The EU Carbon Border Adjustment Mechanism

As part of the European Green Deal the EU has set itself a binding target of achieving a 55% reduction in carbon emissions compared to 1990 levels by 2030, and climate neutrality by 2050. In order to achieve this and as part of the ‘Fit for 55 Package’ of proposals on climate change and energy legislation, the Commission adopted its proposal for a Regulation establishing a Carbon Border Adjustment Mechanism (CBAM).

Why was the CBAM proposed?

The CBAM proposal is a measure specifically intended to address the risk of ‘carbon leakage’. Carbon leakage arises where the costs of doing business in one country as a result of carbon pricing are higher than the production costs in another country that has less stringent carbon pricing legislation so that business relocates to the lower cost country. Energy intensive EU industries are subject to the EU emissions trading scheme (ETS), the EU’s existing carbon pricing mechanism, and are required to pay for and submit emissions allowances for the CO2 (and some other GHGs) they emit.

The EU ETS currently applies to electricity and heat generation, oil refineries, steel, production of iron, aluminium, metals, cement, paper and bulk chemicals among others. It is those sectors that are most at risk of carbon leakage.

The EU ETS only covers emissions generated by businesses operating within the EU and those operating in countries with linked systems such as the European Economic Area countries and Switzerland. It does not cover emissions embedded in products imported into the EU. This not only creates the risk that EU producers may relocate production to areas outside the EU where carbon pricing measures are less stringent, but also encourages customers to substitute cheaper more carbon intensive imports for EU products.

The EU has sought to address this problem in the past by giving free allowances to some sectors in order to ensure that EU industry is not at a competitive disadvantage. However, this has been criticised as it doesn’t incentivise EU producers to decarbonise production or investors to invest in greener production within the EU. The issue of free allowances has also been seen as an impediment to EU and global climate efforts.

The CBAM is intended to avoid ‘carbon leakage’ by encouraging producers in non-EU countries to decarbonise their production processes and to ensure a level playing field between EU and non-EU businesses until free allowances under the EU ETS are completely phased out in 2035.

What is the CBAM?

The CBAM is a mechanism to impose a carbon tax on embedded greenhouse gases in goods imported into the EU. Where a third country has already imposed a price on carbon on the goods where they have been produced the intention is that that should be taken into account and reduce the amount paid by the importer.

• How will the CBAM work in practice?

Importers of goods into the EU will be required to pay for and submit CBAM certificates for the equivalent of the EU carbon price on the CO2 (and some other GHGs) emissions in the goods they import. There are two key issues. Firstly, how embedded emissions will be determined and secondly what will the price for the certificates be?

The embedded emissions in goods other than electricity will be calculated by the importer based on the actual emissions pursuant to the methods set out in the CBAM proposal which include a requirement for emissions to be verified by an independent accredited verifier. The importer is required to keep records of the information used to calculate the embedded emissions. When the actual emissions cannot be determined, or in the case of imported electricity, the embedded emissions will be fixed by reference to default values. The default values for physical goods will be based on the average emission intensity of the 10% worst performing EU installations for those goods. For electricity, it will generally be established using the average CO2 equivalent emission factor for price-setting sources in the relevant country or region.

Embedded emissions include direct emissions released during the production process of the goods. The proposal does not apply to indirect emissions.

In order to minimise the bureaucracy an importer can register with the EU Commission which will decide on the level of emissions produced by manufacturers in the relevant country and these levels can be used for importation.

The price for a CBAM certificate will be calculated by taking the weekly average auction price of EU ETS allowances expressed in € / tonne of CO2 emitted for the week before importation.

EU importers of the goods covered by the CBAM (known as authorised declarants) will have to register with EU member states' competent authorities. Competent authorities will be responsible for authorising registration of declarants for CBAM purposes, as well as reviewing and verifying the accuracy of emissions declarations. Competent authorities will also sell CBAM certificates to the authorised declarants at the price that corresponds to the carbon price that would have been paid had the goods been produced under the EU's carbon pricing rules.

In order to import goods covered under the CBAM into the EU the importer must make a CBAM declaration, by 31 May each year, setting out the quantity of goods and their embedded GHG emissions imported into the EU in the preceding year. At the same time, the EU importer must surrender the number of CBAM certificates that correspond to the amount of GHG emissions embedded in the goods.

