Protection against carbon leakage through Carbon – Border Adjustment Mechanism (CBAM)

published on 28th February 2023

On 1 October 2023, the Carbon Border Adjustment Mechanism (CBAM) will enter its transitional phase and will fundamentally change the import of goods into the European Economic Area. On Tuesday 13/12/2022, the Members of the European Parliament agreed against the background of the "Fit for 55” package on the border adjustment mechanism, which is to make a further contribution to the EU's climate neutrality by levying tariffs on CO₂ emitted by imported goods. In the context of investments in renewable energies, this should further stimulate the current boom in the EU and also boost market growth outside Europe.

So far, Europe has only had an emissions trading system (ETS-1) in place, which operates according to the "cap and trade" concept. Energy-intensive European industries, utilities (with fossil fuel based generation plants), and the aviation industry are allocated CO₂ allowances for their emissions every year. Spare allowances can be used in the next year or sold on the market. The number of allowances issued each year will be gradually reduced to finally be lower by 61% in 2030 compared to 2005, further stimulating active allowance trading. Although this mechanism covers about 40% of the emissions generated in the EU, European allowance trading has gaps.

Some industrial sectors that are included in the EU's so-called "carbon leakage list", such as the sugar industry, the petroleum industry, or the hard coal mining industry, receive their allowances completely free of charge every year. These allowances, currently granted to 63 sectors¹, serve to ensure that industries remain based in the EU, thus preventing the risk of carbon leakage to other countries due to competitive disadvantages. However, the result is that these industries have too little incentive to reduce their emissions, which runs counter to the very goal of ETS-1 or climate neutrality for the EU.

The European economy is thus exposed to the risk of the so-called "carbon leakage", i.e. the risk of energy-intensive industries moving their production to third countries. As the number of free allowances allocated each year will be reduced to zero by 2032, the above-mentioned 63 sectors are now also directly affected by emissions trading.² To prevent them from migrating to other countries to escape from the resulting competitive disadvantage compared to non-European companies, a possibility was sought to include all companies operating in the given sector in emissions trading.

As a solution, the border adjustment mechanism "CBAM"(Carbon Border Adjustment Mechanism, cf. Fig. 1) has been discussed for some time. It is an import duty for non-European companies (from outside the EU 27 + Norway, Iceland and Liechtenstein). The basic mechanism is shown in the following diagram:

Fig. 1: Explanation of how the CBAM works Source: https://www.ffe.de/veroeffentlichungen/carbon-border-adjustment-mechanism-cbam/

When importing goods that would currently have to purchase emission allowances within the EU, importers thus pay a duty calculated as the weekly average of the ETS allowance price. One CBAM certificate represents one tonne of greenhouse gas emissions released in the process of manufacturing the imported goods. The introduction of the CO₂ tariff would increase the prices of CO₂-intensive goods, which will also have an impact on the consumer. However, the rising price creates a further incentive to manufacture with lower emissions.

In addition to compensating European companies for their competitive disadvantage compared to non-European enterprises and helping avoid carbon leakage, the CBAM has another goal at its heart: The tariffs are intended to motivate non-EU countries to improve their climate protection ambitions. Indeed, only countries with systems similar to the EU's emissions trading or tariffs are excluded from the CBAM. Fig. 2 presents a comparison of various CO₂ prices. However, it is unclear how exactly the tariffs will be paid for them in each case. Possibly, only the difference would have to be paid for the CBAM certificates. There is no definitive regulation yet. Varying prices and pricing methods around the world could also complicate the structuring of the CBAM.

Experts say that it is likely that India, the UK, the US and Russia in particular will struggle with the CBAM.

Fig. 2: Selected countries with carbon dioxide pricing, in $/t;

Source: https://carbonpricingdashboard.worldbank.org/map_data

The border adjustment mechanism will begin to operate in the European Economic Area as of October 2023 and will apply to the iron, steel, cement, fertiliser, aluminium, electricity and hydrogen sectors, as well as upstream and some downstream products. In this context, the CBAM certificates will also gradually replace the free allowances of the ETS. From 2030, the mechanism will include all goods traded as part of the EU ETS.

The transitional phase of the implementation will begin in October and will end when no more free emission allowances are issued. Importers are only required to "calculate and document their direct and indirect emissions resulting from the process of manufacturing the imported goods and to submit a quarterly report (for the first time in April 2023) containing data on the import volume of direct and indirect CO₂ emissions emitted outside the EU and the CO₂ price paid in the country of origin". No definitive regulation relating to reporting obligations has been developed yet; at the moment statements and plans dating back to 2021 are relied upon.

Meanwhile, some economic sectors have criticised the border adjustment mechanism. Although the International Air Transport Association (IATA) has not yet commented on the CBAM since the MEPs reached the agreement, a press release of 2021 makes its position clear: "Tax is not the Answer to Aviation Sustainability", reads the title of the article in which IATA is clearly against the CBAM. Instead, it calls for incentives for SAF (Sustainable Aviation Fuels).

Furthermore, there are doubts as to whether the regulation complies with the WTO's laws, as the tariff constitutes a restriction of imports from third countries, which in the sense of the WTO constitutes preferential treatment of intra-European products. At the time of the publication of the MPs’ decision, however, this no longer seems to be a problem.

In summary, it can be stated that the transition phase of the CBAM implementation will start in October 2023. Although the implications are foreseeable, only the coming winter will show how exactly the economy will react to this intervention. However, with the border adjustment mechanism, the EU Commission is definitely taking an important step towards climate neutrality, and other instruments to be implemented under the "Fit for 55" package are also testament to the EU’s commitment towards pursuing an emission-free economy and industry. Although, in general, it can only be speculated about the impact of the CBAM, its consequences on renewable energies are, however, quite clear: the border adjustment mechanism is the direct European call to the global economy to reduce its CO₂ emissions. And what instrument would be better suited for this than the expansion of renewable energies and thus the decarbonisation of energy consumption?

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1 EU-Emissionshandel: Carbon-Leakage-Liste 2021 – 2030 - IHK Karlsruhe

2 Emissionshandel in der Industrie: Gratiszertifikate entlasten (lbbw.de)