Carbon Border Adjustment Mechanism: The Making of a New Trade War

On 1 January 2026, the European Union’s Carbon Border Adjustment Mechanism (CBAM) entered into full force, marking a new phase in global climate governance. Framed as a necessary extension of the EU’s Emissions Trading System (ETS), CBAM seeks to prevent carbon leakage and preserve industrial competitiveness by taxing the embedded emissions of imported goods. Yet beyond its environmental justification lies a deeper political reality: CBAM represents the extraterritorial projection of European climate standards onto global trade. In doing so, it risks reframing climate cooperation as climate confrontation. While designed to equalise the playing field, CBAM may instead ignite retaliatory tariffs, exacerbate geopolitical tensions, and strain relations between the EU and emerging economies.

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Demystifying CBAM

Under ETS, which operates as a “cap-and-trade” carbon market, the EU has limited sectors’ total pollution output since 2005 with the intention of decreasing it annually to achieve climate goals. Should a polluter firm intend to exceed the pollution quota, it would have to purchase additional allowances. Attaching a direct financial cost to pollution is intended to increase production costs for carbon inefficient/high-polluting firms. In theory, pricing emissions incentivises firms to innovate and transition towards cleaner production.

 

Yet, the ETS creates a structural vulnerability – carbon leakage. As carbon-intensive industries face rising compliance costs within the EU, firms may relocate production to jurisdictions with looser environmental regulations. Rather than reducing global emissions, production – and its associated carbon output – is simply displaced. An OECD study on the aluminium, cement, and steel sectors revealed that carbon leakages offset approximately 13% of emission reductions from carbon policy. Beyond environmental inefficiency, the European economy is undermined by reduced economic growth and trade losses. As foreign production costs are relatively lower, companies move production to more competitive countries. Moreover, European countries would have to rely on importing products previously manufactured domestically from countries with cheaper production, worsening the trade balance.

 

Recognizing such drawbacks, the CBAM was introduced to close such loopholes. Fundamentally, the CBAM is a trade policy designed to impose a fee on imported goods, based on their carbon intensity. To put into perspective, when a European firm wants to import carbon-intensive goods such as fertilisers, they have to declare the embedded emissions – how much carbon was emitted during the production – and purchase certificates pegged to the ETS price. Effectively, the EU extends its carbon pricing regime to foreign producers – a tonne of carbon emitted in Beijing is thus priced equivalently to one emitted in Berlin. In principle, this neutralises the cost advantage of high-carbon imports and levels the playing field for domestic and foreign manufacturers. 

 

However, while targeting the trade balance, the CBAM inadvertently introduces domestic and internal economic ramifications. 

 

Rising Costs​

By attaching a carbon levy to imports, CBAM increases the cost base of carbon-intensive goods entering the European market. In practice, these additional costs are passed along supply chains and ultimately reflected in consumer prices. Domestic producers operating under the ETS face similar pressures when purchasing emission allowances, creating cumulative cost effects across both imported and locally manufactured goods.

 

While CBAM is limited to specific sectors, the goods affected – such as steel, cement, fertilisers, and aluminum – are commodities that form the backbone of industrial production. Rising input costs in these sectors can cascade through construction, manufacturing, and food, ultimately contributing to broader price inflation. Without compensatory measures, CBAM may disproportionately affect lower- and middle-income households, worsening existing economic inequality.

 

Inviting Retaliation by Other Countries

By imposing carbon tariffs on imports, CBAM can be framed as green protectionism by trading partners. In a bid to protect their domestic economies and signal resistance to perceived unilateral regulatory overreach, non-European countries may impose retaliatory tariffs on European exports. India’s commerce minister Piyush Goyal has warned that the country would “respond (to CBAM) with full measure” with taxes on European countries. Similar objections have been echoed by China and Brazil, reflecting deeper unease among developing economies that may normatively argue that the EU bears greater historical responsibility for climate change. This invites the subsequent introduction of additional tariffs by both European and non-European countries, parallel to the existing US-China trade war. Therefore, it is probable that a trade war is brewing between the EU and its trading partners, compromising the welfare of citizens from both countries with higher prices. 

 

Mitigating by Redirecting Tax Revenues

Though implemented with good intentions, CBAM inadvertently creates detrimental economic impacts, locally and internationally. Nonetheless, its economic frictions do not render it inherently misguided. Rather, they reveal that carbon pricing alone is insufficient to drive structural transformation. For both CBAM and ETS to achieve environmental objectives without triggering domestic backlash and international retaliation, they must be complemented with proactive industrial policy.

 

Theoretically, widespread adoption of green technology would reduce firms’ reliance on additional carbon allowances, lowering production costs and incentives for relocation. This addresses carbon leakages at its source, rather than merely correcting it at the border with CBAM. Yet, this remains a utopian dream. High upfront costs, technological uncertainty, and competitive pressures discourage firms from investing in low-carbon innovation. 

 

I argue that the framework of ETS can be pivoted to chase this “utopian” dream. Drawing on the revenue of carbon permits, the EU can divert funds to discount the costs of purchasing greener technology or develop affordable, low-carbon technology. By reducing the structural cost of decarbonisation, this shifts carbon pricing from a purely punitive mechanism to a catalytic one. Instead of merely leveling the playing field, the EU would actively reshape it.

 

CBAM captures the paradox of modern climate politics: it aims to advance environmental progress while protecting economic competitiveness, but this risks undermining the global cooperation needed for effective decarbonisation. If seen as protectionism rather than climate responsibility, it may deepen geopolitical divisions and trigger retaliatory trade measures. Reinvesting carbon revenues into green innovation could ease these tensions by lowering the structural cost of transition.

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References

1. Amendola, Marco. 2024. “Winners and Losers of the EU Carbon Border Adjustment Mechanism. An intra-EU Issue?” Energy Economics 142 (December): 108139. https://doi.org/10.1016/j.eneco.2024.108139.

2. “Carbon Border Adjustment Mechanism.” 2026. Taxation and Customs Union. March 6, 2026. https://taxation-customs.ec.europa.eu/carbon-border-adjustment-mechanism_en.

3. “EU ETS Emissions Cap.” n.d. Climate Action. https://climate.ec.europa.eu/eu-action/carbon-markets/eu-emissions-trading-system-eu-ets/eu-ets-emissions-cap_en.

4. “Green Trade or Green Protectionism? The EU CBAM and Odisha’s Steel Industry in  India’s Low-Carbon Transition.” n.d. https://www.econ4future.org/articles/green-trade-or-green-protectionism-the-eu-cbam-and-odishas-steel-industry-in-indias-low-carbon-transition.

5. Lanktree, Graham, and Camille Gijs. 2025. “India Eyes Retaliation Against EU, UK Carbon Border Taxes.” POLITICO, June 19, 2025. https://www.politico.eu/article/india-eu-uk-carbon-border-taxes-cbam-products/.

6. Prideaux, Flora. 2026. “CBAM, COP30, and How Carbon Became an Excuse for Economic Protectionism.” Trade Finance Global. February 6, 2026. https://www.tradefinanceglobal.com/posts/cbam-cop30-how-carbon-became-excuse-for-economic-protectionism/.

7. “The Impact of the EU’s CBAM on Business and the Carbon-pricing Landscape.” 2026. World Economic Forum. January 5, 2026. https://www.weforum.org/stories/2025/12/eu-cbam-impact-business-carbon-pricing-landscape/.