The European Commission’s recently released proposal for a Carbon Border Adjustment Mechanism (CBAM) forms a critical part of the European Union’s Fit for 55 Package, discussed in a previous blog. The proposed EU CBAM will require importers of certain products into the EU to pay for the tons of carbon emissions embedded in those products in the form of CBAM certificates, the price of which would be tied to the price of emissions allowances under the EU Emissions Trading System (ETS). The CBAM is expected to be phased in gradually from 2023 in the form of detailed emissions reporting requirements, transitioning to full implementation by 2026. Although the EU CBAM has yet to be approved and details of the mechanism remain to be fleshed out via implementing acts, companies would benefit by evaluating their potential exposure now, not just to the EU CBAM but also to the measures that may be implemented in response by other countries, including the United States.

Overview of the Proposed EU CBAM Regulation

The proposed EU CBAM has several related objectives. One is to prevent so-called “leakage” of carbon and other greenhouse gas (GHG) emissions from the EU. Carbon leakage refers to the relocation of production from a carbon-regulating jurisdiction (such as the EU) to other jurisdictions with less stringent emissions constraints, or to increased imports of more carbon-intensive products from those jurisdictions, offsetting the emissions reductions policies of the importing country. The level of ambition of the EU’s climate policies exceed those of many of its trading partners, creating a risk of carbon leakage. Another objective is levelling the playing field for EU producers, which would otherwise face increased competition from foreign producers facing lower or no climate policy compliance costs. A third objective is incentivizing other countries to adopt similar climate targets and policies to the EU.

Carbon leakage is a longstanding concern for the EU, mainly arising from its ETS. The EU ETS imposes a declining cap on total emissions to raise the cost of engaging in emissions-intensive activities and allows participants to trade emissions allowances to satisfy their compliance obligations. Until now, the EU has tried to mitigate the adverse competitiveness effects of its ETS by freely allocating emissions allowances to certain sectors. Free allocations are not a sustainable solution to the competitiveness problem, because in order to achieve its emissions reduction objectives, the EU needs to keep reducing the number of emissions allowances available under the EU ETS (meaning that allowance compliance will become a real cost to EU-based companies, if it isn’t one already). The CBAM offers an alternative way to discourage carbon leakage and level the playing field for EU producers vis-à-vis their foreign competitors.

Under the proposed CBAM, importers of covered products into the EU will be required to purchase CBAM certificates for every ton of carbon emitted during the production process of the products. Covered product sectors will include cement, electricity, fertilisers, iron and steel, and aluminium, with coverage expanding to other sectors over time. Importers will need to submit declarations verifying the amount of embedded emissions in their products, purchase CBAM certificates corresponding to the amount of embedded emissions, and surrender the number of CBAM certificates corresponding to the declared emissions to the relevant national authority on an annual basis.

The price of CBAM certificates is to be determined by the price of emissions allowances under the EU ETS. Specifically, the EU Commission expects to determine the price of a CBAM certificate based on the weekly average of the closing prices of EU ETS allowances on the ETS common auction platform and publish this price weekly. (Article 21). The cost of emissions allowances under the EU ETS has risen dramatically, with allowances trading at prices upwards of 50 EUR per tonne. In fact, the EU’s carbon price has more than doubled from levels before the COVID-19 crisis.

Importantly, the CBAM proposes to recognize and reflect carbon costs “internalised” by the importer through its home jurisdiction. Under the proposal the total number of CBAM certificates that an importer would need to declare will be reduced by any “carbon price” paid in the country of origin of the goods, excluding any export rebates or other compensation (Article 9). The EU may enter into agreements with third countries concerning their carbon pricing mechanisms for this purpose. (Article 2.12) As the proposal is currently drafted, it appears that importers will only be able to seek a reduction for a carbon price in the form of a tax paid on GHGs released during the production process or emissions allowances under a GHG trading scheme (Article 3(23)).

