On 14 July 2021, the European Commission presented a legislative proposal on the Carbon Border Adjustment Mechanism (CBAM) as part of its flagship ‘Green Deal’ policy package focused on climate change and the environment. The CBAM is essentially a measure to ensure that imported goods pay a price for their carbon emissions that is comparable to the price paid by EU domestic producers under the EU’s Emission Trading System (EU ETS). Initially, the CBAM will apply to cement, fertilisers, iron and steel, aluminium, and electricity, but the scope could quickly be widened. The CBAM is expected to enter into force as early as 2023 in a transitional form, and to fully apply from 2026, at which point importers will be obliged to purchase CBAM certificates corresponding to the embedded emissions in their imported goods. Below, we explain the five essential things that businesses need to know about the CBAM so as to start factoring in its implications.
Background: CBAM as part of the European Green Deal
When the European Commission (the Commission) unveiled an ambitious climate policy aimed at reaching carbon neutrality by 2050 – the so-called ‘European Green Deal’– on 11 December 2019, the Commission’s package of proposed measures included the introduction of a Carbon Border Adjustment Mechanism (CBAM). The Commission explained that the CBAM would apply to selected sectors to reduce the risk of carbon leakage if other countries do not share the same climate ambition as the EU.
On 14 July 2021, the Commission finally presented its CBAM proposal, together with a package of other legislative proposals aimed at reducing the EU greenhouse gas (GHG) emissions, including the revision of the EU Emission Trading System (EU ETS) to include maritime and road transport, and buildings. See our previous alert.
1. The EU CBAM is a tax in all but name
The CBAM is essentially a measure to ensure that imported goods pay a price for their carbon emissions that is comparable to the price paid by EU domestic producers under the EU ETS. In other words, EU importers must pay for carbon at prices reflecting those under the EU ETS to place CBAM-targeted goods on the EU market. The payment is made through an obligation to purchase CBAM certificates upon importation, as explained below.
Strictly and legally speaking, the CBAM is not a customs duty or import tax. This was done deliberately and carefully by the Commission because a tax would require unanimity by all EU member states whereas a duty would make it more difficult to comply with World Trade Organization rules. However, in essence, the CBAM qualifies as a new ‘own resource’ of the EU levied on goods crossing the EU’s external border, thus, being very similar to a duty or import tax, the need to pay for CBAM certificates is triggered by releasing imported goods into the EU’s customs territory. Exceptions will apply, but these will be subject to a strict and complex administrative process imposed on importers.
2. The legislative process is moving fast: the CBAM is to enter into force in 2023
The EU’s ultimate objective is a broad product coverage of the CBAM. However, due to practical concerns, only the five emissions-intensive, trade-exposed industries under EU ETS are targeted in the current proposal. Initially, the CBAM will thus impose a carbon price on imports of cement, fertilisers, iron and steel, aluminium, and electricity (CBAM goods).
Important to note is that the proposal clearly states that the Commission will consider a broadening of the CBAM scope in terms of targeted sectors, indirect emissions, transportation services and downstream industries before 2026. The sectors identified as having the highest risk of carbon leakage in Decision (EU) 2019/708 include hard coal, crude petroleum, iron ores, other non-ferrous metal ores, chemical and fertiliser minerals, pulp, paper and paperboard, basic chemicals and glass. Beyond these commodity sectors, most downstream industries – including tools, machines, vehicles, plastics – may well end up being covered by the CBAM too. If these sectors were to remain out of the CBAM, while their raw materials would be covered, these downstream industries would become subject to carbon leakage themselves, under pressure to relocate to countries with more lenient carbon emissions requirements.
As of now, the CBAM is expected to enter into force as early as 2023 in a transitional form, and it is likely to fully apply from 2026. During the transitional period (2023-2025), EU importers must comply with reporting requirements, but will not need to purchase CBAM certificates yet. Once the CBAM is fully in place from 2026 onwards, importers will be obligated to purchase CBAM certificates in order to import CBAM goods into the EU. The timeline of the CBAM introduction is something to watch closely, as the EU institutions are currently discussing the Commission’s proposal, and the legislative file will be a priority for the French presidency of the EU Council from 1 January to 30 June 2022.
3. CBAM certificates are linked to the EU ETS
Under the Commission’s proposal, EU importers must purchase CBAM certificates, where one CBAM certificate will correspond to one tonne of GHG emissions measured in the concerned CBAM goods. In essence, the number of CBAM certificates must be equal to the total embedded emissions in the CBAM goods imported. Further, the price of the CBAM certificates will be based on the average trading price of EU ETS allowances in the week prior to the import.
In principle, embedded emissions for the purpose of purchasing CBAM certificates will be calculated based on the so-called ‘default value’, which is the sectoral average emission intensity in the country of export, increased by a mark-up. The calculation of the default value is explained in detail in Annex III, point 4.1 of the Commission’s proposal.
If the actual embedded emissions of CBAM goods are verified by an independent third party accredited by a national accreditation body, the required CBAM certificates can be calculated based on the actual embedded emissions of CBAM goods. For verification, companies with production installations in third countries can register in a central database to be established by the competent authority of each member state and send their verified embedded GHG emissions to EU importers.
