The European Union will soon require EU importers of certain carbon-intensive products—specifically, iron and steel, aluminum, fertilizer, cement, electricity, and hydrogen—to declare greenhouse gas emissions (GHGs) embedded in their imports and pay import taxes that mirror domestic EU carbon prices.

The new regulation—referred to as the carbon border adjustment mechanism or CBAM—is intended to “level the playing field” between EU producers of those products who have to pay an internal EU carbon price and foreign producers who do not. GHG reporting requirements will take effect on October 1, 2023 and the import tax will apply as of January 1, 2026.

Canadian exports of covered products will be subject to GHG reporting requirements and EU importers will have to pay the CBAM import tax unless domestic Canadian carbon price measures have been applied, in which case any corresponding amount paid may be deducted from the tax owed. If no deduction applies and the embedded emissions price cannot be accurately determined under the CBAM, the EU may calculate the import tax based on “default values”, which in turn could make Canadian exports uncompetitive in the EU market. Canadian firms will need to develop systems to ensure that they can provide information required for GHG reporting as of October 1, 2023, as well as to prove Canadian carbon prices paid as of January 1, 2026.

Although the CBAM is limited to the six sectors mentioned above, the product scope may be broadened over time to include other carbon-intensive products. Canadian exports such as pulp, paper, organic chemicals and polymers could be affected.¹

How Does the CBAM Work?

European climate law obliges the EU to achieve climate neutrality by 2050 and to reduce GHG emissions by 55 percent by 2030 compared to 1990 levels. The CBAM forms part of the package of measures designed to achieve these climate ambitions. It complements the EU Emissions Trading System (ETS), a “cap and trade” carbon pricing mechanism introduced in 2005.

The ETS imposes an annual cap on carbon emissions of energy-intensive industries such as oil refineries, steelworks, and producers of aluminum, cement and glass. Annual emission allowances are distributed to EU emission sources. Emitters redeem allowances related to the volume of their emissions during the year. Emitters can buy and sell allowances depending upon their needs, leading to the creation of a market-established price for carbon. Allowances are currently distributed through a mix of auctions and free allocation. However, free allowances will be phased out starting in 2026.

The CBAM is not a cap and trade system; rather, it seeks to ensure that the price of imports is not advantaged competitively as compared with the price of domestic products that include the EU carbon price through a requirement to purchase and surrender carbon certificates when importing carbon-intensive products. EU importers must declare the quantity of GHG emissions embedded in the products they import and surrender the number of purchased carbon certificates corresponding to the carbon price of declared GHG emissions. However, if importers can prove, based on verified information from the producer in the country of export that a carbon price was paid during the production of the imported good, the corresponding amount will be deducted from the carbon price “owed” by the importer. In other words, the CBAM provides for a domestic carbon price offset. If an importer cannot provide the requisite information from the producer (whether or not the producer has claimed a domestic carbon price offset), it will be required to pay import tax calculated on default values, in turn based on the “best available” “secondary data”.

The CBAM includes a robust verification regime to review declarations of embedded GHGs by importers. It also provides operators of production facilities in non-EU countries the opportunity to register with the European Commission. Registered operators are entitled to carry out the calculations of embedded emissions themselves in accordance with the methodology prescribed in the CBAM for the relevant product(s). They must also ensure that the information is verified in accordance with the CBAM verification procedures. EU importers are authorized to use the operators’ verified reports in their declarations of embedded emissions.

Additional aspects of the CBAM regime are still being implemented. The draft regulation on reporting obligations published on June 13, on which the EU is seeking public comment by July 11, addresses several matters including the content of the communication from operators of installations located outside the EU to reporting importers, rules on assessment of CBAM reports and details on penalties.

Reporting requirements will take effect on October 1, 2023, with the first reporting period ending on January 31, 2024. It will not be necessary to surrender corresponding carbon certificates until January 1, 2026, when the CBAM phase-in period ends. Failure to surrender CBAM certificates, or otherwise comply with the CBAM, will result in penalties being imposed.

How Much Will CBAM Add to the Cost of Imports?

The price of CBAM certificates will be calculated based on the weekly average auction price of EU ETS allowances expressed in euros/metric ton of carbon dioxide (CO2) emitted. Prices have fluctuated significantly over the years: in the first quarter of 2023, the price of carbon in the EU ETS exceeded 100 euros per metric ton of CO2.

Will Domestic Carbon Price Offsets Apply to Canadian Exports?

Importers will be able to offset the CBAM import tax payable provided the foreign producers have paid a carbon price “at home” that is equivalent to the carbon price payable in the EU. And therein lies the rub. International efforts have thus far failed to arrive at an internationally agreed price on carbon or methodology for pricing carbon so the challenge will be in comparing the carbon price paid by a foreign producer with that payable in the EU and determining comparability. The lack of precision on carbon price comparability is certain to lead to opportunities for protectionism and trade disputes are bound to arise.

It remains to be seen how carbon price comparisons will be applied to Canadian exports. While Canada has prescribed a minimum price on carbon by virtue of the Greenhouse Gas Pollution Pricing Act (Canada) (the GGPPA), provinces are allowed to implement their own GHG emission regimes so long as the underlying carbon pricing is at least as stringent as that prescribed by the GGPPA. Whether or not such comparisons will be affected by a provincial regime that employs a carbon tax, versus an output based pricing system (OBPS) or cap and trade is unclear but will be an important issue to grapple with going forward.

During her recent visit to Canada, European Commission President Ursula von der Leyen agreed to work towards establishment of a Green Alliance between the EU and Canada to boost energy and climate cooperation, and Canada and the EU committed to work together to explore how to improve collaboration in advancing low-carbon manufacturing through bilateral and multilateral fora.

Is CBAM Compatible with the EU’s International Trade Obligations?

The EU maintains that the CBAM is compatible with its international trade obligations because it levels the playing field between domestic and foreign producers and therefore does not discriminate between foreign and domestic producers. Some jurisdictions have signaled disagreement with this view and international trade challenges are likely as the CBAM takes effect.

Key Take-Aways

Canadian exporters of CBAM-covered products should put in place mechanisms to:

• facilitate provision to EU importers of information on embedded emissions in covered products to enable GHG reporting by EU importers starting in October 2023;
• document domestic carbon price and domestic carbon price payments on covered products exported to the EU; and
• monitor efforts to develop an internationally-agreed carbon price and engage with Canadian and foreign government authorities contributing to this effort.