The EU's controversial extension of its carbon market regime to foreign producers takes shape
As the climate crisis intensifies and the rigour of measures to reduce emissions in the EU increases, the problem of carbon leakage – where carbon-heavy production moves out of the EU to jurisdictions with laxer regimes – has triggered increasingly urgent calls to level the playing field. In response, the EU is introducing a Carbon Border Adjustment Mechanism (CBAM) that will impose additional duties on certain imported goods to reflect the carbon emissions generated from their production. This is designed not only to prevent carbon leakage and maintain the competitiveness of EU producers, but also encourage other countries to raise their climate ambitions and prevent global increases in emissions. It has also been touted as a means of raising much-needed revenue for climate action.
We outlined the essential features of the Commission proposal for CBAM in blog posts in July and October 2021. The Council and the European Parliament as co-legislators proposed many amendments that needed to be reconciled during discussions with the Commission. They have recently reached a conditional and provisional agreement on a compromise text. This text is not yet published and formal adoption will occur after legal revision and together with another element of the Fit for 55 package of climate change measures, reform of the EU Emission Trading Scheme (ETS). For context, Fit for 55 aims to co-ordinate EU policy to drive emissions 55% below 1990s levels, while the ETS, as the world's first and largest carbon market, is a cornerstone of EU efforts to combat climate change.
The main results of the negotiations are:
- CBAM will apply from October 2023
- The scope of CBAM that the Commission had proposed to limit to cement, electricity, fertilisers, iron, steel and aluminium is extended to cover many downstream products derived from iron, steel and aluminium as well as indirect emissions from electricity consumption (emissions considered as embedded in products because of electricity consumed in their production)
- The inclusion of hydrogen as a product within the scheme
- More centralised management by the Commission, which will have to maintain a centralised registry of CBAM declarants and the third country facilities from which they import as well as exercising reinforced control over the implementation of the scheme by Member States
- Further powers for the Commission to adopt implementing, amending and supplemental acts not only to fill in the gaps but to act against circumvention, which is broadly defined.
The compromise text has been extensively amended during the legislative process and we will comment in more detail on the resulting CBAM scheme once we are able to share the compromise text following its publication. In this piece, we highlight three important features of the looming regime that are crucial for companies preparing for CBAM.
The vulnerabilities of the CBAM
CBAM is designed to level the playing field in climate action and will have adverse effects on third countries and their producers of the covered products. The CBAM will be hotly contested in multiple fora including the World Trade Organisation (WTO) and the UN's Framework Convention on Climate Change (UNFCCC). The EU is acutely aware of this and the CBAM Regulation refers repeatedly to the need for meet WTO rules. However, saying CBAM will be WTO-compliant is not enough.
The EU ETS is a “cap and trade” system designed to reduce EU emissions progressively over time in the most economically efficient manner by incentivising individual installations to reduce their emissions. The incentive is provided by avoiding the need to surrender allowances and by being able to sell the allowances that are often given out for free to installations that need them. The CBAM, however, will require the surrender of allowances from an unlimited pool and in effect act as a straightforward charge on imports. The calculation of the number of allowances to surrender will in most cases be based on default carbon emission factors calculated by the Commission while the price of CBAM allowances will be based on the prevailing market price of EU ETS allowances.
For this reason, the impact of CBAM on imports will not be equivalent to the impact of the ETS on EU producers. In some cases, it is likely to be greater on importers – or at least perceived to be so – and this will give rise to complaints that the CBAM conflicts with WTO obligations. As we previously noted, it could be considered an illegitimate tariff or an “internal measure” that does not accord to imports treatment that is “no less favourable” than the treatment accorded to like domestic products. The WTO has been strict in applying this test and has already ruled against a number of national schemes designed to promote renewable energy (cases DS412, DS456 and DS510).
The WTO does provide an exception or defence for measures necessary to protect the environment but it is subject to strict conditions. Crucially, such measures must not be applied in a manner which would constitute a means of “arbitrary or unjustifiable discrimination” against other WTO members and must not function as a “disguised restriction on international trade”.
WTO precedents are not encouraging for the EU. The US lost a similar WTO dispute concerning its measures relating to “reformulated gasoline” precisely because US refiners were entitled to individual treatment taking into account their specific circumstances whereas foreign refiners were subject to benchmarks based on averages. The fact that some foreign products were subject to discrimination was sufficient to constitute unjustifiable discrimination and a disguised restriction on trade, even if others may have received better treatment. Also, in a rather different environmental case, a US measure requiring measures to be taken by shrimp fishermen to protect sea turtles, the US was considered to have engaged in “arbitrary and unjustifiable discrimination” because of the inflexible administration of the measure and, in particular, because the US had negotiated solutions with some countries but not others.
