Trade Wars Threaten EU Border Patrol

Trump’s tariffs are not the only headwind facing CBAM as Europe seeks to balance climate ambition with new realities.

The European Union’s plan to impose a carbon tax at its borders from next January was always going to test its policymaking powers and relationships with global trading partners. But doing so against the backdrop of a trade war fomented by incoming US President Donald Trump could stretch them to breaking point, potentially damaging its economic prospects without supporting global climate goals.

The health of the European economy and the competitiveness of its manufacturing industry have become key priorities for the newly installed European Commission, as reflected in the recent Draghi report, which outlined a new balance between growth and sustainability.

The former president of the European Central Bank believes the success of the Carbon Border Adjustment Mechanism (CBAM) is “key”, due to the “massive near-term investment needs for EU companies” imposed by Europe’s commitment to slashing emissions by at least 55% by 2030.

CBAM will level the playing field between carbon-intensive European firms – who currently pay the world’s highest carbon price (€70/tCO2 per permit at the end of 2024) – and their international peers, many of whom pay none.

But its design flaws have led Draghi to propose a rethink, arguing the EU should “closely monitor and improve the CBAM design during the transition phase” and consider postponing the phase-out of the free certificates that cushion the cost of emitting carbon for Europe’s manufacturers, planned to start next year.

His report was published in early September, almost two months before the US voted to put Trump back in the White House and tariffs back on the global trade negotiating table.

2025 was supposed to be the year that Europe stepped up its carefully engineered transition to CBAM. But the disruptive impact of higher US tariffs could make for choppy conditions in which to fix the holes in the carbon leakage prevention tool.

“CBAM was already an imperfect mechanism,” says Brian Hensley, Partner at climate policy advisors Kaya Partners. “On top of structurally high energy prices causing further deindustrialisation, Trump will be demanding from Europe higher defence spending and more LNG exports to avoid tariffs. We can’t rule out him putting CBAM in the crosshairs either.”

CBAM in transition

For two decades, European firms in a limited set of carbon-intensive sectors have had to purchase allowances when they emit CO2 above certain levels. The allowances are bought and sold on Europe’s Emissions Trading System (ETS), with higher prices – which have marched steadily north from €15 since 2020 – theoretically incentivising firms to invest or innovate in order to reduce their emissions levels.

CBAM is being introduced to prevent those firms being undercut by high-carbon imports from firms that do not pay a carbon price at home, alongside a raft of other measures to increase the reach and ambition of Europe’s carbon pricing system.

2025 is the last year of the transition phase, during which importers must apply for ‘authorised declarant’ status as a precursor to purchasing CBAM certificates and submitting annual declarations. CBAM is expected to generate around €9 billion per annum by 2030, to be spent on decarbonisation initiatives, but the commission has suggested it is open to trading partners collecting and keeping funds raised domestically instead.

But even before Trump’s tariff plans, CBAM was facing headwinds. As Draghi noted, its numerous challenges include the difficulties of ensuring comprehensive implementation, the potential for circumvention and the risk that carbon leakage simply shifts downstream.

Further, CBAM does not level the playing field entirely, as European exporters are not compensated for the high price of their goods resulting from the ETS. It’s unlikely that this issue can be addressed, e.g. through rebates, without provoking either bilateral retaliation or breaking multilateral trading protocols.

Although Europe has tried to keep within World Trade Organization rules, CBAM has been treated with suspicion. Countries from the Global South, including India, claim it imposes an unjustified financial burden given their level of development, which may slow their decarbonisation efforts.

Free trade discussions between India and Europe have ground to halt, in part due to CBAM’s potential impact on Indian steel exports, even though it is recognised as incentivising the development of greener production processes.

Green reciprocity

To ease concerns, Dr Aurélien Saussay, Assistant Professor at the London School of Economics’ Grantham Research Institute on Climate Change and the Environment, suggests ‘green reciprocity’ could be incorporated into trade agreements, whereby tariffs could be lowered for products not impacted by CBAM in return for countries agreeing to comply with it for a limited number of carbon-intensive ones.

Another approach could be to allow firms or even individual factories to avoid or reduce charges by demonstrating below average carbon intensity. As outlined in a paper by Steve Cicala at Tufts University et al, it is possible to incentivise firms in partner countries to improve carbon intensity and measurement by offering the opportunity pay a tax on voluntarily and verifiably disclosed emissions.

“Applying a blanket country- or sector-level carbon intensity level would not reward those that have invested in best-in-class technology to have a less carbon intensive production process,” says Saussay.

Other options include temporary exemptions offered to the most vulnerable of the least developed countries, or countries facing specific circumstances, such as Ukraine.

For countries with lower emissions than the EU, in absolute or per capita terms, the income generated by CBAM could be used to fund decarbonisation in the country of origin. With Article 6 of the Paris Agreement now finalised, it might be possible to recognise an investment in a decarbonisation project in a developing country as the equivalent of a CBAM charge.

In an unpredictable and multi-polar world, flexibility is necessary. “The landscape is shifting beneath our feet,” says Saussay. “A lot of the assumptions that were valid in the post-Cold War framework no longer apply, and that impacts the kind of environmental international trade agreements that are feasible in this setting.”

