Carbon border adjustments

Carbon border adjustments

August 13, 2021 | By Andrew Hedges in London

As the United States debates whether to impose a carbon border adjustment, it might be instructive to understand how Europe is proposing to do it.

Detailed proposals on a carbon border adjustment mechanism—referred to in Europe as CBAM—were released by the European Commission in mid-July as part of a wider package of reforms designed to implement a target of a 55% reduction in carbon emissions by 2030.

The CBAM proposals are just the start of a legislative process that will take months to complete. The final design may well be different as the EU navigates that process.

Why CBAM now?

CBAM is the next stage in the EU tackling the issue of carbon leakage.

Carbon leakage refers to a possible increase in global emissions linked to the relocation of industry from countries with stringent climate policies to countries with no or limited climate policies in place.

This has been a long-standing issue in the EU (particularly for industry groups) as the EU has had in place an emissions trading system (called the EU ETS) since 2004. Industrial sectors that compete in international markets have been consistently concerned with the impact of the EU ETS.

To date, the EU approach to managing the risk of carbon leakage has been by allocating free emission allowances to sectors that face stiff competition from companies in other countries that do not require allowances to cover emissions and by allowing EU member states to compensate exposed sectors for increased energy costs arising from the EU ETS. The exposed sectors are defined by the EU, with the current list specified through 2030.

These carbon leakage tools have been subject to regular adjustments, such as tying the level of free allowances allocation to the emissions performance of the best installations (known as benchmarks).

In late 2020, the EU agreed to increase the 2030 reduction target to 55%. This triggered a process to re-assess existing climate policies with a view to amending those to achieve the increased target. For example, the cap on emissions under the EU ETS is to be tightened and new sectors will be covered. Carbon leakage tools have also undergone a review.

EU policy makers were driven to a CBAM by two key factors.

First, as the cap on emissions under the EU ETS decreases, free allocation of allowances is increasingly unworkable as it will start to shift a disproportionate level of cost onto sectors that are not on the list of exposed sectors.

Second, the EU wants to push trading partners to make stronger efforts to reduce emissions. A policy paper the European Commission issued in 2019 on the European green deal said, "should differences in levels of ambition worldwide persist, as the EU increases its climate ambition, the Commission will propose a carbon border adjustment mechanism, for selected sectors, to reduce the risk of carbon leakage."

By imposing a carbon cost on certain imports, a CBAM can enable the progressive winding back of free allocation to exposed EU sectors.

For EU policy makers, ending or reducing free allocation would also significantly increase government revenues through the auctioning of those allowances. Supporting analysis released with the proposal estimates additional revenues in 2030 from reduced free allocation and CBAM to be between €13 and €15 billion.

Core CBAM elements

At a high level, the proposed CBAM creates an obligation on importers of certain products to purchase CBAM certificates matching the embedded emissions associated with that product at a price matching then-current EU ETS allowance prices, unless certain exemptions apply.

It will be introduced on a transitional basis starting in 2023, with full implementation for covered products from the start of 2026.

The initial products to be covered are cement, electricity, iron and steel, fertilizers and aluminium.

The proposed regulation provides detailed breakdowns of sub-product types within each of these. For example, for iron and steel, ferrous scrap is not covered, but a range of other sub-products are, including sheet piling of iron or steel, railway track, tubes and pipes, vats and structures such as bridges, gates, towers, roofing and window frames.

The European Commission is authorized to monitor and adjust the scope of products covered to address circumvention risks, such as changes in the pattern of trade due to replacing CBAM-covered goods with slightly modified products that are not covered.

When a product (or a processed product from it) is imported into the EU, the importer will have to apply for authorization under the CBAM regulation. The process for authorisation will involve assessment of the financial and operational capacity of the applicant. If the applicant has been in existence for less than two years, then bank guarantees will be required for the maximum likely annual liability of the applicant.

This could inject some sand in the gears of cross-border trade in theory, but it is not expected to be any more burdensome than current processes for clearing imported goods that are subject to duties.

