As a key part of the "Fit for 55" European Green Deal package, the European Commission has published its controversial proposal for a carbon border adjustment mechanism ("CBAM"). The CBAM, if adopted, will impose a levy on imports in carbon-intensive sectors like steel, cement and fertilizers from countries with lower environmental standards than the EU. The scheme would start in 2023 with a transition period until 2025, when importers will be subject to significant reporting obligations. From 2026, importers will have to purchase "CBAM Certificates" to cover their carbon emissions at prices corresponding to the EU's current carbon price. Countries from the US to Ukraine have been highly critical of a CBAM, leading to the Commission's emphasis on the WTO-compatibility of its proposal. The design will result in the phase-out of free allowances under the EU's ETS, making it potentially unpopular with EU industry and some Member States, as well as exporting countries. A rough passage to adoption can be expected.
The EU CBAM was first announced by the Commission in 2019, as a central element of the European Green Deal intended to achieve the goals of the Paris Agreement.1 This week's "Fit for 55" package introduces a large number of different legislative measures aimed at reducing the EU's emission by 55% compared to 1990 levels by 2030, en route to the 2050 net-zero goal. These include a revision of the EU Emissions Trading System ("ETS"),2 and several other EU laws on emissions and energy,3 as well as the adoption of more stringent CO2 emissions standards for vehicles, including the phase-out of the combustion engine with the requirement that all new cars registered as of 2035 must have zero emissions.4 A common theme throughout the "Fit for 55" package is that carbon emissions should have a price, and the CBAM is intended to "align the carbon price on imports with that applicable within the EU".5
The CBAM is intended to impose a charge on imports which corresponds with the charges imposed on EU domestic industry under the EU ETS.6 The EU ETS requires domestic producers in certain high carbon emitting sectors (e.g., steel, cement, electricity generation) to surrender a number of allowances on a yearly basis to cover their emissions. It works on the basis that over time the number of available allowances is decreased. The ETS market enables those producers who have reduced emissions (e.g., by investing in new technologies) to sell allowances they do not require, and companies to purchase additional allowances. A system of free allowances exists in those sectors at risk of "carbon leakage" – the risk of production shifting outside the EU to countries with less stringent climate ambitions - in order to help EU industries to adjust.
The CBAM proposal is a measure specifically intended to address the risk of carbon leakage. In its press release, the Commission states that "(…) carbon leakage can shift emissions outside of Europe and therefore seriously undermine EU and global climate efforts."7 The Commission also stresses that the aim of the CBAM is to encourage cleaner production processes abroad, while still ensuring World Trade Organization (WTO) compatibility.8 In those sectors covered by the CBAM, the allocation of free allowances under the EU ETS will be gradually phased out over a ten year period starting in 2026.9 As long as free allocation of allowances under the ETS exists, the proposal provides that the amount of allowances that importers would need to buy would be reduced accordingly.10
Some of the most important features of the Commission's proposal include:
- Sectors covered
The proposed CBAM would apply to the following sectors: cement, iron and steel, aluminium, fertilizers and electricity.11 The CBAM would only apply to the direct emissions released during the production process. The proposal does not cover indirect emissions, such as emissions necessary to generate electricity for the production of products. The CBAM would also not apply to downstream products using materials from the sectors covered.12 The Commission indicates that the extension of the scope will be evaluated as regards "...more products and services (…) and whether to cover so-called ‘indirect' emissions".13
- Imports covered
The proposal would apply to imports from all non-EU countries, including the United Kingdom (with the possible exception of Northern Ireland). Only Iceland, Liechtenstein, Norway and Switzerland are exempt from the mechanism.14 Switzerland's ETS is linked with the EU ETS and so the country is exempt from the CBAM. If the UK decided to link its own ETS to the EU ETS it could also be exempt.
- CBAM certificates
In practice, only those importers that have been accredited by a designated authority in the Member States would be able to import products covered by the CBAM.15 These importers would need to buy on an annual basis sufficient CBAM certificates to cover the emissions of their imports. The price of CBAM certificates would be determined by reference to the weekly average price of carbon permits auctioned by governments under the EU ETS.16 CBAM certificates would be sold by the competent authority for each individual Member State.17
- Embedded emissions
Importers would have to make a yearly declaration, in which the total of embedded emissions (by way of a specific calculation method18) of imports is declared, to enable the amount of corresponding CBAM certificates to be determined.19 Importers would also need to obtain certain verifications for the accuracy of declarations.20 Where an importer cannot determine actual emissions, the CBAM foresees a system of "default values" to be applied.21
- Carbon price in exporting country
An important part of the CBAM proposal is the mechanism envisaged to take account of measures in exporting countries intended to achieve CO2 reductions. An importer may claim a reduction in the number of required CBAM certificates to account for the carbon price paid in the country of origin. Certain certification requirements will apply to demonstrate that the emissions were subject to an actual charge in the country of origin.
- Entry into force and transition period
The CBAM would enter into force on 1 January 2023. A transition period would apply between 2023 and 2026. During this transition phase, importers would not have to buy CBAM certificates, but would have to report on a quarterly basis the actual embedded emissions in goods imported, detailing direct and indirect emissions as well as any carbon price paid abroad. During this period, the CBAM would entail a reporting obligation for importers, rather than a direct financial burden. Interestingly, the reporting obligation as currently outlined would also include embedded indirect emissions. This seems intended to assist the Commission in evaluating if in the future (and assuming it is adopted) the CBAM should be extended.
- WTO compatibility
A number of countries have criticised the EU's plans to introduce a CBAM and questioned the WTO compatibility of such a measure. The European Parliament adopted a Resolution in March 202122 supporting the adoption of an EU CBAM provided it is compatible with the rules of the WTO. The Commission has underlined its view that the proposed CBAM is fully compliant with WTO rules: "Designed in compliance with World Trade Organization (WTO) rules (…) EU importers will buy carbon certificates corresponding to the carbon price that would have been paid, had the goods been produced under the EU's carbon pricing rules."23
The Commission proposal will now be subject to much discussion and analysis: by third countries in terms of the proposal's compliance with the WTO, by EU industry in terms of its implications for their competitive position (e.g., the phase-out of free allowances) and whether it goes far enough, and by the climate change and environmental lobby in terms of the limitation to certain sectors and direct emissions only. The proposal is set to follow the ordinary legislative procedure,24 meaning that it requires the approval of both the European Parliament and the Council before it comes into effect. The European Parliament's proposal had a wider sectoral scope, also covering indirect emissions, and provided for faster implementation of the CBAM, without any transition period, so the institutional debate on this proposal cannot be underestimated.