The Carbon Border Adjustment Mechanism explained

On Wednesday 14 July, the European Commission presented 13 policy measures to reduce greenhouse gas emissions by 55% in 2030, from their 1990 levels. Among these proposals are a new additional EU Emissions Trading System (ETS) for buildings and transport; the phasing out of free emission allowances for aviation and the inclusion of shipping in the existing EU ETS; and tougher emission standards for cars. The package also contains a highly touted and internationally controversial CBAM on which we will focus in in this special.

The novel Carbon Border Adjustment Mechanism (CBAM) proposes a levy on imports of specific products. The system is complex, but it also brings the EU a step closer to fully pricing in carbon, as it creates a level playing field for EU producers in specific sectors.

The CBAM explained

The EU envisages the CBAM as a component of the EU ETS and its main purpose is to prevent carbon leakage by creating a level playing field for EU producers in sectors covered by the EU ETS. The CBAM is in fact a replacement of the free ETS allowances currently granted to EU producers assessed to be at high risk of carbon leakage. The free allowances will be phased out between 2026 and 2035. The CBAM will be implemented in 2026, following a transition period of three years characterised by data collection only.

The initial proposal applies to imports of electricity, cement, aluminium, fertilizer as well as iron and steel products, as specified in the annex. The levy is to be paid by EU importers of non-EU products. EFTA countries are exempted due to their participation or link to the EU ETS. Other countries with equivalent carbon pricing could follow in the future. The regulation targets direct emissions from the production process (scope 1), though the scope could be extended to purchased electricity (scope 2) and other upstream emissions (scope 3) after the transition period. The emission verification and declaration process is fairly complex (see appendix I). The price of the CBAM certificates will reflect the EU ETS prices corrected for any free allowances EU producers still receive and carbon costs incurred during the production process in the producing country.

The CBAM also contains an article about circumvention. Namely, the EU will monitor for significant changes in trade flows and slightly modified products that have “insufficient due cause or economic justification other than avoiding obligations as laid down in this Regulation”.

The CBAM interpreted

The border mechanism would be the first national mechanism of its kind in the world, though California has a similar system in place for electricity. Yet, the EU mentions that Canada and Japan are considering similar mechanisms and Democrats in the US senate were quick to announce a similar proposal on the same day that the EU package was announced.

The EU regards the CBAM as an integral part of the EU ETS and its main purpose is to replace current arrangements under EU ETS that aim to prevent carbon leakage, such as the free emission allowances. Evidence suggests that carbon leakage has not been an issue so far – a 2020 OECD report observes little change in foreign emissions embodied in domestic final demand in EU countries despite the implementation of the EU ETS and other relevant directives (Figure 1). However, the studies concern a period of low carbon prices and with anti-leakage measures in place such as the free allowances for producers at high risk of carbon leakage. The very same allowances that are intended to be phased out. Moreover, while the EU acknowledges these ex-post observations, it focuses its rationale around ex-ante simulations reflecting the ambitious targets to reduce emissions by 55% in 2030 and which do find a higher level of carbon leakage.

As a vehicle to prevent carbon leakage and replace free allowances by 2035, the CBAM is (i) a welcome step towards equal treatment of domestic and foreign producers, while (ii) leading to full internalisation of the costs of global warming into economic decisions in the sectors concerned. Free allowances are currently fairly generous in some sectors (80% of allowances in the steel sector are allocated for free) and thereby impair the working of the EU ETS pricing mechanism. Hence, they are also unlikely to allow the market to search for the most cost-efficient mitigation solutions, to stimulate a change in production practices or induce technological advance towards lower carbon technologies. As such, the CBAM would not only create a level playing field for domestic and foreign producers in the sectors covered in the EU ETS, it would also create the conditions for an effective carbon market.

Lots of red tape

However, the CBAM seems very complex and therefore the administrative burden is likely to be high, and its implicit costs come on top of the relatively high expected level of the import levy itself. Given the tracking paperwork involved, the Rules of Origin (ROO) seem to be a reasonable proxy for the eventual administrative burden. If anything, that may be an underestimation given that emissions have to be verified by a third party. Many Brexit impact studies assess that ROO implementation raises trade costs by 4% on average, although they can cause an increase of up to 15% (HM Treasury, Review of the Balance of Competences between the United Kingdom and the European Union, page 74). The regulation places them directly on the EU importers and this can prove to be particularly punitive for SME’s. The negotiation power of the importers in the chain and the substitution options they have will determine who will ultimately bear the brunt of the costs.

