Part 1 of the ‘Tip of the Iceberg’ series
The EU Carbon Border Adjustment Mechanism (CBAM) marks the start of a new era by entering a transitional period in October 2023. This regulation is the first of its kind, as it will require importers to buy certificates for emissions generated outside the EU. This new regulation is urgently needed as a correction to the existing EU Emissions Trading Scheme (EU ETS), and it is designed to have a global impact.
Unintended Consequences
The ETS was also the first of its kind when introduced in 2005. It is still considered the EU’s flagship policy to combat climate change and the world’s largest carbon market. Although it successfully reduced emissions by 41% in targeted sectors, it had some unintended consequences. With a carbon price reaching a record high of EUR 100, the EU ETS placed a staggering EUR 40bn financial burden on local producers in 2022.
Consequently, the production of certain goods started to shift to countries with lower climate ambitions and lower, or no carbon prices. This phenomenon is called ‘carbon leakage’ and it defeated the original intension of the ETS to reduce emissions.
CBAM is therefore seen as a correction to the ETS, and its introduction will facilitate several linked objectives:
- providing EU producers with a level playing field
- incentivising suppliers globally to decarbonise
- meeting the EU’s ambitious ‘Fit for 55’ emissions reduction targets by 2030
To remain aligned with WTO rules, CBAM and ETS will be tightly coupled. The CBAM scope and coverage is expected to expand over time, but it must mirror the ETS to ensure that it does not impose a bigger burden on imports. If ETS expands to new sectors, it will also be fair game under CBAM.
In future, there could be other regulatory areas with overlap, for example Circular Economy is intrinsically linked to decarbonisation.
A Phased Rollout
CBAM will be implemented in phases, starting with a transition phase from October 2023 to the end of 2025. During this time, importers will have a quarterly reporting obligation, with the first report due on 31 January 2024. Reporting requirements focus on the quantity of the goods imported, and the calculated embedded greenhouse gas emissions.
The definitive period kicks in from January 2026, marking the start of the financial impact and the need for verification. With the introduction of mandatory CBAM certificates from this point onwards, a carbon price will be payable for imported emissions, aligned with what local EU producers pay under ETS. Double taxation can be avoided if it can be shown that an equivalent carbon price was paid outside the EU.
The gradual rollout of CBAM hinges on implementing acts and an overhaul of ETS in parallel. The phase out of ‘free allowances’ is a pre-requisite. These were introduced under ETS, to temporarily protect certain hard-to-abate sectors from carbon leakage. The goal is for the two regulations to be fully aligned by 2034.
CBAM Impacted Goods
During the transition phase, CBAM is limited to certain items made from iron, steel, aluminium, cement, fertilisers, hydrogen production, and electricity imported into the EU. It is important to note that it is not just the industries producing these commodities that are directly affected, but also downstream items that are made from it.
The impacted items are identifiable by the EU Combined Nomenclature codes (CN codes). Lists of impacted CN codes have been published for the transition phase, with two implementing acts already covering a raft of different products under the main sub-categories. The number of impacted items is expected to expand over time, with more finished goods and additional sectors, such as polymers and chemicals, to be covered next.
Embedded Emissions
CBAM departs from the GHG Protocol definitions for direct and indirect, or scope 1, 2 and 3 emissions. Instead, CBAM has its own definitions for ‘direct’ and ‘indirect’ emissions, focussing on what was emitted during selected steps of the production process, while remaining aligned with the ETS coverage.
Other new terms that CBAM introduce, is the concept of ‘simple’ and ‘complex’ goods. With complex goods, data is required from more than one installation or supplier upstream to calculate the embedded emissions. An example of complex goods would be cement made from clinker, where the latter is considered a ‘pre-cursor’ material. The same concept can be applied to other multi-step processes, all of which are described in detail for the transition phase.
Impacted Parties
Different types of businesses are impacted globally:
- Non-EU producers aka ‘Operators’ need to calculate their emissions intensity per production site, aka ‘Installation’ and share the product information with their local authorities and buyers.
- EU Importers aka ‘Declarants’ must request the information from their suppliers and declare imported emissions periodically. They will also be responsible for procuring CBAM certificates from 2026.
- Importers may appoint an indirect customs representative, who is then responsible for reporting as ‘Authorised Declarant’.
Some global businesses are both Operators and Declarants, and they typically have more complex intercompany and supplier relationships.
The introduction of CBAM is also expected to have indirect impacts, for example:
- EU manufacturers and consumers may experience price increases due to more expensive imports.
- Businesses subject to EU ETS will see a bigger financial impact over time, as free allowances are phased out from 2026 to 2032.
A Sense of Urgency
CBAM is an urgent matter for the EU as these sectors are critical to retain from a strategic perspective. Besides the ETS burden, producers are also facing increased energy costs due to the war in Ukraine. Another unexpected, and presumably unintended, blow came from an ally, with the US Inflation Reduction Fund (IRA), which gives US investors long-term clarity and tax incentives.
Together, these factors pose a real risk that EU businesses may shift their operations elsewhere. Hence, there is an urgency in the EU surrounding the implementation of CBAM. The timing is critical, as the impacted sectors have long investment cycles, and they need to embark now on projects to adopt lower emission technologies for the EU to reach their climate targets by 2030.
In summary, it is now clear that a local solution like an ETS cannot solve a global problem. That is why CBAM is designed to have a global reach and incentivise other countries to decarbonise. As a correction to ETS, CBAM is expected to set in motion a wave of regulations in other parts of the world. In the next blog, we will explore why the regulation is controversial and how other countries are responding.
For more information read: The Controversial Regulation with a Global Impact
