Summary
- The Carbon Border Adjustment Mechanism (CBAM) is the EU’s latest proposed tool to help achieve its climate goals.
- The CBAM will complement the EU Emission Trading System (ETS) which will drastically change over the coming decade.
- Its goal is to prevent carbon leakage in high emission sectors, particularly in cement, iron and steel, aluminium, fertilizers, and electricity. Carbon leakage occurs when companies relocate their emission-intensive operations to countries with less stringent climate regulations.
- The basic idea is to charge import tariffs on imported products in the amount of their greenhouse gas emission content. This levels the playing field between EU and non-EU producers and discourages moving polluting activities abroad.
- This document helps to quickly get to the heart of the matter, to understand what the CBAM is, how it will work and what it will mean for companies.
Background
The EU pursues the ambitious target of a 55% reduction in greenhouse gas (GHG) emissions compared to 1990 levels by 2030, paving the way for climate-neutrality by 2050.
To achieve this, the European Commission adopted the “Fit for 55” package on July 14, 2021. The package will adapt existing EU climate and energy legislation and introduce further climate-related legislation and initiatives.
The most hotly debated legislative proposal of the Fit for 55 package is the Carbon Border Adjustment Mechanism (CBAM).
What is the goal of CBAM?
At its simplest, the CBAM aims at reducing the risk of carbon leakage. Carbon leakage occurs when companies based in the EU move carbon-intensive production abroad to places with more lenient regulations and standards, or when EU products are replaced by more carbon-intensive imports. Both result in a relocation of GHG-emissions outside of the EU instead of a reduction of global emissions. Carbon leakage therefore undermines climate change mitigation efforts at a global level. According to the EU, the threat of carbon leakage has increased due to the raising of its climate ambitions, especially compared to other continents.
The CBAM aims to address this by equalizing the price of carbon emissions between domestic EU products and imports while ensuring compatibility with the World Trade Organization (WTO). Ideally, introducing the CBAM would eventually encourage producers in non-EU countries to green their production processes.
How will CBAM work?
Once fully in place (potentially as early as 2026), it will work as follows:
- EU importers of goods covered by the CBAM will buy carbon certificates corresponding to the carbon price that would have been paid if the goods had been produced in the EU. To do so, EU importers register with national authorities where they can buy CBAM certificates. The price of the certificates will be calculated depending on the weekly average auction price of EU ETS allowances expressed in € / ton of CO2-equivalent emitted.
- The EU importer must declare by 31 May each year the quantity of goods and the embedded emissions in those goods imported into the EU in the preceding year. At the same time, the importer hands over an amount of CBAM certificates that corresponds to the amount of greenhouse gas emissions embedded in the products.
- If EU importers can prove, based on verified information from third country producers, that a carbon price has already been paid during the production of the imported goods, the corresponding amount can be deducted from their final bill.
- The national authorities will review and verify the declarations.
Which sectors and countries will be covered by CBAM?
According to the EU Commission’s proposal, the CBAM will initially apply to imports of the following goods:
- Cement,
- Iron and Steel,
- Aluminium,
- Fertilizers,
- Electricity.
The EU claims that it is these sectors which have both high carbon emissions and a high risk of carbon leakage.
In principle, imports of these goods from all non-EU countries will be covered by the CBAM, except for members of the European Economic Area (Iceland, Liechtenstein, Norway) and Switzerland as they participate in the ETS or have an emission trading system linked to the EU’s.
What is the schedule?
The CBAM will be phased in gradually and will initially only apply to the aforementioned goods. Specifically, under the EU Commission’s proposal, a transitional phase will start in 2023 where importers will only have to report the emissions embedded in their goods without paying a financial adjustment. Only from 2026 onwards will importers start paying the financial adjustment according to the system described above.
Which emission scopes will be covered by CBAM?
The CBAM will apply to direct emissions of greenhouse gases emitted during the production process of the products covered (Scope 1). By the end of the transition period, the European Commission will evaluate how CBAM is working and whether to extend its scope to indirect emissions from energy use (Scope 2) and/or from the value chain (Scope 3).
In cases where information from non-EU producers on their embedded emissions is not available to EU importers, EU importers are allowed to use country-specific averages on GHG emissions for each product to determine the number of certificates they need to purchase. If no country-specific data exists either, then EU importers have to use the average of the 10% most carbon-intensive producers in the EU.
How does it relate to the EU Emissions Trading System?
The EU’s Emissions Trading System (ETS) has tried to address the risk of leakage by distributing free allowances to sectors with high risk of carbon leakage. But this reduces the business incentive to invest in greener production at home and abroad. Since the system of free allowances will be gradually phased out between 2026 and 2035, the CBAM is essentially replacing these free allowances. The CBAM will only begin to apply to products from the five sectors described above and in direct proportion to the reduction of free allowances allocated under the ETS for those sectors.
What is next?
The European Commission’s CBAM proposal has triggered substantial public debate on the suitability of the CBAM to prevent carbon leakage and help achieve the EU’s climate goals, on its compatibility with WTO law, on its effects on developing countries, on its potential red tape, etc. It has also drawn strong criticism from important international partners such as the BRICS countries and the US.
Nevertheless, decision-makers in the EU seem poised to establish the CBAM. The Council of the EU, representing the member states, has published its position on the CBAM in March 2022. It generally supports the CBAM proposal and makes only minor suggestions, such as centralizing the CBAM governance on the EU level and introducing a minimum threshold which exempts consignments (shipments) with a value of less than €150.
The European Parliament is now to publish its position. All indications are that the Parliament will seek to increase the ambition of the CBAM by including more sectors, widening the emissions scopes, and shortening the transition phase.
After that, the Council and the Parliament will negotiate the final rules of the CBAM, possibly coming to an agreement this year.
While it is hard to gauge whether the CBAM will indeed be introduced as currently proposed, it is clear that EU importers, both in the cement, iron and steel, aluminium, fertilizer, and electricity sectors and beyond, are strongly advised to take the necessary steps now and begin understanding the carbon footprints of their products.
The question is not if but when regulation comes into play, and how demanding it will be.