Moreover, if importers can prove that a carbon price has been paid in the country of origin of the imported goods, the required CBAM certificates can be accordingly reduced to account for carbon prices already paid in the country of origin (e.g., because the country of origin has its own ETS or carbon tax in place). EU importers must keep records of the documentation, certified by an independent person, to demonstrate that the declared embedded emissions were subject to a carbon price in the country of origin of the goods. The details on the methodology for calculating the reduction in the number of CBAM certificates, the conversion of the carbon price paid in foreign currency into euro, the qualifications of the independent person certifying the information, etc., will be further determined by implementing acts to be adopted by the Commission.
CBAM certificates will be valid for two years from the date of purchase. In order to give EU importers flexibility in complying with their CBAM obligations and to allow them to benefit from fluctuations in the price of EU ETS allowances, importers can re-sell CBAM certificates to the competent national authorities if they buy more than they end up needing. However, the number of certificates subject to resale is limited to one-third of the total CBAM certificates purchased by importers during the previous calendar year.
4. It is a complex administrative process, but that’s nothing unusual for the EU
The key elements of the CBAM process, once it is fully in place from 2026, are as follows:
- Authorised declarants: EU importers must apply for authorisation and be authorised by the competent national authorities before importing CBAM goods. Only importers who are authorised may import CBAM goods.
- CBAM declaration: EU importers must submit a CBAM declaration for the preceding year on the quantity of imported goods and their total (verified) embedded emissions. Embedded emissions in imported goods will be calculated on the basis of direct emissions of GHG per tonne of goods produced in the production installations.
- CBAM certificate: EU importers must purchase CBAM certificates corresponding to the embedded emissions in the imported goods, either based on the actual embedded emissions or the default value, as explained above.
- Default value: embedded emissions in CBAM goods will be calculated based on the default value unless lower emissions are demonstrated upon importation.
- Carbon prices already paid in the country of origin: CBAM certificates can be reduced to account for carbon prices already paid in the country of origin, but this needs to be certified by an independent person.
- Geographical exemptions: Countries that adopt the EU ETS (Iceland, Norway, Liechtenstein) or are linked with the EU ETS (Switzerland) are exempted from the CBAM. The EU will further elaborate a mechanism for other third countries to be exempted in the future.
While this is clearly a complex administrative process, it is, in fact, at the crossroad of two long-established EU schemes: on the one hand, the ETS, and on the other hand, the enforcement by customs authorities of product content requirements similar to what already exists for the claim of duty reduction under preferential origin. Albeit complex, those schemes work and are effectively enforced by the EU and the customs authorities and other competent agencies of the member states.
5. The CBAM is an ‘own resource’ of the EU, just like customs duties
The application of the CBAM is directly linked to EU customs laws. This matters to understand how the CBAM will be enforced. Imported goods must first be classified correctly (as CBAM application is linked to the customs classification code) and their origin must be determined correctly (in accordance with the customs rules on non-preferential origin), as only products from countries that are not exempted are covered. The person authorised for import must be the declarant in the customs meaning of the term (this means that a declarant that is not authorised, even by mistake, will have to pay the CBAM certificates and penalties). Then, EU importers must correctly calculate the embedded emissions and submit the calculation in the CBAM declaration. This will require detailed carbon accounting for the whole supply chain, which will be an exercise quite similar to what is required to claim preferential customs origin, though with the added complexity of how to calculate the carbon footprint.
It is important to note that the CBAM revenue will be a new own resource of the EU (the only other own resource of the EU is customs duty). This means that the CBAM will be enforced in the same manner as EU customs law:
- If not declared to customs by an authorised declarant, goods can be stopped at the border. As a result, supply chains may be disrupted as deliveries of goods are held up.
- If not declared correctly, the authorities can claim the CBAM-related payment after the import. This could be the case, for example, if goods are classified incorrectly, or if the origin is not determined properly.
- The EU Anti-Fraud Office (OLAF) will aggressively pursue an incorrect or false CBAM declaration. After an investigation (if necessary, in countries outside the EU), the European Commission may demand that individual EU member states recover the CBAM-related payment from economic operators.
Conclusion: start preparing now and be ready soon
Importers of products currently in the CBAM scope will have to calculate accurately the emissions embedded in the goods they import and submit this calculation in the CBAM declaration. Failure to do so will mean having to purchase more CBAM certificates, thus, paying more, based on the high default value. Importers must be ready to account for and report embedded emissions in imported goods from 2023 and be able to buy CBAM certificates in 2026. The earlier importers start preparing, the better.
Importers of products that are not currently covered by the CBAM should also prepare and be ready for the CBAM to extend beyond the CBAM goods currently in scope. While it is difficult to predict when that will be, the end of the decade is probably a fair guestimate. The CBAM is bound to quickly extend further to downstream products that undergo complex manufacturing processes by using various raw materials (steel parts, plastics, etc.), as well as finished products (e.g., automobiles, machines, electronic devices and toys).
All this will require detailed carbon accounting for the whole supply chain, including the collection of manufacturing and supply chain data comparable to that currently needed to claim preferential customs origin. There could be synergies as the new data on carbon emissions for the CBAM and the data on the origin of parts needed to claim preferential origin will both need to be requested and obtained from the same suppliers, and the collected information will have to be available upon request from the same authorities: customs and regulatory agencies of the member states.