1. Introduction

The EU's Carbon Border Adjustment Mechanism ("CBAM") regulation officially entered into force on 17 May 2023 (see here). The CBAM works in a similar way to the EU's Emission Trading System ("EU ETS"), by creating a market mechanism that puts a price on carbon, but unlike the EU ETS, which prices carbon emitted by EU producers, the CBAM will price the carbon emitted by non-EU producers importing into the EU. This is designed to put EU and non-EU producers on a level playing field by equalising the tariffs they pay on carbon. During CBAM's transitional period, which will run from 1 October 2023 to the end of 2025, traders will be required to report on the quantity of goods which will be covered by CBAM, the goods' embedded and indirect emissions, and the carbon price due in the country of origin. Then, from 1 January 2026, relevant entities importing carbon-intensive goods into the EU will be required to pay a levy on the embedded emissions of those goods.

This briefing explains how the CBAM supplements the EU ETS, by addressing potential competitive disadvantages caused by the EU's relatively ambitious climate policy and to reduce the risk of so-called carbon leakage.

2. Purpose of the CBAM

The CBAM has been enacted as part of the European Green Deal ("EGD"), which included a commitment by the EU to reduce carbon emissions by 55% by 2030 and to reach carbon neutrality by 2050 as well as a very broad range of measures to help achieve those commitments. In July 2021, the EU announced a set of proposals (known as the 'Fit for 55' package) that aim to deliver the EGD and help achieve the emissions reduction targets. As part of this package, the CBAM was proposed for certain imports from third countries.

The EGD recognised that the introduction by the EU of more stringent restrictions on the production of carbon-intensive goods creates a risk of so-called 'carbon leakage'. This risk can occur for one of two reasons: (i) either because carbon-intensive production is moved from the EU to countries with lower environmental standards (and subsequently imported back into the EU) or (ii) because EU goods are replaced by carbon-intensive non-EU goods (this can occur if the price of EU goods rises as compared with non-EU goods as a consequence of the carbon levies EU producers pay under the EU ETS).

It was feared that a failure to mitigate the risk of carbon leakage could leave EU energy-intensive industries at a competitive disadvantage compared with foreign competitors from overseas economies which may not be subject to similar constraints. From an environmental perspective, the risk is that a dramatic shift in production to economies without stringent emissions limits would mean that global emissions do not decrease.

The CBAM is a measure designed to counter these competitive and environmental disadvantages by equalising the carbon price between domestic and foreign products, thereby preventing the risk of carbon leakage. There is the additional benefit of encouraging cleaner industrial production in non-EU countries.

3. CBAM and the EU ETS

The CBAM is closely linked to the EU ETS, which was introduced in 2005 as the world's first international emission trading system (see here). The EU ETS was legislated as part of the Emission Trading Directive, which was part of a wider set of international measures similarly aimed at promoting reductions of greenhouse gas emissions through carbon trading (most notably the International Emissions Trading system and Clean Development Mechanism established under the Kyoto Protocol).

The EU ETS works on a 'cap and trade' principle, whereby the EU sets a cap, which decreases over time, on the volumes of GHGs which can be emitted by traders covered by the system. Member States are responsible for developing a "National Allocation Plan", which states the total quantity of EU Allowances ("EUAs") it will allocate for that period and the amount it intends to allocate to each operator. The EUAs are either allocated for free at the start of the period or are sold at auction. By 30 April each year, each operator must surrender one EUA for every tonne of CO2 emitted at the installation for that year. Operators of installations located outside of the EU, that are importing goods into the EU, are not required to surrender EUAs.

The EU has historically used free allowances under the EU ETS to discourage offshoring of carbon-intensive production of goods. However, whilst free allowances have been shown to be effective in fighting carbon leakage, they have a financial and climate cost that appears to warrant their phaseout (see impact assessment carried out by the Commission here). The CBAM is designed to work as an alternative to free allowances.

Calls for a CBAM pre-date the EU ETS, but the introduction of the CBAM has been impeded by several market factors. The price of carbon emissions under the EU ETS has historically been too low to warrant such a corrective measure. However, EU carbon prices have risen sharply in recent years which increases the likelihood of carbon leakage and has enhanced the policy need for a cross-border mechanism such as the CBAM.