Importers would be required to surrender their CBAM certificates to the relevant national authority by 31 May of each year (rather than upon importation). They also will be required to hold certificates equivalent to at least 80 percent of embedded emissions at the end of each quarter (Article 22). Following the surrender of required allowances, upon request from an importer, the relevant national authority will repurchase a maximum of one third of the importer’s total unused CBAM certificates at the original purchase price. (Article 23) Any emissions remaining in an importer’s account by 30 June of each year will be cancelled. (Article 24). Unlike under the EU ETS, trade in CBAM certificates will not be permitted. According to the EU, because the total number of CBAM certificates will not be capped (in contrast to emissions allowances under the ETS), if importers were permitted to carry forward and trade CBAM certificates, that would affect the price for CBAM certificates and potentially lead to divergence from the ETS allowance price and/or lead to differences among the prices paid by individual importers.

Embedded emissions for goods are to be calculated in the first instance based on actual emissions of goods produced in a given installation. Different formulas are provided in the draft CBAM for simple goods and complex goods. (Annex III). The emissions attributed to a particular production process, including the embedded emissions of the input materials consumed in the production process of a complex good, will depend on the “system boundaries” of the production process as elaborated in implementing regulations.

Where actual emissions for goods “cannot be adequately determined”, default values will be used based on the average emissions intensity of each exporting country or, when “reliable data for the exporting country cannot be applied,” default values would be based on the average emission intensity of the 10 percent worst performing EU installations for the good in question. (Annex III, Article 4). Notably, there is a possibility of adjusting default values based on regional characteristics such as “geography, natural resources, market conditions, energy mix, or industrial production”. (Annex III, Article 6).

Emissions embedded in electricity are to be calculated based on specific default values for a third country or if those values are not available, on EU default values for similar electricity production in the EU, unless the importer satisfies certain criteria and chooses to apply actual embedded emissions (Annex III, Articles 4.2, 5).

Certain countries and territories are proposed to be excluded from the CBAM. At present, only those countries and territories already subject to the EU ETS or fully linked to the EU ETS may qualify for an exemption as concerns trade in goods (Article 2(3); Annex II, Section A). Exemptions are currently limited to the EU’s closest neighbours – Iceland, Norway, Liechtenstein and Switzerland – but importantly, not the United Kingdom. Possible exemptions for trade in electricity are still under evaluation, but they will likely include Norway and Liechtenstein (Article 2(7); Annex II, Section B). The explanatory memorandum accompanying the CBAM proposal notes that “[a]greements with third countries could be considered as an alternative to the application of CBAM in case they ensure a higher degree of effectiveness and ambition to achieve decarbonisation of a sector.” In other words, the EU is making distinctions only where the equalizing objectives of the CBAM already have been achieved for producers from exporting countries already subject to EU-recognized carbon costs internalisation.

What Happens Next

The publication of the EU Commission’s proposal is not the end of the road. The CBAM proposal will undoubtedly be subject to numerous amendments before it is ready for final adoption by the European Parliament and the Council. The legislative process could be lengthy. Opposition to the gradual phase out of free allocations is likely to prompt significant debate.

The proposal provides for full implementation beginning in 2026, with a transition period running from 2023 to 2025. During the transition period, importers will not incur any financial liability, but they will be subject to significant reporting obligations. Beginning in 2023, importers will need to submit quarterly “CBAM reports” detailing the total quantity of goods imported, the actual total embedded emissions (direct and indirect) per ton of goods imported, and any carbon price due in the country of origin of the imported goods. Penalties would apply for failure to submit a CBAM report. (Article 35) Satisfying these reporting obligations is likely to prove especially burdensome on installations in developing countries, where, in contrast to many developed countries, national or subnational emissions reporting requirements and standards may not be in place and companies may have little or no experience with monitoring and verifying the emissions in their supply chain.

Responses from the EU’s Trading Partners

In a prior blog, we noted some of the criticisms of the CBAM proposal voiced by the EU’s trading partners, several of whom are highly exposed due to the carbon-intensive nature of their exports to the EU, e.g., Russia. The proposal is also of significant concern to the UK, given the importance of the EU market for UK exporters. Although the proposal still needs to be adopted and the CBAM certificate purchase requirement would not come into effect until 2026, some of the EU’s trading partners are already responding with their own border measures and/or threats of legal action.

