CBAM: What you need to know about the new EU decarbonization incentive

This article is brought to you thanks to the collaboration of The European Sting with the World Economic Forum.

Author: Joachim Monkelbaan, Lead, Climate Trade, World Economic Forum, Tim Figures, Associate Director, EU & Global Trade and Investment, Boston Consulting Group

• The EU has agreed to the world’s first Carbon Border Adjustment Mechanism (CBAM), a measure aimed at preventing “carbon leakage”.
• CBAM will initially cover several specific products in some of the most carbon-intensive sectors.
• CBAM, which some argue violates international trade rules, also aims to incentivize trading partners to decarbonize.

After months of negotiations, EU Member States and the European Parliament have agreed to the world’s first Carbon Border Adjustment Mechanism (CBAM) – a tariff on carbon intensive products, such as cement or fertilizer. While CBAM’s implementation is still being worked out, we at least know the scheme’s scope.

CBAM’s purpose

The new levy is to deter carbon-intensive processes and encourage manufacturers to “green” as much of their processes as possible.

The levy would mirror the EU’s carbon market price to prevent “carbon leakage”. That’s when the EU’s emission reduction efforts are offset by increased emissions outside the bloc through relocation of production to non-EU countries with less ambitious climate policies; or offset through increased imports of carbon-intensive products.

Companies in countries with a domestic carbon pricing regime equivalent to the EU’s will be able to export to the EU without buying CBAM certificates. According to the European Parliament’s lead negotiator, Mohammed Chahim, “[CBAM] is one of the only mechanisms we have to incentivize our trading partners to decarbonize their manufacturing industry.”

What was (not) agreed?

CBAM will initially cover several specific products in some of the most carbon-intensive sectors at risk of “carbon leakage”: iron and steel (including some downstream products such as nuts and bolts), cement, fertilizers, aluminium, electricity and hydrogen (which was recently added because it is mainly produced with coal in non-EU countries).

The European Parliament also signalled a clear intention to include plastics and chemicals by 2026 and all sectors covered by the EU Emissions Trading System (ETS) by 2030. At this point, finished or semi-finished products such as cars could also be included. In addition, indirect emissions (those caused by the production of the energy used in the manufacturing process) will also be included in calculating the carbon content of an imported product “under certain circumstances” (which are still to be clarified).

The EU ETS assigns free allowances to certain hard-to-abate sectors but to comply with World Trade Organization (WTO) rules, these need to be phased out as the CBAM is phased in. Free allowances under the EU ETS will diminish over a nine-year period between 2026 and 2034. Given this means that EU producers will pay their full domestic carbon costs, industry representatives say the removal of free allowances will cripple certain sectors and poses particular challenges for exports.

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We need to find a way to square the need to take climate action with the fundamental principles that underpin the global trading system.”— Joachim Monkelbaan, Lead on Climate Trade, World Economic Forum

What’s the context?

CBAM is part of the “Fit for 55 in 2030 package”, the EU’s plan to reduce greenhouse gas emissions by at least 55% by 2030 compared to 1990 levels, in line with the European Climate Law. The EU’s primary mechanism for incentivizing industry to decarbonize is through carbon pricing and to meet its 2050 targets; these prices will need to rise substantially.

CBAM extends the concept of carbon pricing to imports for the first time. Its advocates say that it has become even more relevant now with Europe’s rocketing energy prices meaning it is harder for EU companies to compete against industry abroad. The United States, meanwhile, has taken a different approach. Rather than pricing carbon, it has decided to subsidize decarbonization by offering tax credits to support the development of green technologies in the United States through its Inflation Reduction Act.

Many of the tax credits, however, are conditioned on local content requirements in a way that experts say conflicts with WTO rules and has escalated trade tensions with key US trading partners such as the EU, Japan and South Korea.

Why does this matter?

Companies and countries outside the EU may raise two concerns over CBAM:

• It places a carbon charge on companies from countries that did not primarily cause climate change. Mozambique’s GDP, for example, would drop by about 1.5% due to the tariffs on aluminium exports alone, according to the Center for Global Development. This has led to calls for revenue from the sale of CBAM certificates to be ring-fenced to support climate action in less developed countries. However, this provision is not included in the final agreement.
• According to the EU, CBAM is designed to be in full compliance with WTO rules and international climate law. However, questions have been raised over the consistency of CBAM with international trade law and environmental principles. Given its innovative nature and global impact, it is likely to be the subject of a legal challenge to the WTO.

What’s next?

Under the provisional agreement, CBAM will begin to operate from October 2023 onwards. Initially, a simplified CBAM would apply with importers obliged to collect and report carbon data.

From 2026 onwards, the full CBAM will kick in and the levy – linked to the EU’s carbon market price, currently around €90/tonne – will be payable. It would be phased gradually, in parallel to a phasing out of the free allowances under the ETS for the sectors concerned to ensure compatibility of CBAM with international trade rules. If companies cannot provide emissions data or their data are regarded by the EU as unacceptable, they will face punitive default values for emissions.

According to the European Commission, several countries, including Canada and Japan, are planning initiatives like CBAM.

Climate club to ease tensions?

This week, on behalf of the G7 group of countries, German Chancellor Olaf Scholz also presented terms for a “climate club.” His speech suggested this would be a platform to rally “ambitious, bold and cooperative” countries around climate schemes, such as carbon pricing.

According to the club’s four-page “terms of reference,” its aim is to “raise climate action by facilitating a near-zero emission industrial production transition.”

The climate club’s launch will be at the United Nations Climate Conference in December 2023 (COP28). The G7 is asking the Organisation for Economic Cooperation and Development, together with the International Energy Agency, to host an interim secretariat to take work forward.

One topic the climate club will try and address is the trade tensions that measures such as the EU CBAM and the US Inflation Reduction Act will otherwise cause. However, given the very different ways the EU and United States have chosen to incentivize decarbonization, finding equivalence between the two blocs will be challenging.

The EU, for now, is adamant that only carbon pricing schemes like the EU ETS will be acceptable for CBAM-free trade and is concerned that the very generous US subsidies on offer might incentivize the delocalization of EU industry. The United States, on the other hand, is clear that it will not introduce carbon pricing or significantly change the Inflation Reduction Act. And to be impactful, the climate club will need to expand its membership beyond developed economies to include countries in the global south – such as India – which will account for most industrial emissions in the future.

One thing is clear; we need to find a way to square the need to take climate action with the fundamental principles that underpin the global trading system. The year 2023 will be critical in working through how best to do this.