4. Scope of the CBAM

The CBAM will apply to all goods listed in Annex I to the Regulation, that originate in a third country and are imported into the customs territory of the Union. The CBAM will initially apply to imports of certain goods and selected precursors whose production is carbon intensive and at most significant risk of carbon leakage, being:

  • cement,
  • electricity,
  • fertilisers,
  • iron and steel,
  • aluminium, and
  • hydrogen

The Annex to the Regulation lists, with commodity codes, several sub-categories of goods in these sectors. The list includes raw materials, such as iron ore or steel ingots, but also certain semifinished products and structures, such as tubes, pipes, railway tracks, roofs, doors and screws. The list does not include any complex manufactured or processed goods.

The Commission has proposed that, despite traders having to report on their embedded emissions (i.e. scope 2 and 3) during the transitional phase, the CBAM will initially apply to direct emissions only (i.e. scope 1) and that indirect emissions (i.e. scope 2 and 3), such as the electricity used for manufacturing any of the goods mentioned above, will not be used as a basis for calculating the CBAM levy. It is yet to be seen whether the CBAM will be extended in future iterations to encompass indirect emissions.

5. How will the CBAM work?

CBAM will enter its transitional phase from the from 1 October 2023 to the end of 2025. During this period, "authorised CBAM declarants" will be required to provide a quarterly CBAM report on the quantity of goods which will be covered by CBAM, the goods' embedded direct and indirect emissions of CO2 (and where relevant nitrous oxide (N2O) and perfluorocarbons (PFCs)) and any carbon price due in the country of origin. The Commission will specify the precise format for reporting in its Implementing Regulation, which will be published later this summer. Importantly, traders will not yet have to pay any financial adjustments during this period.

At the end of the transitional period, the Commission will re-evaluate whether to extend the scope of the CBAM to indirect emissions and/or to extend the scope of the CBAM to include more products down the supply chain. Once the CBAM becomes fully operational from 1 January 2026, only authorised CBAM declarants will be able to import any of the goods listed in Annex I to the Regulation into the EU. Applicants can apply to their CBAM authority for authorisation at any point after 31 December 2024.

Authorised CBAM declarants will need to buy CBAM certificates ("CBAM Certificates"), which work in a similar way to the EUAs traded under the EU ETS. The price of the CBAM Certificates will be calculated depending on the weekly average auction price of EUAs expressed in €/tonne of CO2 emitted. A trader importing goods into the EU must declare by 31 May each year the quantity of goods and the embedded emissions in those goods imported into the EU in the preceding year. At the same time, the importer surrenders the number of CBAM Certificates that corresponds to the amount of GHGs emitted in the production of their goods. The first surrender will happen by 31 May 2027, based on 2026 imported volumes.

If importers can prove, based on verified information from third country producers, that a carbon price has already been paid during the production of the imported goods, the corresponding amount can be deducted from their final CBAM payment.

As mentioned above, CBAM Certificates have been created as an alternative to the free allowances allocated to heavy industry under the EU ETS, to ensure that they remain competitive with businesses outside of the EU who were not subject to the EU's carbon levies. The phasing-out of free allocation under the EU ETS will take place in parallel with the phasing-in of CBAM in the period 2026-2034.

6.Next steps

The first step to compliance with the CBAM is to determine whether the relevant entity is importing any covered goods. The full list of relevant goods is sorted by CN code and listed in Annex I to the Regulation (here). Traders that are importing covered goods should review Annex IV of the Regulation, which details the methods importers should use for calculating embedded emissions for the purpose of Article 7 of the CBAM in preparation for reporting later this year. These methods are relatively complex and will require importers to gathering data on the goods' direct (i.e. scope 1) and in some cases indirect (i.e. scope 2) emissions.

The details of the reporting obligations as well as the provisional methodology for calculating embedded GHG emissions will be specified in an Implementing Regulation to be adopted by the Commission (here). A consultation period on the draft act recently closed on 11 July 2023. The final draft of the implementing Regulation is expected to be adopted by the Commission later this summer.

Originally published by 18 July, 2023

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.