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Lost in Retaliation: Redrawing Focus to Mutually Agreed Solutions in Light of EU CBAM Regulations

About the Author: Shubhankar Sharan, a third-year student pursuing B.A. LL.B from Gujarat National Law University.

Image by Christian Lue showing the European Union flags. Available here.


Introduction

The European Union (“EU”) recently announced the phased implementation of the Carbon Border Adjustment Mechanism (“CBAM”) Regulations. CBAM is a price adjustment mechanism for certain goods imported into the EU based on the amount of carbon dioxide emitted during the production of such goods. Broadly, CBAM aims to reduce carbon emission and encourage sustainable production to prevent climate change. Unsurprisingly, it has raised much discontent, especially in India, as the Minister of Power and New & Renewable Energy has highlighted that India may impose retaliatory tariffs in the face of CBAM Regulations. Given the currently disrupted global supply chains and a weak economic recovery rate, the undue risk that CBAM might cause a trade war should be minimized at best. In addition, this is not the first time a European Policy has come under the radar. A 2008 Directive of the European Parliament, which required airline operators to pay emission allowances based on the amount of carbon dioxide released during flights to and from EU airports, had already raised severe criticisms. Several countries, including the United States, India, and China, opposed the Directive and imposed retaliatory measures, including suspending major deals with European aircraft manufacturers.


Against this backdrop, this piece attempts to elucidate the legal merits and reasonableness of retaliatory measures against the imposition of the CBAM Regulations, considering the possibility of violations of the World Trade Organisation (“WTO”) provisions and rules. Lastly, the piece puts forth mutual agreement as a tenable alternative to retaliatory measures.


Nature of CBAM Regulations

The European Commission (“EC”) will be implementing CBAM Regulations in phases. From January 1, 2026, the EU will begin imposing import tariffs on carbon-intensive products. In India, the 20%-35% tariff rates will affect steel and aluminum exporters, as well as producers of fertilizers, cement, and electricity. One major objection from EU trade partners is that proceeds from CBAM will contribute to the EU’s annual budget. This has reignited the debate about the responsibilities of the developed countries in taking responsibility for their previous emissions.


The UNCTAD has raised concerns about the European Union tilting trade patterns favoring trade with carbon-efficient countries while neglecting developing countries. In addition to India, China has also questioned the regulations’ compliance with WTO principles, including the Principle of National Treatment and Non-Discrimination. For instance, the regulations run counter to the EU’s commitments towards the Most Favored Nation principle, which refers to discrimination between trading partners selling “like” products. Additionally, the CBAM Regulations potentially violate the ‘Common but Differentiated Responsibilities’ principle (“CBDR”) recognized in the United Nations Framework Convention on Climate Change (“UNFCC”). The CBDR principle ascribes different duties to take climate actions to countries based on their different capabilities. Least-developed Countries have flagged the Regulations as ignorant of varied national circumstances, resulting in disproportionate burdens on them.


Further, CBAM Regulations’ potential limit on imports is a violation of Article XI of the General Agreement on Tariffs and Trade (“GATT”). In view of these potential legal discrepancies, the affected countries, including India, have reasons to either initiate retaliatory measures, such as CBAM-like regulations to offset the loss.


Dispute Settlement Body and Associated Issues

The potential issue highlighted above is sufficient for the affected countries to seek redressal from the WTO Dispute Settlement Body (“DSB”). However, even when a panel report is released after a lengthy process, there is no definiteness about its implementation as the parties have the option of appealing before the Appellate Body (“AB”). It further becomes uncertain considering the recent deadlock in appointing members to the AB. Hence, the appeal would be sent “into the void”. A dysfunctional AB ostensibly extends the timeline of disputes between the parties with no result in sight. Moreover, bearing in mind the costs incurred in facilitating a dispute at DSB, the countries may “take the law into their own hands” without utilizing the WTO proceedings, as expressed by the European Commission.


Retaliatory Measures: A Look at the WTO

Despite the attractiveness of retaliatory measures, there are distinct drawbacks. Retaliatory measures require express authorization of the DSB, as mentioned in Articles 22.6 and 23.2(c) of the Dispute Settlement Understanding (“DSU”). If authorized, the country can be exempted from complying with the most favored nation (“MFN”) principle and effect discriminatory treatment against other countries, thereby affecting the balance of trade. However, it must be noted that retaliatory tariffs are not mentioned in Article 22.1 of the DSU, which only mentions “compensation,” “suspension of concessions,” and “other obligations.” Instead, the retaliatory tariffs are implied in “suspension of concession” since discussions on “concessions” in former GATT rounds included tariff reductions. To prevent trade distortion and subsequent trade wars, the member countries had agreed not to impose unilateral retaliatory measures unless the arbitrators of the DSB grant permissions to do so, only to the extent as decided. It is further complicated when the country facing retaliation challenges the said measures on the grounds of violation of principles outlined in Article 22.3., which then sends the matter back to arbitration by the original panel. Article 23 of DSU provides the members with a recourse to redressal in case of violation of obligations by countries.