Kaya’s Hensley agrees that the EU is “not exactly in the driving seat” when negotiating with countries that are growing faster, have higher emissions, and have the products and materials the EU needs.

CBAM may have encouraged other countries to think about how they structure their own domestic ETS and carbon pricing, “but attempting a ‘no mercy’ version in light of new realities would be very damaging to the EU’s industry and likely not achieve its intended goals”, he says.

New rules

One of those new realities is the Trump tariffs, which Hensley sees as more than short-term leverage as the US pursues a transactional approach to international diplomacy. One indicator is scale. As well as raising tariffs on all electric vehicles (EVs) to 100%, Trump has threatened imposing 60% levels on Chinese goods, versus the 10-20% hikes seen in his first term.

Tariffs could become a more permanent part of the landscape, not only because the new president sees them as a long-term source of revenue, but also because they could prompt Chinese retaliation in the form of export restrictions or outright bans. “That could escalate the trade schism much further,” says Hensley, warning investors not to count on a repeat of Trump’s first term, whereby tariff rises on both sides were relatively contained, culminating in 2020’s Phase One agreement.

“The rule book is being rewritten. It’s pretty apparent economic growth will be hit,” he says, adding that lower GDP levels will curb investment in decarbonisation efforts. “CBAM will be challenged in that environment. ETS prices will be lower, for example, so you won’t get that economic incentive to transition to lower emission business models.”

Ignacio García Bercero, former director of DG Trade at the European Commission, says a trade war would also hamper cooperation on climate policy. Trump’s well-trailed plans to leave the Paris Agreement, impose tariffs not only on China but also allies, and revisit the Biden administration’s decarbonisation measures would “create tensions” in the trading system.

“That would make it much more difficult to cooperate towards decarbonisation goals. And it would raise difficulties for how the EU should position itself in that context,” he says.

In a recent paper, Saussay calculated the impact of Trump’s proposed tariffs, predicting they could reduce GDP in the US by -0.64%, China by -0.68%, and the EU by -0.11%, albeit with bigger impacts in the event of retaliatory measures, and differences across EU member states.

Saussay says the EU needs to be cautious in its response, and advises against using CBAM, only partly because it would need to levy a €240/tCO2 tax on US products to match tariff revenues from EU exports to the US.

“If the EU were to use CBAM to retaliate, or even use a blanket carbon price on US imports as a retaliation mechanism against the 10% tariff Trump is planning on imposing on European exports to the US, you’d get an unrealistically high carbon price,” he says.

Weaponising CBAM in an escalating trade war would also confirm the suspicions of the Global South, he adds. “It could be construed as a defensive mechanism by the EU, even though it was really not designed that way, nor does it have the strength really to operate as such.”

Shifting landscape

So far Europe has adopted a cautious approach to tariffs, imposing modest charges on Chinese EV imports, within WTO guidelines, compared to the more punitive levies imposed by the Biden administration. This implies a respect for global trade norms, but also acceptance of the need to balance priorities in a shifting landscape.

Europe may need to rely on Chinese battery technology to support its automotive sector’s shift to EV production, but too many cheap imports could stall that transition.

“Do we want the fastest possible path to net zero – in which case, having cheap decarbonisation technologies manufactured by China is an advantage – or do we want to safeguard the largest remaining European industry?” posits Saussay. “At a time of increasing geopolitical risks, requiring Europe to re-arm, destroying what would ultimately be your military vehicle factories may not be the wisest move.”

Given the extensive lead enjoyed by the Chinese EV industry, it is open to question whether Europe or the US can complete in the long term. But, for now, their responses reflect their wider world views, according to García Bercero, a Fellow at the Bruegel think tank.

“In the EU, there’s a clear recognition of the need for trade-offs,” he says. “The US has decided to go full speed in the direction of decoupling from China, getting it out of the green value chain, and investing in domestic manufacture, no matter how much it costs, no matter the level of external protection needed.”

The investor’s trilemma

As a veteran negotiator, García Bercero expects trade and sustainability to collide more frequently in the future. While trade agreements such as the one the EU recently signed with the Mercosur countries have long contained sustainability chapters, emissions have not played a part in tariff negotiations on specific sectors, such as steel.

US volatility makes a diversified trade portfolio more important for the EU, but comprehensive deals face mounting hurdles. “We may want to look into agreements that are more nimble, that do not require as much time and resource to be negotiated,” says García Bercero.

Incoming EU Trade Commissioner Maroš Šefčovič has been tasked with developing ‘clean trade and investment partnerships’, which are expected to be more targeted deals connected to green value chains that can be signed off more quickly. These could help certain African countries invest to develop new processing capabilities alongside existing mineral extraction industries, suggests García Bercero.

The trilemma of balancing an affordable transition with industrial competitiveness and energy security is one that poses challenges not just for trade negotiators and their political masters, but also investors, says Hensley, noting that few countries can remove China from their supply chains while keeping a lid on their upfront decarbonisation costs.

“[Investments in] industries that rely on a lot of regulation, have high costs and which don’t solve for national security, energy security or competitiveness need to be questioned,” he says.

“Investors should also double check the forward paths of businesses dependent on CBAM or carbon pricing. That said, there are opportunities in other sectors for deregulation to generate productivity gains.”

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