EU carbon pricing goes global: How much is it going to cost your business?

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On July 14, 2021, the European Commission published a proposal for a regulation of the European Parliament and of the Council establishing a Carbon Border Adjustment Mechanism (“CBAM”).

The CBAM is a new form of carbon pricing. It would apply to a subset of the products whose production in the EU is already subject to the EU Emissions Trading System (ETS). When the selected products are imported from countries outside the EU, their importers would have to purchase one CBAM certificate (at a price derived from EU ETS auctions) for each tonne of CO2 (equivalent) deemed to have been emitted in their production, less whatever carbon price has been paid on such emissions in their country of origin. The CBAM aims to discourage EU businesses from moving their production to (or sourcing key primary products from) countries with less ambitious climate change policies, (carbon leakage) and to encourage a global move towards net zero carbon emissions by 2050 in line with the 2015 COP21 Paris Agreement.

The main issues raised by the CBAM are:

Legal context

The CBAM is part of the Commission's ‘Fit for 55’ package of legislative proposals on EU Climate & Energy policy, which aims to support the delivery of the European Green Deal. The EU has now committed to become the first climate-neutral continent in the world by 2050, and it has increased its greenhouse gas (GHG) emissions reduction target for 2030 from the current 40% to 55% of 1990 emissions. 

The ‘Fit for 55’ package spells out the measures that the member states must take to fulfil the new 55% GHG target and the Green Deal Strategies at national level. The package consists of the partial revision of eight existing EU laws and five new proposals for legislation, including the CBAM.

Sector coverage

The CBAM would initially apply to imports of goods in five categories, defined by reference to CN codes: iron and steel, aluminium, cement, ammonia and some fertilizers, and electricity. Among the products covered by the EU ETS that the CBAM would not initially apply to are organic chemicals, refinery products, ferrous scrap, ferro alloys and other fertilizers.

Geographic scope

The CBAM would apply to imports of the selected products from all countries unless they are part of, or linked to, the EU ETS. In the first instance, this means Norway, Switzerland, Iceland, and Liechtenstein.

Design of the CBAM

In the EU ETS, the obligation to surrender one EU allowance per tCO2 (equivalent) emitted falls on the operators of the installations manufacturing the relevant products. Under the CBAM, registered importers ("authorized declarants") would be required to purchase certificates in respect of the emissions produced by the installations where they were manufactured outside the EU – whether direct (for example, in the case of steel, blast furnace emissions) or indirect (from the generation of electricity that powers the installation).

Declarants are so called because they would have to make an annual declaration, by May 31 of each year, of the goods subject to the CBAM that they have imported, the emissions embedded in those goods, and the number of CBAM certificates they are required to surrender (total emissions minus carbon price paid in country of origin). They would purchase CBAM certificates from the national competent authority (NCA) that each member state would be required to establish to administer the CBAM in its territory.

The unit purchase price of CBAM certificates would be equivalent to the average EUA auction price of the previous week. In this way, imports would (at least in theory) be subject to the same carbon costs as EU producers. As well as ensuring that they have the necessary number of certificates available in their accounts in the national registry maintained by the NCA, declarants would be obliged to keep a balance of at least 80% of the certificates they are required to surrender based on their imports in the year to date. 

Unlike in the EU ETS, there appears to be no provision for secondary trading of certificates. They would be purchased from the NCA, and could be sold back to it at the price paid for them if the declarant finds itself with more certificates than it needs to settle its annual obligation, but only up to one-third of the total it has purchased in the preceding year. Any further excess certificates would simply be cancelled. 

Also, unlike in the EU ETS, where a significant proportion of EU allowances are allocated for free, all CBAM certificates would have to be purchased at the going rate. Indeed, because the EU ETS free allocation regime is designed to address carbon leakage, it will be progressively phased out.

Although the proposed regulation (particularly in its annexes) goes some way into the details (for example, regarding the methods for calculating embedded emissions, in Annex III), it leaves a number of areas to be fleshed out by the Commission in implementing and delegated acts.

All importers of products within the scope of the CBAM will need an authorization to import products covered by the CBAM and will need to register with the NCA for this purpose. Only verifiers accredited by the CBAM authority will be authorized to assess the carbon content of the products.

