of the world’s steel. While it consumes half of that for domestic use, the rest is exported. In 2020, China had a net export of 13.5 million tons of steel, according to the World Steel Association. About 90% of crude steel production uses coal-based, blast furnace-basic oxygen furnace (BF-BOF) routes, a method that generates significant carbon emissions. While Beijing has a plan to reduce greenhouse gas emissions that includes bringing the steel sector into the existing national carbon market, current trends are problematic. Chinese steel companies are making significant investments now in new, coal-based steelmaking capacity, locking in this carbon intensive production for another 40-year lifespan.

Coal is the dominant fuel for steelmaking in China but makes up significantly less for steel produced in the U.S., UK and EU (around 27%, 17% and 60%, respectively). In all three, governments and steelmakers are making significant investments to transition to less carbon-intensive processes, including using hydrogen as fuel.

The EU and China already have trade disputes over steel, with the EU imposing anti-dumping tariffs. CBAM risks increasing trade tensions at a time that the EU is already re-evaluating the trading relationship to address over-dependency in key sectors. 

China is not alone in being highly invested in coal-based steel production. India is the world’s second-largest crude steel producer and is seeking to expand production capacity by 300 million tons by 2030 – using coal for fuel.

Compliance, Costs and Supply Chains

Due to EU rules, implementation of CBAM within the EU will vary from state to state, risking a complicated compliance environment, different processing times impacting customs clearance and verification of emissions. For U.S. exporters, the administrative processes will be the biggest headache. 

Calculating emissions will require a level of sophistication and extensive benchmarking, with less developed countries potentially facing reporting requirements that they cannot meet. These countries will likely be forced to look for alternative markets.

State-owned companies in less transparent jurisdictions may be unwilling to share emissions information that may be considered confidential or a trade secret. Outright cheating is always a risk, with a product being falsely sourced to lower emissions factories in a .

While supply chain disruption and increased trade tensions are downside risks, the upside risk is that CBAM will trigger more transparency in emissions data around the world, as companies see the incentives to show improvement as they move towards net-zero emissions.

There is an understanding that CBAM may increase importation costs, and these costs would likely be passed on to consumers. The EU, however, has a mature level of support for carbon pricing in the transition to a decarbonized economy. The legal documents behind CBAM policy action are written sector-neutral, enabling the EU to expand the scope of climate-related tariffs without a new legal process. CBAM 2.0 could include organic chemicals and polymers, impacting oil and gas downstream products.

The EU has a track record of establishing regulatory regimes and standards that are adopted internationally. If other advanced economies adopt the EU approach, or variations on it, we could see the emergence of a green trading bloc, where partners have preferential market access based on environmental policies and metrics. However, for those countries left outside, by design or circumstance, climate-friendly trade practices could be seen as another tool in a trade war.