If the EU importer can prove, based on verified information from the third country producers (known as operators), that they have already paid a price for the carbon used in the production of the imported goods in a third country, the corresponding cost can be deducted from their final bill.

In contrast to the EU ETS, the proposal does not envisage any possibility of CBAM certificates being traded between importers on a market. Where the authorised declarant has bought too many CBAM certificates, it can ask the competent authority to re-purchase up to one third of the excess remaining after its annual surrender obligation has been met. Any CBAM certificates that have not been re-sold to the competent authority can be banked for use in the following scheme year but will be cancelled t if not used or re-purchased by the competent authority in that year.

• Product scope

The CBAM will apply to imports into the EU of energy intensive goods such as cement, iron, steel, aluminium, fertilisers and electricity.

The Commission has indicated that its scope will be evaluated and possibly extended to other products and services and indirect emissions at the end of a transitional period.

• Territorial scope

Generally, imports of goods from all non-EU countries will be covered by the CBAM. Certain third countries that participate in the EU ETS or have an emission trading system linked to the EU will be excluded from the mechanism. This is the case in relation to members of the European Economic Area and Switzerland.

Other countries with equivalent carbon pricing could follow in the future. California has a similar system as the CBAM in place for electricity. The UK, China and South Korea already have an ETS in place and Canada and Japan are considering similar mechanisms.

• Transitional period

The CBAM will come into force on 1 January 2026, following a transitional period of three years from 2023 to 2025. During the transitional period importers will be required to report on their embedded emissions. The obligation to report will apply to the total volume of the relevant goods imported, embedded emissions in those goods and any carbon price paid in the country of origin. Unlike the position under the full CBAM, indirect embedded emissions must be reported during the transitional period.

The CBAM proposal confirms that the CBAM would operate in parallel with the continued issue of free EU ETS allowances covering relevant goods during the transitional period. The aim is to gradually reduce the number of free allowances from 2026 to 2035 when no further allowances will be allocated on a free basis. However, the number of CBAM certificates required to be surrendered by importers will be reduced to reflect the level of free allowances granted by the EU for the same type of goods in order to ensure EU’s compliance with the World Trade Organisation’s rules.

• Enforcement

Where an importer fails to surrender sufficient CBAM certificates by 31 May of each year, it will have to pay a penalty of €100 for each CBAM certificate not surrendered. Payment of the penalty will not release the authorised declarant from the requirement to surrender CBAM certificates which it will also have to do. In addition to the fine, Member States may apply administrative or criminal sanctions for failure to comply with the CBAM legislation in accordance with their national rules.

What does the CBAM mean for the UK?

The UK is the second most exposed country after Russia to the CBAM proposal which is a threat in particular to its exports of iron, steel and aluminium. The EU trading block is the main destination for UK raw material exports. Analysis by the London School of Economics suggests that approximately 34% of the total value of all UK goods exported to the EU could be affected by the CBAM. This suggests that it is important for the UK to retain its alignment on climate policy ambition with the EU to avoid being charged a CBAM on UK exports. The UK is not currently listed as exempt from the CBAM regulation.

Besides the significant additional administrative costs that importers of UK goods from the UK would incur, calculating the carbon emissions embedded within goods can be complex. If it is not possible for a business to calculate the emissions embedded in their goods, then the use of the EU’s default figure, based on the emission record of the EU’s 10% worst emitters could put UK exporters at a competitive disadvantage.

The UK introduced its own Emissions Trading Scheme (UK ETS) following its departure from the EU on 1 January 2021 which came into force at the end of April 2021. This means that UK exporters may benefit from a reduction in the number of CBAM certificates they will need to surrender based on the UK tax charged for carbon. However, there would still be unavoidable costs associated with CBAM bureaucracy as UK importers would still need to register with the CBAM authority to prove that their imports have already been subject to a carbon price.

To be fully exempted from a charge on UK exports associated with the CBAM the UK would have to be added to the EU’s exemption list. For this to happen the UK would have to link the UK ETS to the EU’s ETS. This was left a possibility under the Trade and Cooperation Agreement where the UK agreed to uphold common high standards on carbon pricing under Article 7.3. At the moment however, it is unclear whether the UK government wants to link its scheme to the EU’s, because doing so leaves the UK with less flexibility to design and shape its own carbon pricing system.