Many industries worldwide have been implementing eco-friendly measures – some willingly, others due to imposed regulation. The European Union, at the frontline of environmental law, particularly for renewables and greenhouse gasses, has turned its attention to the global supply chain with its Carbon Border Adjustment Mechanism (CBAM). Questions popping up include what CBAM is, what products it will cover, and how it will affect supply chains and participating businesses.
What is CBAM?
The EU is shifting its focus from local to global carbon emissions. However, this shift comes when manufacturing and energy policies are in turmoil due to the Ukraine conflict and widening sanctions against Russia. The sanctions, targeting financial institutions and oil imports, now include industries from coal to building materials, furniture and wood products, and even caviar. As a result, the impact on global trade will persist.
So, what is the Carbon Border Adjustment Mechanism? CBAM is part of the EU’s “Fit for 55” program to reduce carbon emissions by 55% by 2030 compared to 1990 and become a climate-neutral continent by 2050.
So far, drafts of the CBAM legislature only cover specific carbon-intensive products – electricity, aluminum, steel, fertilizer, and concrete. These products emit a substantial amount of greenhouse gas during the production process and have regular inputs. Therefore, it is simpler to calculate CBAM costs for them. Furthermore, there will be a transitional phase from 2023 to the end of 2025 until full implementation, where importers must report emissions entrenched in their products but not pay for any adjustment. This phase-in gives EU and non-EU business and authorities time for a cautious, predictable, and balanced transition. Once up and running in 2026, EU importers will annually declare the number of goods and embedded emissions in the total they imported in the previous year and surrender the equivalent number of CBAM certificates.
The legislation will probably evolve and include more products, including down the value chain, as the EU evaluates the CBAM’s performance and how companies react to the tax by modifying what they import. The EU will also decide whether to cover ‘indirect’ carbon emissions from electricity used in goods production.
Why start with the products mentioned above? According to Eurostat, the EU’s statistical office, most EU imports in 2021 and 2022 were from metals. Total trade in 2021 was 94.3 billion euros, of which 55.3 billion were iron and steel imports and 24.9 billion were aluminum imports. In 2021, steel also ruled imports by weight, accounting for 60.8% per kilogram. All products covered by CBAM have seen recent increases in imports. Between 2020 and 2021, steel imports increased by 67.3% and 112.0% year-on-year in the two months to Feb 28, 2022.
Why CBAM? What about ETS?
Global traders might be asking why we need CBAM? Doesn’t the EU’s Emissions Trading System (ETS) already address carbon leakage? To answer that requires understanding ETS, the adverse outcomes, and how CBAM intends to fix them.
The first of its kind in the world, the ETS carbon emissions trading plan is the EU’s flagship program to fight climate change. ETS is a cap and trade program where companies with carbon-intensive industrial producers have a ceiling on their allowed amount of greenhouse gas (GHG) emissions. The producers must purchase emission allowances (permissions) on the ETS trading market. For instance, a production company can buy emissions as required or sell-off (auction) those not used. There are, however, some free allowances distributed to prevent carbon leakage. The aim is to lower permission granted over time to incentivize companies to invest in carbon offsetting technology and solutions to reduce GHG.
So, how has the system been working? ETS has addressed leakage risk with carbon permits increasing by 11% since the beginning of 2022, despite a slight drop due to the Ukraine conflict. On the downside, investment incentives in eco-friendly production at home and abroad have dampened. While the EU bloc raises its climate ambitions, non-EU countries have laxer climate and environmental policies. This imbalance prompts EU-based companies to move their carbon-intensive production overseas – carbon leakage. Alternatively, companies can switch EU products with more carbon-intensive imports.
The CBAM will level the playing field regarding carbon prices between domestic products and imports and ensure that production relocating to countries with less ambitious policies will not undermine the EU’s climate objectives.
The CBAM will progressively become an alternative to ETS. Under the European Commission’s new proposal for a revised ETS, however, the number of free allowances for all sectors will decline over time so that the ETS can have maximum impact on achieving the EU’s climate goals. Furthermore, for the CBAM sectors, the free allowances will gradually be phased out from 2026.
In short, until the total phase-out of ETS in 2035, the CBAM will only apply to emissions that do not benefit from ETS’ free allowances, ensuring that importers are treated fairly compared to EU producers.