On the same day that the proposed EU CBAM regulation was published, U.S. Democrats announced a proposal to include “polluter import fees” as part of a forthcoming 3.5 trillion budget reconciliation bill. Following the publication of the polluter import fee, U.S. Senator Chris Coons (D-Del.) and U.S. Representative Scott Peters (D-Calif.) proposed new legislation that they hope will be part of the reconciliation bill that would establish a border carbon adjustment (BCA) on polluting imports—the FAIR Transition and Competition Act.

Similarly to the EU CBAM, the initial list of sectors covered by the BCA under the FAIR Transition and Competition Act includes steel, aluminium, cement, and iron, as well as derivative products, and may extend to additional sectors as U.S. government processes for determining carbon intensity of different types of goods improve. However, the BCA in its current proposed form differs from the proposed EU CBAM in several key respects.

First and foremost, the BCA does not “adjust” a national carbon price on imports. Unlike the EU, the United States has not implemented a national carbon pricing mechanism and the proposal is not conditional on one being implemented. The fee is therefore not a “border carbon adjustment” as conventionally understood. In lieu of a national carbon price, the amount of the adjustment under the Fair Transition and Competition Act would be calculated based on production emissions of the product, multiplied by the “domestic environmental cost incurred” by each covered sector or in the production of a covered fuel. This “environmental cost” would be constructed from the costs of compliance with various existing U.S. environmental programs, including federal, State, regional and local programs. (Sec. 9902) How precisely this cost would be determined for each covered sector is not specified. The lack of specification is unsurprising given how complicated this exercise will be, particularly when it comes to accounting for differences in the costs of State and regional programs. Embedded emissions would be calculated based on the production emissions of the product or, where reliable data is not available, a benchmark based on the emissions of the highest emitting sites within the sector. (Sec. 9904).

The criteria for exemptions from the Fair Transition and Competition Act are also more flexible than those included in the EU CBAM proposal. Exemptions will be granted to Least Developed Countries, as well as to any country that does not impose a BCA on U.S. products and that “enforces laws and regulations designed to limit or reduce greenhouse gas emissions that are at least as ambitious as Federal laws and regulations designed to limit or reduce greenhouse gas emissions.” (Sec. 9904). Accordingly, countries will not necessarily need to impose an ETS or carbon tax to obtain relief for their exporters under the Act.

In addition or in the alternative to imposing their own border measures on carbon-intensive products, if and when the CBAM proposal is approved, some EU trading partners may decide to launch a legal challenge to EU CBAM before the World Trade Organization (WTO). At this stage it is too early for detailed comments on the merits of any potential legal challenge to the EU CBAM. In general, CBAMs run the risk of violating WTO non-discrimination obligations and market access commitments to the extent they discriminate against products from certain countries that have not adopted carbon pricing mechanisms deemed acceptable to the importing country; exceed the importing country’s tariff bindings for products in covered sectors; and/or discriminate against foreign producers versus domestic producers by subjecting them to different and less favorable requirements. Although WTO rules on border adjustments may be interpreted to accommodate CBAMs, that does not guarantee WTO-consistency. How a CBAM is applied in practice will be critical to any assessment of its legality. Potential violations might possibly be justified under one or more WTO exceptions, but this too is difficult to predict, as the applicability of the exceptions will similarly depend on how the CBAM is applied in practice.

The European Commission has emphasized repeatedly that it has designed its CBAM to be WTO-consistent. Nevertheless, various features of the proposal raise questions under WTO rules. There are differences between the treatment of domestic goods under the ETS and imported goods under the CBAM. For example, under the EU ETS, domestic producers may purchase and trade allowances. Trade in EU CBAM certificates will not be permitted, under the current proposal. Nor will EU goods and imported goods be subject to an identical carbon price. The fact that EU producers will continue to receive free allocations until they are gradually phased out may prove particularly provocative to the EU’s trading partners, many of whom raised concerns about the potential for “double protection”. Starting in 2026, free allocation will gradually be phased out by 10 percentage points each year and the CBAM will be reduced proportionally to the amount of free allowances distributed to a given sector. Whether the EU’s trading partners will consider this approach sufficient to ensure that imported goods are not subject to discriminatory treatment relative to EU goods remains to be seen.