For instance, in European Communities – Bananas III, Ecuador was not permitted to initiate retaliatory measures until the damages inflicted by the European Commission’s non-compliance with the DSB Ruling were determined. The underlying purpose of authorization of retaliatory measures is not about punishment but about rebalancing trade levels. In the process before the DSB, the parties first go through mediation. However, if a settlement is not achieved, the parties can move to the WTO for adjudication. After the release of the DSB report, the same can be appealed before the AB. However, in the current scenario, it is a frivolous exercise. Only when there is non-compliance with the Report or continuance of violation of WTO Rules the trading partners can seek remedy in the form of trade retaliation or compensation.


Limits of Retaliation

Article 22.6 of the DSU outlines the requisites to establish the upper limit of retaliation. Primarily, the amount authorized for retaliation shall not exceed the impairment suffered by the complaining county. Not to mention, the arbitrators in EC – Bananas III (US) have elaborated on the meaning of ‘equivalence’ as mentioned in Article 22.4 of the DSB. In simpler terms, the arbitrators in another case disallowed trade retaliation as a punitive measure while extending its scope only to nullification or impairment due to the flawed policy. The WTO uses the “Trade Effects” formula to determine the amount of retaliation to be permitted. Additionally, the panel ascertains the retaliatory measures in view of the nullification or impairment of the state’s benefits. To date, the DSB has authorized the adoption of retaliatory measures against the violator only seventeen times. However, trade retaliation is still considered a “last resort” remedy. It can be used only when the multilateral trading system cannot resolve the dispute.


Loopholes in the System

The procedural aspects of sanctioning retaliation indicate the undue time involved in “rebalancing” the position. For instance, WTO Arbitrators granted China the right to impose retaliatory tariffs on the U.S. imports after a decade-long dispute. Moreover, the U.S. also initiated WTO proceedings against India pursuant to the latter's retaliatory tariffs in 2019, which had not been resolved until the recent diplomatic efforts undertaken by the USA and India. Though subversion of the procedural rules is neither feasible nor advisable, the long-drawn dispute also bears significant repercussions on the retaliating country (commonly referred to as “shoot itself in the foot”) and the “innocent bystanders” of the country.


Even if proceedings for retaliation are initiated, the violating country is not required to provide monetary compensation for the harm already caused. Further, when retaliation is sanctioned, the violating country is not required to rescind its illegal policy: it can choose to bear the retaliation concurrently with the implementation of the policy. Thus, the retaliatory efforts do not guarantee responses of compliance actions. Apart from it, the price of a breach is too low as nothing in the DSU ensures or obliges the actual imposition of retaliation.


In a similar vein, the measurement method of equivalence amounts is not clear enough to avoid situations of under-compensation or over-compensation. The rebalancing act through retaliation necessarily requires accurate determination of the retaliatory amount. Retaliation through tariffs seems feasible, but it has negative consequences for business of both countries involved in the dispute. Given that the EU is India’s third largest trade partner, retaliation would only increase the cost of the targeted products, harming industries in both regions. Furthermore, the “sequencing” problem, as to when the WTO can authorize retaliation in case of non-compliance, further perpetuates ambiguities regarding trade retaliation. For instance, it is uncertain yet when the compliance period begins, highlighting a discrepancy between Articles 21.5 and 22 of the DSU.


Mutually Agreed Solution: The Need of the Hour

Article 22.8 of the DSU provides three situations under which retaliatory measures have to be withdrawn: removal of the illegal policy, arrival at mutually agreeable solutions, or the provision of a solution to nullification or impairment. Apart from these three scenarios, Article 3.7 of DSU ascribes clear preference to a mutually arrived conclusion. The enlarged scope of retaliatory measures aims at ultimately achieving mutually agreeable solutions. The underlying purpose is demonstrated in the withdrawal of post-agreement retaliatory measures through mutual agreement between the USA and the EU in the EC – Hormones case. Renowned disputes like US – Softwood Lumber IV have also been resolved by the parties under Article 3.6 of the DSU. Similarly, India and the USA announced their mutually agreed solution on 13 July 2023 regarding the retaliatory tariffs imposed by the former in India -Export Related Measures. To prevent hardships from arising in the initial stages, countries should engage in multiple rounds of negotiations to reach a mutually agreed solution. Therefore, the potential dispute between EU and countries raising objections to the CBAM Regulations should negotiate mutually agreeable solutions, which will cause little or no economic harm to either side.


Conclusion

The European Union is encouraged to adopt an internationally agreed upon legislative framework delimiting the scope of carbon border measures. If the current situation persists, multiple developing countries, including India, may devise their specific retaliatory measures or proceed with formal procedures to resist the Regulations. No parties want to dismantle the existing system for establishing an FTA over domestic regulations and incisive trade measures. Given that the global economy has emerged from a pandemic only to have immediately encountered inflation, a trade war is especially undesired. Retaliation will only contribute to our existing economic issues. Therefore, negotiating mutually agreeable solutions has an undeniable role in ensuring a fair assessment and country-specific equilibrium.


The author would like to express gratitude to Mr. Varun Chablani for his guidance throughout the research and drafting process.

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