CBAM and ETS Consulting
A provisional agreement to implement a European Union (“EU”) Carbon Border Adjustment Mechanism (“CBAM”) starting on October 1, 2023 was made as a result of ongoing discussions, the European Parliament and the Council of the European Union declared on December 13, 2022.
The CBAM, the first of its kind, is applied to imports of goods from the iron and steel, cement, aluminium, fertiliser, hydrogen, and electricity sectors and is intended to reduce the risks of “carbon leakage,” which refers to the relocation of facilities outside the EU to avoid emissions limits only to then ship goods back into the original EU markets. The EU’s goal to become climate neutral by 2050 is said to include the CBAM as a key component.
The CBAM was first presented by the European Commission in July 2021 as a component of its “Fit for 55” in 2030 package, a collection of connected and all-encompassing ideas intended to get the EU’s policies (climate, energy, land use, transportation, and taxation) ready to reduce net greenhouse gases (GHGs) by at least 55% by 2030, in comparison to 1990 levels.
The CBAM must now be approved by the European Parliament and the ambassadors of the EU member states in accordance with EU legislative procedure. The agreement will then need to be officially approved by both the European Parliament and the Council of the European Union before CBAM goes into effect. Before formal adoption can take place, a number of other pieces of legislation that are dependent on the partial agreement must first be resolved.
As stated, the CBAM primarily targets imports from sectors that produce large amounts of carbon dioxide, but it also covers “some precursors and a limited number of downstream products”1 (e.g., screws and bolts and other similar articles in the iron and steel industries). Given the size of these sectors, this programme will result in higher import fees for a wide range of goods into the EU. While “embedded” emissions, or those that happen during manufacturing, are the main focus, indirect emissions will also be covered by the relevant regulations, but “in a well-circumscribed manner.”
The CBAM includes a transitional period during which the CBAM’s scope will be expanded to include additional goods at risk of carbon leakage and additional downstream products. By 2030, all products covered by the EU Emissions Trading System (“EU ETS”) are to be included, and the European Parliament has indicated that it intends to include chemicals and plastics in the CBAM before it is fully implemented. It is also important to evaluate the indirect emissions methodology.
The CBAM is intended to operate concurrently with the EU ETS, the largest carbon market in the world, which is based on a cap and trade system. Fundamentally, the CBAM will compel businesses importing into the EU to buy CBAM certificates in order to cover the difference between the carbon price (or lack thereof) in the country of production and the cost of carbon allowances in the EU ETS. These CBAM certificates are not exchangeable. Additionally, a free certificate allocation period is anticipated, just like the EU ETS. The CBAM is intended to prevent companies from moving production to non-EU nations with less stringent climate regulations, undermining global climate efforts, and to incentivize EU trading partners to limit CO2 emissions as well.
On October 1, 2023, the CBAM will go into effect, but it will be implemented gradually. The CBAM will initially only have reporting requirements, with the objective of gathering data. Beginning in 2026, importers of covered goods (which may have been expanded by that point) will be subject to a charge based on the price of the weekly average EU ETS allowance, which, as of December 1, 2022, traded above 80 EUR. Importers are required to register with the relevant governmental agency and submit recurrent reports on imported goods emissions information. Any covered entity that is unable to supply the necessary emissions data computed in accordance with the applicable requirements will be forced to use default values and be subject to a higher emissions factor, increasing CBAM obligations. An EU-accredited third party must verify direct emission reporting. Later implementing acts will decide on the methods for calculating reductions and other specific procedures.
The phase-in of the CBAM will take place concurrently with the phase-out of free allowances under the EU ETS for the relevant sectors. On December 18, 2022, it was decided to reform the EU ETS, phasing out free allowances starting in 2026 and eliminating them entirely by 2034. The European Parliament and Council of the European Union agreed to the following schedule for shipping companies, extending this phase-out to emissions from maritime shipping:
Verified emissions must be reduced by 40% in 2024, 70% in 2025, and 100% in 2026. The phase out will initially only apply to carbon dioxide emissions, but starting in 2026, it will also cover nitrogen oxide, soot, and methane emissions. The EU ETS phase out includes the vast majority of large vessels.
Although the EU intends to gradually stop giving private businesses allowances, it will continue to give allowances to a “Innovation Fund” and a “Market Stability Reserve.” The proceeds from the sale of these allowances will be used by the proposal for a number of climate-related goals, including reducing the “energy poverty” that these programmes cause for households.
Although the CBAM is an EU-based policy, its effects go far beyond the boundaries of the organisation. For instance, the EU wants to improve the non-EU nations’ climate policies by implementing the levy. Additionally, regardless of changes in policy, businesses making goods outside the bloc that want access to EU markets will need to conduct thorough emissions analyses and evaluate opportunities to reduce emissions, or else risk losing market share.
The CBAM’s implementation is likely to accelerate efforts to decarbonize levy-exempt industries with high GHG emissions, like steel and cement production. Additionally, the CBAM’s implementation will encourage more attention to be paid to opportunities for green and blue hydrogen and ammonia.
While the CBAM may result in sizable additional costs, it also offers opportunities to use Inflation Reduction Act incentives to support the development of less carbon-intensive products and possibly gain a competitive advantage for CBAM-covered goods in EU markets. Along with closely related reforms and policies, like the EU ETS, the CBAM’s progress through the EU legislative process should be closely monitored.