There is a workaround for the high administrative burden: declarants can use default values for the emission embodied in the products they import. The EU provides two options for this values: 1) based on the average in the country of production according to data or literature and 2) in the absence of 1, based on the average of the worst 10% performers in the EU. However, this set up could have adverse effects as it creates perverse incentives for importers of high emission intensity products to strive for falling back on option 2. Namely, with the EU being on average the least emission intense producer in many sectors in the world, this option could be the least costly and underestimate the imported emissions. It also raises the bar for “cleaner” producers to use actual emission content, as the benefits from the lower emission estimates would have to cover for the higher administrative costs. Either way, some emissions could be left out in this process.

By analysing trade flows, (i) we gauge the exposure of non-EU countries to the CBAM and (ii) provide an indication of the potential vulnerability of EU Member States to the CBAM. To gauge which non-EU countries are likely most exposed to the CBAM, we look at their exports of products subject to the CBAM (from here onwards “CBAM products”) to the EU as a whole. To get an idea of which EU Member States are most at risk of incurring higher input costs due the CBAM, we calculate how reliant EU Member States are on imports from countries outside of the EU ETS system with regards to the CBAM products. We specifically focus on vulnerability related to the CBAM and not to the accompanying proposal to build down free allowances under the EU ETS.

Which non-EU countries are most exposed to the CBAM?

Russia is by far the largest provider of CBAM products to the EU27, followed by Turkey, the UK and China (Figure 2)[1]. Out of the 12 largest exporters to the EU, the EU seems to be most important market for the UK, Serbia and Mozambique (Figure 3). About 80% of their CBAM exports go to the EU. Yet in fact, with an export share of over 10%, the EU is important for all CBAM related sectors in the EU’s major trading partners (Figure 3).

[1] Note that we have excluded the four non-EU countries that are exempted from the CBAM by definition (Norway, Liechtenstein, Iceland and Switzerland).

Whether exporters to the EU or importers into the EU will indeed face large costs depends on more than just export/ import reliance, however. Factors such as the emission intensity, the power of the importers to pass through the administrative costs upstream and the substitution options that importers have also play an important role (see also Appendix I for the calculation of the import levy). Finally, as explained, the CBAM costs can turn lower if the producing country has some carbon pricing in place. The UK is actually likely to be exempted from it (see next section).

Any CBAM exemptions in sight?

Based on the ETS systems currently in place in major trading partners, imports from the UK are most likely to be exempted from the CBAM levies, while the price for CBAM certificates for imports from South Korea should also be relatively low.

Importers can deduct any carbon costs incurred by third country producers at home from the CBAM certificates they have to purchase. Hence, countries that will have an ETS in place covering those sectors before 2026 could be exempted from the CBAM. Among the 12 top exporters of CBAM products to the EU, only UK, China and South Korea have an ETS in place (Table 1), though there are several voluntary carbon trading systems at the state level in the US. The UK is likely to be exempt as their ETS comes close to the EU ETS and the price skyrocketed to 50 GBP/tCO2eq on trade opening day May 19th 2021. South Korea is also well advanced with the implementation of the ETS which currently covers 75% of the country’s emissions. Trading on China’s ETS started on 16 July 2021 at a price of USD 6.80 per tonne of carbon, and only covers electricity at the moment, which accounts for 30% of the country’s emissions. There are plans to expand the system to seven other sectors, however, including the ones targeted by CBAM.

To further assess the possibility for deductions from the CBAM certificates we also consider the OECD effective carbon rate, which also includes countries without an ETS and gives further nuance on the carbon price levels. The OECD carbon rate considers fuel excise taxes, carbon taxes and tradable emission permit prices - we note, however, that it is unclear whether the EU will also consider fuel excise taxes as a carbon price. The OECD translates the carbon rate to a carbon pricing score against a carbon price of USD 60/tCO2eq. This can be interpreted as follows ”100% shows that a country prices all carbon emissions at USD 60/tCO2eq or more, and a carbon pricing score of 0% shows that a country does not price any carbon emissions (Table 1). As the current EU ETS price is close to the OECD reference price, a lower the score is a good proxy for a lower of deductions within the CBAM and, thus, the higher the impact of the CBAM. Although the data stems from 2018 and so does not fully reflect the latest state of play, it nevertheless provides a plausible perspective on the size of the challenge to move towards CBAM exemption for the different countries.

According to this analysis, the effective carbon price in most important trading partners is still far below that of the EU, with the exception of South Korea and the UK.

Which EU Member States are most exposed to the CBAM?

Not only non-EU countries, but also EU Member States themselves could be hurt by the introduction of the CBAM as they potentially face higher input costs. Bulgaria, i.e. its importers, is most vulnerable to the introduction of the CBAM given its large reliance on imports from non-EU countries.