Another forum in which the CBAM may be contested is the UNFCCC since an important principle underlying that treaty and subsequent climate agreements is the need for differentiation between countries according to their historical responsibility for emissions and capacity to deliver reductions. For this reason, the latest agreement – the Paris Agreement – is based on countries specifying nationally determined contributions and thus reduction commitments that are indicative but not binding. The CBAM conflicts with these principles by providing for countries to align with the EU (or demonstrate plans equivalent to EU rules) or bear extra charges on their exports to the EU.
Geographical coverage and the “Climate Club”
The CBAM Regulation itself only exempts the EFTA countries and sets strict criteria for the exemption of other third countries by Commission delegated act. These would not appear to allow the exemption of the UK, for example.
However, there is reference in the recitals to the creation of a “Climate Club” of countries with comparable climate ambition designed to promote global co-ordination of action and support the comparability of relevant climate measures. This suggests that a further avenue for exemptions will be available through some form of international agreement.
Certain countries have already started to exert pressure on the EU seeking preferential treatment under CBAM. The Climate Club is a response to this pressure. It was first proposed by Germany and was endorsed by the G7 in June 2022.
According to the recitals to the compromise text, the Climate Club is intended to be open to all and operate under the auspices of a multilateral international organisation. It is therefore possible that the CBAM might result in the creation of an international system that would render the initiative unnecessary. The EU will then be able to claim it was only because it proposed to introduce CBAM unilaterally that the rest of the world finally came to an agreement. There is a parallel with the EU’s unilateral inclusion of aircraft emissions in the ETS in 2007. That eventually led to International Civil Aviation Organization creating a Carbon Offsetting and Reduction Scheme for International Aviation and the EU removing international air transport emissions from the scope of its ETS.
Opportunities open to companies
The need to make CBAM compliant with the WTO also explains the presence of a further important feature of the initiative – the possibility for exporters to be accorded individual treatment on the basis of the carbon intensity of their production.
Imports into the EU of goods in the CBAM's scope will be subject a special authorisation regime and must be made by an authorised CBAM declarant who will normally be the person performing other import obligations prior to release for free circulation in the EU. The authorised CBAM declarant must not have been involved in any infringements of customs, taxation or market abuse rules or have criminal offences relating to its economic activity and will require:
- an Economic Operators Registration and Identification number (EORI);
- certification by the tax authority in the Member State where the declarant is established; and
- making to the competent authority a declaration containing information on the goods imported and its environmental implications for the previous calendar year.
The authorised CBAM declarant will be required to keep records of the imports and the information required to calculate the embedded emissions in accordance with the CBAM and have them approved by an accredited verifier.
Importantly, authorised CBAM declarants must also keep records of the documentation, certified by an independent person, required to demonstrate the declared embedded emissions were subject to a carbon price in the country of origin of the goods. Declarants must also keep evidence of the proof of the actual payment for that carbon price which should not have been subject to an export rebate or any other form of compensation on exportation. Absent such proof, reductions will not be granted.
Third country producers exporting covered products to the EU will therefore have to ensure they have satisfactory import arrangements in the EU to comply with these requirements. In addition, they may request registration in a central EU database of operators that will open the door to further individual treatment. Registration will give rise to additional obligations including:
- the maintenance of records of the embedded emissions calculated in accordance with the methods set out in the CBAM Regulation by type of goods produced in its installation;
- verification conducted by an accredited verifier;
- maintenance of the verifier’s report as well as records of the information required to calculate the embedded emissions in goods for a period of four years after the verification has been performed.
The CBAM regime is the result of several difficult-to-reconcile objectives. There has not only been some tension between the objectives of discouraging carbon leakage or deindustrialisation in the EU and promoting climate ambition globally but also between creating an effective regime that will resist challenge in international fora without creating an impossible bureaucracy.
Although the legislative text has now been agreed between the co-legislators, much of the detail of how the system will operate remains to be decided through the preparation and adoption of Commission implementing and supplementing acts. The final shape of the regime will also be influenced by international negotiations – and ideally these could render the EU CBAM unnecessary.
Either way, the impact on international trade will be great and carbon-intensive producers should carefully follow developments and prepare to adapt to the looming regime.