On 14 July 2021, the European Commission (“Commission“) adopted a proposal for a new Carbon Border Adjustment Mechanism (CBAM), which will require importers to report the embedded emissions in certain carbon-intensive products (initially aluminum, cement, iron and steel, electricity and fertiliser) and buy certificates to account for these emissions. The CBAM is intended to complement the EU Emissions Trading System (EU ETS) and level the playing field between EU and non-EU businesses, ensuring that production of carbon-intensive goods does not shift from within the EU to third countries in order to take advantage of less stringent climate policies. It is due to take effect in a transitional form from 1 January 2023 and be fully operational from 1 January 2026.
The proposal is part of the EU’s ‘Fit for 55‘ policy package to reduce greenhouse gas (GHG) emissions by at least 55% compared to 1990 levels by 2030 and ultimately achieve climate neutrality in the EU by 2050 as part of the ‘Green Deal‘. Fit for 55 is a package of interconnected policy proposals to strengthen eight existing pieces of legislation (including revising the Energy Tax Directive and the EU ETS) and introduce five new initiatives, of which the CBAM is one.
The CBAM proposal follows both public and targeted consultation by the Commission and the publishing of an impact assessment. The respondents to the public consultation, predominantly EU companies, broadly agreed that the new CBAM would be effective in aiding the EU’s climate policies and mitigating the risk of carbon leakage. The impact assessment found that the CBAM should bring carbon leakage down to -29% by 2030 and lead to a 1% emission reduction in the EU. A final report on the purpose, scope and various implementation options under the proposal was then published in July 2021.
The new mechanism would place a carbon price on the import of selected carbon-intensive goods to ensure that the EU’s climate policies do not simply push the production of these goods outside the EU to countries with less stringent environmental standards; so-called ‘carbon leakage’. It has been designed as an alternative to the measures that currently address the risk of carbon leakage in the EU ETS and is not a self-standing measure.
How will the CBAM fit with the EU ETS system?
The EU ETS is a ‘cap-and-trade system’ which sets a ‘cap’ on the total amount of greenhouse gases that can be emitted by the approximately 10,000 ‘installations’ covered by the system. Within this cap there are ‘allowances’ which give these installations a right to emit greenhouse gases into the atmosphere. After each year an installation must surrender enough allowances to cover their own emissions, while the system also allows for the trade of these allowances to profit on spares or cover shortfalls.
Free allowances are currently allocated to installations operating in sectors identified at risk of carbon leakage. The proposed revision of the EU ETS would gradually remove these free allowances. The CBAM aims to complement the EU ETS and address the risk of carbon leakage as these free allowances are removed.
How will the mechanism work in practice?
Once the CBAM is fully in place in 2026, importers will need to apply for authorisation from their national authority prior to importing in-scope goods into the EU.
By 31 May each year importers will then need to declare (in respect of the preceding year) the total quantity of each type of good they have imported as well as the total associated embedded emissions in respect of each type of good. They will also need to surrender CBAM certificates to cover the relevant amount of embedded emissions for the preceding year.
The price of CBAM certificates will be calculated based on the weekly average auction price of EU ETS allowances. It will be possible for the number of CBAM certificates surrendered to be reduced to the extent that the importer can prove, based on verifiable data, that a carbon price has already been paid in the country of origin.
One important distinction between the CBAM and the EU ETS is that there is no proposal for a market to trade these certificates. CBAM certificates will, however, be valid for two years and can be sold back to national authorities if an importer has bought an excess of them.
Which industries and exporting countries are affected?
The sectors that are initially covered by the CBAM are ones that the Commission has identified as having particularly high greenhouse gas outputs and which are most susceptible to carbon leakage. The CBAM will apply to the direct emissions released during the production process of the goods that fall under the CN Codes of the sectors listed in Annex I of the proposal. The types of goods covered by the proposal include aluminum, cement, iron and steel, electricity, and fertiliser.
The proposal will apply to imports into the EU from all non-EU countries with the exception of EEA countries (which participate in the EU ETS) and Switzerland (which operates a separate Emissions Trading System linked to the EU ETS).
Compatibility with WTO
The Commission has stated that the CBAM is designed in compliance with World Trade Organization (WTO) rules but the risk of potential challenges to the CBAM if it is perceived to be discriminatory against other WTO members or favours domestic products over imported goods cannot be ruled out. In these circumstances, the EU may attempt to rely on the environmental exceptions written into WTO rules, such as the “conservation of exhaustible natural resources” in Article XX(g) of GATT. This will certainly be an interesting area to watch as the CBAM makes its way through the legislative process.
Subject to approval by the European Parliament and European Council, a simplified CBAM will take effect on 1 January 2023 before the full system becomes operational on 1 January 2026. During the transitional period, EU importers will have to comply with reporting requirements but will not need to purchase and surrender CBAM certificates.
The CBAM will likely lead to an increased compliance burden for importers of certain goods into the EU, with associated administrative costs. These importers should ensure that they are aware of the potential new requirements and have in place adequate systems, controls and procedures to report the embedded emissions in the goods caught under the system.
Finally, it will be interesting to see if the UK follows suit and develops its own CBAM to complement the post-Brexit standalone UK ETS.
Please contact us if you have any questions or would like to discuss the potential impact of these new requirements on your business.