As explained, carbon leakage due to the EU’s stronger standards on and higher prices for emissions seems to have been rather limited up until now – although admittedly, the full scope of the 2013 revisions of the ETS system are not yet visible. Accordingly, while theoretically domestic producers of for example steel could benefit from the introduction of the CBAM, the scope for benefitting from the CBAM should be rather small. At the same time, domestic companies using CBAM products as input are likely to see their costs rise, whether they keep on importing from the same non-EU countries or whether they switch to domestic producers.

Bulgaria, Ireland and Greece are most at risk of higher input costs, with around 60% of their total imports of the CBAM products coming from non-EU regions[2] (Figure 4). Whether this will actually affect the overall economy depends on the share of these imports in GDP, and this seems to be modest overall (Figure 5). For Ireland the imports amount to only 0.2% of its GDP, for Greece we are talking about 0.7% of GDP and for Bulgaria 1.9%. Still, for specific companies in these countries, the CBAM could lift input costs substantially.

[2] Note, this excludes the four exempted countries i.e. Norway, Liechtenstein, Iceland and Switzerland.

Note that for several reasons, the above graphs do not provide the whole picture. The graphs do not include the emission intensity of these imports, which could vary. The graphs also do not correct for any carbon costs incurred in the country of production. As illustrated earlier, imports from the UK and South Korea could enjoy some reductions. This in turn is relevant for Ireland whose high dependence on non-EU imports is driven by the UK. Nevertheless, the graphs give a decent first glance of which EU Member States are most likely to face higher input costs due to the CBAM.

Yet when taking into account all measures proposed to reach the EU’s increased climate ambitions, such as the phasing out of free ETS allowances for example, introducing the CBAM would soften the overall economic impact for the EU. Since clearly, it would level the playing field for domestic and foreign producers and prevent carbon leakage, i.e. a significant impact on market shares. With respect to the broader economic impact, the EU estimates that its increased climate ambitions would only reduce economic growth by roughly 0,22% in 2030 when accompanied by CBAM. The impact on investments should be modest, but the impact on consumption would be slightly more negative in a scenario with than in one without the CBAM.

Agreement on the CBAM will likely be a time-consuming process. There are different stakes at play and the EU will likely prefer to get major trading partners on board of its climate policy agenda, rather than go at it alone risking a trade backlash. That said, the EU has an ambitious emission reduction target for 2030 and looks determined to realize it; hence the EU is unlikely to let less ambitious countries slow it down.

For the mechanism to be adopted, a qualified majority of Member States will need to approve it and also the EU parliament (EP) will need to give its consent, which can be time consuming. In any case, the EP would need to be convinced that a gradual implementation of the CBAM, including a limited amount of sectors at first is the best way forward. The European Parliament earlier already issued its position on the matter, which includes a more stringent approach. It had suggested that all sectors included in the EU ETS system would be included in the CBAM.

Agreement on the CBAM among Member States will likely also be a time-consuming process. First, as explained, some countries and their importers will possibly face a substantial rise in costs of certain inputs. The exact impact will diverge among member states and sectors, possibly complicating reaching an agreement. Second, it is a highly cumbersome mechanism, difficult to implement. And third, it can count on international objections running the risk of retaliatory measures and WTO complaints, which the EU and its Member States would seem to prefer to prevent. Especially for exporting power house Germany, it seems important to prevent any trade backlash.

In essence, the EU’s goal is that greenhouse gas emissions are cut globally, which is more likely to be reached if countries around to globe work together rather than engaging in a climate trade war. This is also what the IMF has recently advocated and what the rather influential advisory board to the German Federal Ministry for Economic Affairs and Energy (BMWi) has told the ministry, for example.

Against this backdrop, the CBAM is likely to be used by the EU as a lever to enforce carbon pricing internationally.

The EU as a climate kingmaker

That said, the green agenda is of major importance to the EU and the EU does want to present itself as the global kingmaker in this respect. Hence, if partners are unwilling to cooperate at sufficient speed it is likely that the European Commission, European Parliament and at least a bunch of Member States will try to push the CBAM to move forward. Moreover, Member States have approved the EU’s target of reducing emissions by 55% in 2030 and of climate neutrality by 2050. Consequently, they have committed the EU and themselves to take measures to reduce emissions. So in the absence of CBAM somethings else in the Fit for 55 EU package has to give and the alternatives might be more painful. In other words, the EU’s ambitions to be a global driver of the green agenda almost automatically forces it to project it’s ideas on its major trading partners. This may be turn challenging in particular when dealing with less cooperative partners.

International objection

Over the past months multiple countries, such as Russia, India, Brazil, South Africa and China have already lashed out at the EU, arguing that it is introducing protectionist measures under the pretext of its climate policy. The US has also said a CBAM should only be an option of last resort. Some major trading partners, such as Russia and India, have also warned the EU they will file a case at the WTO, which lawyers will then have a hard time evaluating and of which the outcome would be unsure.