Calculation basis for carbon pricing for imports to be parallel to EU ETS valuation rules 

The proposal contains formulae for the calculation or determination of the carbon content by reference to the emissions embedded in imports of tangible goods (steel, aluminium, cement, fertilizers) and electricity.

The emissions included in the carbon content calculation cover direct process emissions (scope I) and indirect emissions resulting from electricity use (scope II).

  • In the case of tangible goods:
    • Actual emissions are to be calculated at installation level using a formula set out in Annex III, which divides the total emissions attributed to the production of the tangible good in question by the volume of that good.
    • In case actual emissions cannot be determined, default values will be used. These will be determined on the basis of the 10% worst performing installations in the EU.
  • In the case of electricity:
    • The calculation of actual emissions will be the exception rather than the rule and subject to stringent cumulative criteria that will not apply to imports from countries that are not interconnected with and capable of physically trading power with the EU. 
    • “Specific default values” will be calculated on the basis of the “best data available” to the Commission concerning the tonnes (average) of CO2 emitted per MWh of price-setting sources in the third country, group of third countries or region within a third country (borrowing from its practice in the context of trade defence instruments such as anti-dumping investigations). Where such information is unavailable, “alternative default values” will be used, based on the average CO2 intensity of electricity produced from fossil fuels in EU.

Timeline with tentative dates for EU CBAM legislative process and its implementation

The ‘Fit for 55’ package will now go through the ordinary legislative procedure whereby the proposed regulation text may be amended by the European Parliament or Council, provided the other agrees, and the Commission effectively accepts them. This procedure, known as a trilogue, will involve negotiations between the European Parliament, member states in the Council and the European Commission on any proposed amendments or new provisions. This normally takes about 18 months before the final text of the regulation will be adopted and the member states of the EU-27 are required to apply it in their national legal orders.

Perhaps one of the most controversial features of the proposal is its provision for a transitional period to cover the three-year period from January 1, 2023, to December 31, 2025. During this period, the CBAM will apply as a quarterly reporting obligation only – the surrender of CBAM certificates to be purchased from the NCA will not be required. The Commission's impact assessment of the proposal contains an estimate that the CBAM will initially involve 1,000 traders realizing 239,000 import transactions on an annual basis from 510 production sites outside the EU, so the need for a "warm-up" period is understandable, but some will see this as an unnecessarily slow start.

The most important provisions (e.g. relating to surrender of CBAM certificates) will not enter into force until January 1, 2026.

International trade law issues for business and governments arising from the impact on carbon leakage, free allocations and export refunds

In its own initiative Resolution of March 2021, the European Parliament supported the introduction of a CBAM, provided that it is compatible with WTO rules and EU Free Trade Agreements by not being discriminatory or constituting a disguised restriction on international trade (see link to Dentons alert). 

The CBAM is likely to be controversial with many of the EU’s WTO trade partners and their exporters who have already criticized the continued use by member states of free allocations, albeit for a limited period. Equally, certain member states and their industries affected by the CBAM proposal are likely to contest the removal of export refunds relating to carbon allowance payments when they consider their exports to be at a disadvantage in world markets.

Recently, EU industries such as producers of aluminium have challenged the Commission’s expectation that the proposed mechanism would support the EU’s green objectives, in particular to better address GHG emissions embedded in EU industry and in international trade, while being non-discriminatory and striving for a global level playing field. This is because they believe that carbon leakage will be encouraged rather than curtailed, with more GHG-sensitive products being imported from countries with lower carbon emission control standards. The Commission's impact assessment reflects a concern about "resource shuffling", and the proposal focuses entirely on what might be called primary products, rather than more "downstream" products made out of them. Although it would give the Commission powers to address "practices of circumvention", there is no guarantee that the CBAM, even if it survives legal challenge, will actually deliver its objectives.

The European Parliament is likely to support the Commission’s desire that revenues generated by the CBAM should be used as part of a basket of own resources (i.e. money that belongs to and can be spent by the EU centrally) to boost support for the objectives of the Green Deal under the EU budget, and to assist poorer households in the context of transport and housing. Again, this may encourage challenges by non-EU countries and exporters to potential unlawful subsidies under the WTO Agreement on Subsidies, depending on who are the real beneficiaries, or unlawful EU state aid if the financial support is provided in reality by the member states.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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