The Carbon Border Adjustment Mechanism (“CBAM”) – the European Union’s Next Climate Action Step

Background

The European Commission first introduced the CBAM in July 2021 as part of its “Fit for 55” in 2030 package — a series of interconnected and comprehensive proposals designed to ready the EU’s policies (climate, energy, land use, transportation, and taxation) to reduce net greenhouse gases (“GHGs”) by at least 55% by 2030, as compared to 1990 levels.

Per the EU legislative process, the CBAM now needs to be confirmed by ambassadors of the EU member states and by the European Parliament. Both the European Parliament and the Council of the European Union will then have to formally approve the agreement before CBAM comes into force. The partial agreement is dependent on a number of other pieces of legislation which will first need to be resolved before formal adoption can occur.

Key Provisions and Items

As noted, the CBAM currently targets the imports of carbon-intensive industries, although it does extend to “some precursors and a limited number of downstream products”¹ (e.g., screws and bolts and other similar articles in the iron and steel industries). Given the scope of these industries, this program will impose additional costs on imports of many different products into the EU. While the focus is on “embedded” emissions (those occurring upon manufacture), indirect emissions are also set to be included in the applicable regulations “in a well-circumscribed manner.”² The CBAM incorporates a transition period during which extending its scope to other goods at risk of carbon leakage, and additional downstream products, will be assessed. The goal is to include all goods covered by the EU’s Emissions Trading System (“EU ETS”) by 2030, and the European Parliament has also signaled its intention to include chemicals and plastics within the scope of the CBAM prior to full implementation. Assessment of the methodology for indirect emissions is also to be considered.

The CBAM is designed to work in parallel with the EU ETS — the world’s largest carbon market — based on a cap and trade system. Fundamentally, the CBAM will obligate companies importing into the EU to purchase CBAM certificates to pay the differential between the country of production’s carbon price (or lack thereof) and the price of carbon allowances in the EU ETS. Such CBAM certificates cannot be traded. In addition, similar to the EU ETS, a period of free certificate allocation is expected. The CBAM is designed to ensure that global climate efforts are not undercut by companies relocating manufacturing operations to countries outside of the EU with less ambitious climate policies and to create an incentive for EU trading partners to regulate CO₂ emissions as well.

The CBAM will take effect on October 1, 2023, but will be phased in gradually. Initially, a simplified version of the CBAM will apply with reporting obligations only, the aim being to collect data. Starting in 2026, a levy will be imposed on importers of covered goods (which may have been expanded by that time) tied to the weekly average EU ETS allowance price, which, as of December 1, 2022, traded above 80 EUR. Importers must register with the applicable governmental authority and provide periodic reports on imported goods emissions data. Any covered entity that cannot provide the required emissions data calculated in accordance with applicable requirements will be forced to use default values and be subjected to a higher emissions factor, increasing CBAM obligations. Direct emission reporting must be verified by an EU-accredited third party. Methodologies for calculating reductions and other detailed procedures will be determined by later implementing acts.

The phasing in of the CBAM will coincide with the phasing out of free allowances for the applicable sectors under the EU ETS. On December 18, 2022, reformation to the EU ETS was agreed to with the phasing out of free allowances from 2026 onward, with total disappearance of the allowances by 2034. This phase out was also extended to maritime shipping emissions with the European Parliament and Council of the European Union agreeing to the following schedule for shipping companies:

• 40% for verified emissions for 2024;
• 70% for 2025; and
• 100% for 2026.

Initially, the phase out will apply only to carbon dioxide emissions, but nitrogen oxide, soot, and methane will be included beginning in 2026. Most large vessels are included within the EU ETS phase out. Although the EU plans to phase out the allowances granted to private enterprises, it will be providing allowances to an “Innovation Fund” and a “Market Stability Reserve.”  The proposal has plans for using the proceeds of the sale of these allowances for various climate-related purposes, including relieving the “energy poverty” affecting households associated with these programs.

The EU hopes that the CBAM will be fully compatible with international trade requirements, although legal challenges are likely to occur given the controversial nature of the levy.

Takeaways

Although the CBAM is a EU-based policy, its implications extend far beyond the bloc’s borders. For example, with the implementation of the levy, the EU hopes to strengthen the climate policies of non-EU countries. In addition, companies producing goods outside the bloc seeking access to EU markets will need to perform detailed emissions analyses and assess opportunities to reduce emissions regardless of policy developments, or otherwise risk losing market-share. Implementation of the CBAM is likely to also intensify efforts to decarbonize GHG-intensive industries subject to the levy, such as steel and cement production. Moreover, implementation of the CBAM will spur increased focus on green and blue hydrogen and ammonia opportunities. While the CBAM represents potentially significant added costs, domestically it also presents opportunities to leverage Inflation Reduction Act incentives to support the development of less carbon-intensive products and potentially secure a favorable position in EU-markets for goods covered by the CBAM. The CBAM’s movement through the EU legislative process should be carefully tracked, alongside closely related reforms and policies, such as the EU ETS.

¹ Press Release, Council of the EU, EU Climate Action: Provisional Agreement Reached On Carbon Border Adjustment Mechanism (CBAM) (Dec. 13, 2022), https://www.consilium.europa.eu/en/press/press-releases/2022/12/13/eu-climate-action-provisional-agreement-reached-on-carbon-border-adjustment-mechanism-cbam/.

² Id.