Each authorized importer will have to submit, by May 31, CBAM certificates matching the embedded emissions determined for imports of the covered products for the previous calendar year. Failure to do so will trigger financial penalties, including a fine of €100 per certificate not submitted plus a continuing obligation to submit the shortfall in certificates.

Importers will buy CBAM certificates that will be issued into an electronic registry account of the authorized importer.

The price for CBAM certificates will be set weekly at the average price of auctioned EU ETS emission allowances for that week.

If an authorized importer holds excess CBAM certificates after the compliance date of May 31, then it can return them for a refund of the original price paid. All excess CBAM certificates for a year will be cancelled on the June 30 after the compliance deadline. The draft regulation does not appear to allow the trading of CBAM certificates, but this is not entirely clear. Stakeholders are expected to suggest enabling trading of CBAM certificates to support risk mitigation tools such as hedging products.

The general approach is to use actual emissions calculations, but the use of default values is allowed where actual emissions are not available.

Although the draft regulation specifies a formula for the determination of the embedded emissions of a covered product, the regulation also envisages the European Commission developing detailed rules. For example, the expectation is that the default values will be "adapted to particular areas, regions or countries to take into account specific objective factors such as geography, natural resources, market conditions, prevailing energy sources, or industrial processes."

Importantly, installations outside the EU will be able to register under the CBAM in order to generate product-specific embedded emissions information for importers.

When an importer submits its annual calculation of embedded emissions of imported products, this will need to be accompanied by a verification statement from an accredited verifier. The challenges of this requirement are recognized by the draft regulation by noting that the European Commission may develop rules relating to the waiver of this requirement.

There are two ways an importer will be able to reduce its liability under the CBAM.

The first is where it can be demonstrated that declared embedded emissions were subject to a carbon price in the country of origin. A "carbon price" is defined as "the monetary amount paid in a third country in the form of a tax or emission allowances under a greenhouse gas emissions trading system, calculated on greenhouse gases covered by such a measure and released during the production of goods."

The second way is where there continues to be free allocation of EU ETS allowances for the same product in the EU. In that case, the CBAM obligation for the importer is reduced to take account of this. The notion must be that importers should not be put at a disadvantage in instances where there is no requirement for the same product made in the EU to reduce emissions.

Full implementation of the package is not planned until January 2026. In the initial transitional phase from January 2023 to December 2025, the obligation will be limited merely to reporting of embedded emissions.

Implementation challenges

CBAM remains a proposal. Ahead is the usual fraught EU legislative process involving the European Commission, EU member state governments, the EU parliament and stakeholders such as industry and environmental groups.

In addition, EU trading partners will have strong views on these proposals. Trading partners that will be particularly affected are those with the largest exports of relevant goods to the EU. For example, the top exporters for covered products are (using 2019 data): Russia, Ukraine, Turkey and China for iron and steel, Russia, the United Arab Emirates and China for aluminum, Russia, Egypt and Algeria for fertilizers, and Turkey, Ukraine and Belarus for cement.

If CBAM moves ahead, it is not hard to envisage challenges being made under World Trade Organization rules.

WTO disputes regarding trade issues arising from environmental measures date back decades, with likely focus being on issues such as whether the final CBAM breaches binding tariff arrangements the EU has agreed to on products, discriminates between imported products and EU products, amounts to a prohibition on certain types of imports or amounts to discrimination among countries. It is worth noting that the European Commission analyzed these issues in designing the proposed CBAM. Further, a WTO dispute does not prevent the CBAM being implemented while the dispute is ongoing.

On balance, we do see the CBAM moving ahead broadly as planned. However, it is important to recall the design element that that the CBAM obligation will not apply to the extent free allocation continues within the EU for a relevant product. As such, while the CBAM system may be implemented from 2026, the extent to which it starts to bite will be linked to the phase out of free allocations. That is likely to move at a slower pace than EU policy makers hope.

Much of the implementation period from 2026 to 2030 is likely to be taken up with the painful process of trying to translate the CBAM into workable rules for importers and exporters. As with the introduction of the EU ETS, this will also involve discussions between contract parties regarding allocation of liabilities for the additional costs arising from the CBAM.