The FAIR Transition and Competition Act as currently conceived could be relatively more vulnerable to challenge, compared with the EU CBAM. Without a national carbon price, the BCA cannot qualify as a “border adjustment” and therefore would have no prospect of benefiting from the accommodations provided to measures that fall in that category. The potential applicability of any of the WTO exceptions to the legal obligations implicated by the EU CBAM or the FAIR Transition and Competition Act will depend largely on how these measures were applied, but without a national carbon price underlying it, the latter certainly will face additional hurdles.

The EU’s trading partners may also respond to the EU CBAM by developing, strengthening, or expanding their existing climate policies and carbon pricing mechanisms. China recently launched a national emissions trading scheme covering approximately 40% of national emissions to support its goals of peaking carbon emissions by 2030 and achieving carbon neutrality by 2060. In theory, this could help reduce the exposure of Chinese companies. China’s ETS differs from the EU ETS in important ways, however, most notably the cap on emissions is flexible and can rise or fall depending the outcome of covered installations. The EU may have concerns regarding the structure and operation of China’s ETS that affect the degree to which its allowances are credited under the CBAM. Assuming that a carbon price paid in China qualifies Chinese exports to the EU for a reduced CBAM certificate purchase requirement, the amount of the reduction will depend on the price actually paid and the ability of importers to verify that fact. The opening price of carbon emissions allowances under China’s system on the first day of trading was CNY 48 (USD 7.4), much lower than recent price levels on the EU ETS.

Considerations for Companies with Potential Exposure

The CBAM proposal and the border measures that may be adopted in its wake by other governments are part of a broader shift toward more aggressive climate actions now taking place in countries around the world, including the United States. The EU has made clear it is prepared to act unilaterally and other countries may soon follow suit. Barring some sort of multilateral agreement on how to recognize and account for the climate policies of all or major groupings of countries, which at the moment appears unlikely, the result of these unilateral actions is likely to be a maze of interconnected border and domestic measures that will disrupt international trade.

Companies should not wait for final measures to be imposed. Understanding how various national climate measures compare and interact and developing the processes necessary to ensure compliance and capitalize on business opportunities will require significant time and resources for many companies, particularly those that have not yet invested in emissions monitoring technology and verification and those operating in countries with comparatively weak climate regulations and reporting requirements.

Companies can start preparing now, by evaluating their ability to accurately measure embedded emission (direct and indirect) and assessing their options for mitigating adverse effects on their supply chains. Companies can also start evaluating their own potential comparative advantage under new climate policies. U.S. steel companies are a prime example. The U.S. steel industry is considerably less carbon-intensive than those of other countries. U.S. steel producers could therefore find themselves at an advantage relative to more carbon-intensive steel producers in other countries covered by the EU CBAM and/or a U.S. carbon border measure.

In addition to taking steps individually, companies could also benefit by coordinating on climate standards development for their particular sector. A growing number of sectors are already doing this effectively. Companies should explore working with each other and industry associations to determine what climate regulations they are likely to face and how to respond effectively. For example, it may be useful for companies to evaluate whether to participate in the development of production emissions benchmarks to be used in estimating sectoral emissions or petition for the expansion of sectors under a possible U.S. carbon border measure. Companies potentially affected by the EU CBAM could also coordinate to develop emissions reporting standards that could be used across the sector and share lessons learned, thereby reducing the compliance burden on individual companies and enhancing the competitiveness of the sector overall.

Companies that take steps now to develop a detailed understanding of the potential costs and opportunities of new domestic and international climate measures to their supply chains and put together a proactive engagement strategy will be at an advantage relative to their competitors, not only in regard to the CBAM but also with respect to measures that may be imposed soon in the United States and elsewhere.