The European Union’s (EU) Carbon Border Adjustment Mechanism (CBAM) is a form of carbon pricing and an increasingly popular policy response chosen by governments around the world struggling with the complex problem of climate change and its increasing effects on economies and business. With strong market focus and attractive revenue-raising potential – in 2022, global-carbon pricing revenues reached almost USD$100bn – carbon pricing is here to stay.
Emitters pay the price for their emissions
There are two main carbon-pricing initiatives: Emissions Trading System (ETS) and carbon taxes .
An ETS allows emitters to trade emission units on a carbon market to meet their emission targets. Under a ‘cap and trade’ principle, a government sets a cap on the total amount of emissions that a particular industry is allowed to produce. This cap is typically set to decline over time in order to meet emissions-reduction targets.
A carbon tax directly sets a price on carbon by defining an explicit tax rate on greenhouse gas (GHG) emissions or, more commonly, on the carbon content of fossil fuels. It is different from an ETS in that the emission-reduction outcome of a carbon tax is not pre-defined but the carbon price is. Many countries have carbon-tax instruments in place. A number of countries which participate in ETSs; including Norway, Sweden, France and the UK, also have carbon taxes applied to ensure certain carbon-intensive industries are priced at higher rates.
Implementing these schemes is relatively straightforward. In short, instead of dictating who should reduce emissions; where and how, a carbon price provides an economic signal to emitters. This allows organisations responsible for the emissions to decide to either transform their activities and lower their emissions, or continue emitting and pay the assigned price.
Societal impact of carbon pricing
The EU’s CBAM introduces a new form of carbon pricing that most closely mirrors the carbon-tax approach, with slightly different nuts and bolts designed to address the societal impacts of carbon pricing.
Carbon-pricing initiatives have a number of potential social impacts, depending on how they are implemented. They can impose a cost on economic activities that may lead to social discontentment and unrest, as witnessed in France by the gilets jaunes demonstrations of 2018 onwards in response to a planned rise in the tax on diesel and petrol intended to aid the transition to greener fuels.
They also risk organisations moving their emitting economic activities to a jurisdiction with lower, or no, taxation with a resulting loss of employment in the country imposing the carbon-price scheme, known as carbon leakage.
Addressing carbon leakage
One emerging form of carbon pricing is the CBAM, which seeks to address the risk of industrial production either closing down or moving to a jurisdiction with lower or no-carbon taxation through the imposition of a tariff on imported carbon-intensive products. Covering the emissions-intensive sectors of steel, iron, cement, aluminium, electricity, fertilisers and hydrogen, as well as some downstream products containing steel or iron, the CBAM will impose a tariff on these goods when they are imported into the European Union from countries that are not covered by the EU Emissions Trading Scheme – the EU ETS also covers Iceland, Liechtenstein and Norway. The European Commission has referred to CBAM as “the EU’s landmark tool to fight carbon leakage” and sees it as a key policy mechanism to support the just transition to a low-carbon economy that maintains Europe’s economic competitiveness and industrial sectors.
How does the CBAM work?
In August 2023, the European Commission adopted the rules governing the implementation of and reporting on the CBAM during its transitional phase. Payments will be phased in from 2026 until 2032 when the scheme is fully implemented, although businesses will have to begin reporting on imports from October this year – just a few weeks away.
Importers will have to pay the same amount per tonne of CO2 emitted as if the goods had been made in the EU. That is, the importer will need to purchase CBAM certificates to pay the difference between the carbon price in the country of manufacture and the carbon price in the EU.
If an importer can demonstrate that the producer has paid the same carbon price as they would have, were they located in the EU, then no purchase of CBAM certificates is required. That key provision has the potential to facilitate a Brussels Effect on carbon-pricing levels, where prices rise to meet the EU’s to ensure that countries’ exports to the bloc are not negatively impacted.
Until 2026, when payments begin to be phased in, companies are only required to report on their imports. However, with the reporting rules only being finalised in August of this year, there is a lack of widespread awareness of the implications of the CBAM on businesses. In a recent survey of 700 companies, Deloitte found that 60 per cent of decision-makers in German companies that will fall under the scope of the CBAM are not familiar with its requirements, suggesting a steep learning curve awaits these sectors ahead of the imminent reporting deadline – 31st January 2024.
The global picture
Global reactions to the EU’s CBAM have been mixed. From a US perspective, despite US producers not exporting a significant amount of any of the affected goods to the EU, concerns have been raised by politicians in the US as to the CBAM’s effects on US industry, in light of the lack of federal carbon pricing (4), a situation which is unlikely to change anytime soon. China, concerned about the likely impact of the CBAM on its industries supplying materials to the EU markets, has criticised the CBAM as ‘unfair to developing countries’ that do not tax carbon to the same level as the EU.
However, a number of countries that transact a significant proportion of their trade with the EU have indicated that they will speed up decarbonisation efforts to avoid suffering a loss of business caused by importers turning to alternative suppliers. Turkey cited the CBAM as one of the driving reasons it decided, belatedly, to ratify the Paris Agreement in the run-up to COP26.
The UK has also raised its own concerns, not about the introduction of the EU CBAM, but about the risk to its own industrial sector from carbon leakage driven by the UK ETS and its own carbon-tax policies. In response, it is exploring the introduction of a range of potential policy responses, including a UK CBAM. Although at a much earlier stage of development than the EU’s mechanism, businesses in the UK should be looking to their EU counterparts to understand how they adjust to the introduction of a CBAM.
Five months to comply
Mapping supply-chain imports against national carbon pricing is the first place to start, to understand the potential implications of the CBAM and to begin to delve into the detail of the reporting requirements. With only five months until the CBAM’s initial reporting requirements come into force, there is a brief window for in-scope industries to prepare themselves to avoid future costs and penalties.
- Download the new Risilience report: ‘The value of carbon pricing: navigating climate-policy risk to maximise business opportunity’, the latest addition to our Transition Risk Series.