Apart from litigation at the WTO (see appendix II), there is a risk of retaliation by hard-hit trading partners. Retaliation can take the form of explicit tariff hikes, but can take more ‘subtle’ forms as well. For example, China –a strong opponent- has not refrained in the past from bullying foreign companies active within its borders to pressure their governments to alter course in other policy fields.

That said, the EU’s biggest overall trading partner, the US, seems to be only impacted to a limited extent, lowering the risk of a major US backlash at this point. And, as mentioned, multiple trading partners are either thinking about, introducing or have already started to implement some form of domestic carbon pricing mechanisms themselves, possibly reducing the price for CBAM certificates needed for imports from those countries. Moreover, the G20 on 10 July endorsed some form of carbon pricing mechanisms to bring down global greenhouse gas emissions ‘if deemed appropriate’. Yet the question arises, when is it deemed appropriate. According to US Treasury secretary Janet Yellen the focus should be on tackling climate change, not necessarily on carbon pricing, as there are multiple roads to ‘Paris’. It is no secret that while President Biden’s administration is a strong proponent of climate policies –and is as of recently also thinking about a carbon border tax in the US-, the conviction that such a policy is needed is certainly not as broadly shared in the US as it is in the EU.

We would temper expectations as to the implementation of the CBAM’s transition phase in 2023, as planned, although the official start date of 2026 should be possible if there is a will. If discussions and the entire process run smoothly, it could easily take up to two years for such legislation to pass all hurdles. Let alone, when preferences and goals among different Member States and the EP differ, as mentioned.

Most importantly, however, the proposal foresees in an article to conclude alliances with third countries or sectors in these countries, to exempt them from the CBAM on the basis of the implementation of equivalent carbon pricing mechanisms. Overall, it the EU seems better off by forging international alliances around carbon pricing upfront rather than go at it alone on the cumbersome CBAM with all possible backlashes. In that sense, we think the EU’s strategy going forward will be to use the CBAM as leverage in talks with trading partners, trying to persuade countries to introduce carbon mechanisms alike. As mentioned earlier this is slowly materializing. The main question is how long will the processes abroad take; the EU will likely proceed on its own track if it finds progress abroad too slow

But it seems to be in the EU’s interest to get the world on board in its fight against climate change. Not only to avoid trade backlashes but also because climate change is not a zero sum game and cooperation is likely to lead to better outcomes. And, if anything, the EU has always shown to prefer the talking option rather than the nuclear option.

The importers or declarants representing them need to register with the EU CBAM authority and have an authorised third party verify the emissions embodied in their imports. This verification can also be done by exporting third country producers (per production facility/ installation) by requesting to be included in a CBAM database. Such a registration is valid for 5 years. The importer/ declarant can also choose to use default values rather than verification of emissions. The default values will be based on literature and other data available about the production in the specific third country. In the absence of such data the default value will be based on the 10% worst performing EU producers.

The declarants can purchase EU CBAM certificates throughout the year and the price will be settled on a weekly basis on the basis of the weekly average of ETS auctions closing ETS prices. The declarants must hold certificates equivalent to 80% of the emission embodied in imports at the end of each quarter. The amount of certificates will be based on default values. Reconciliation takes place once a year, as the importers need to fill in a declaration on 31 May and offset the embodied emissions of exports with the certificates they possess. Any carbon costs incurred in the country of production can be deducted from the CBAM certificates to be paid. Also, the amount of certificates will reflect the free allowances awarded to the specific sector under EU ETS. The EU CBAM authority will re-purchase 1/3 of excess certificates in chronological order of purchasing and at the original price paid and the remainder of purchased certificates will be annulled by 30 June of the same year.

The World Economic Forum recently presented several issues that could lead to violation of WTO rules. Rules that might be violated are:

Furthermore the CBAM could lead the EU to apply higher charges on imported goods than the agreed customs duty ceilings in WTO agreements. The EU should also make sure that it evaluates imports on their actual emission content rather than generic metrics based on averages or promises made by the country of origin.

Besides these possible violations, the WEF has mentioned several ways out for the EU, if it can show that the CBAM is necessary to protect human health and/ or prevent the exhaustion of natural resources. Clearly, the EU advocates that its proposal is in line with WTO regulation, as it does not discriminate against foreign companies, but rather prevents unfair competition for its own producers; its measures are targeted at companies rather than countries; and foreign producers are granted free CBAM certificates, equivalent to the free allowances EU producers receive under the EU ETS. But given the complexity of the matter, trials and procedures would likely be lengthy.