Climate-related regulation has been increasing over the past few years, and in 2022, corporations will need to prepare for the EU’s proposed carbon border adjustment mechanism, or CBAM. The mechanism would impose a carbon price on imports in the form of a levy. If passed in its current form, the CBAM will be phased in between 2023 and 2026.
Why did the EU introduce CBAM?
The European Commission proposed the mechanism in July 2021 as part of a broad climate package named Fit for 55 designed to reduce carbon emissions by 55% compared with 1990 levels by 2030. The CBAM would put a tariff on imports from countries where carbon prices are lower than those in the EU or nonexistent — in other words, where goods can be produced without accounting for the hidden costs of contributing to greenhouse gas emissions.
Putting a price on every tonne of carbon emissions reflects the impact producing goods has on the climate. The proposal aims to prevent carbon leakage, where an offshored European firm or a foreign exporter produces goods more cheaply in jurisdictions that do not require them to account for the cost of their emissions via a price on carbon. Domestically produced goods must then compete with carbon-intensive imports. Carbon prices in the EU have hovered around €80 per tonne so far in 2022. The EU has estimated the cost of the CBAM for importers at €9.1 billion by 2030.
What sectors will be affected and how will it work?
The CBAM would gauge the carbon content of a product and put a price on it at the European border, thereby encouraging companies to cut emissions in their supply chains to lower the tariff. At the outset, the proposal would subject imports of cement, iron and steel, aluminum, fertilizer and electricity to the CBAM, but the EU has not ruled out expanding it to other sectors at the end of the three-year transition period. The mechanism will initially apply to embedded emissions, or the carbon emitted in manufacturing a product. The EU also plans to evaluate whether it will cover indirect emissions, or the emissions from electricity used to produce a good. As of 2023, importers will only have to measure and report on their embedded emissions. However, from 2026 importers will have to buy CBAM certificates, based on EU carbon prices. If an importer has already paid a carbon price in the country of origin, it can deduct that cost.
What impact might the CBAM have on carbon pricing?
EU officials have said the tool is designed to put a price on carbon emissions. Imports will be subject to the same carbon price as EU production, and in its proposal, the EU says the CBAM would ensure that the price of imports “reflects more accurately” their carbon content. CBAM certificates will be based on carbon prices on the EU's Emissions Trading Scheme, the bloc’s regulated market for trading and auctioning carbon emission allowances.
Currently, European companies in scope of the ETS must buy emission allowances, giving the holder the right to emit one tonne of carbon dioxide. These can also be traded, and the EU also gives companies some allowances for free. The market covers 11,000 power stations and manufacturing plants as well as aviation in the 27 EU member states, as well as Iceland, Liechtenstein and Norway.
The EU is planning to reduce free allowances to encourage companies to cut emissions more aggressively. Under the Fit for 55 carbon emission reduction package, the EU is reforming the ETS to cut emissions in ETS-related sectors by 61% from 2005 levels by 2030. Under the reform, free allowances for CBAM-impacted sectors will be phased out from 2026. Other parts of the package include proposals for greener fuels in the shipping and aviation industries, and a reform of energy taxation as well as revised carbon emission standards for cars.
“Now that carbon cost is visible because the cost of CBAM certificates will be tied to the weekly average of ETS,” Yaroslav Alekseyev, a partner at the law firm Linklaters, said in a recent interview for the ESG Insider podcast.
Importers will need to purchase special CBAM certificates, the price of which will be based on ETS carbon prices. The CBAM could encourage other countries to raise their carbon prices to match the EU’s or create their own carbon pricing scheme if they don’t have one.
"[The CBAM] could really set incentives around the world: First to bring carbon prices up to the level in the EU and then also incentivize governments to think about accelerating their initiatives in actually implementing carbon prices,” Sanjay Patnaik, director of the Center on Regulation and Markets at the Brookings Institution, a think tank in Washington, D.C., told S&P Global Sustainable1.
What happens next and what challenges might the proposal face?
The proposal was open for consultation until Nov. 17, 2021. Negotiations will take place at the European Parliament and among EU member states. Both the parliament and the Council of the EU, composed of EU member states, would have to sign off on the project. The withdrawal of free carbon allowances is a point of contention for CBAM-affected industries, including steel and aluminum producers, who say it will lead to rising costs for their industries. European Aluminium, a trade group representing the interests of European aluminum producers, says aluminum should not have been part of the CBAM proposal, which it says is “not fit for the aluminium-specific climate and competitiveness challenges we face in Europe and globally.”
The trade group believes European producers will face higher costs and be less competitive and wants CBAM to be tested before it comes into force to gauge the impact on specific sectors, Emanuele Manigrassi, public affairs manager at European Aluminium, told us in the podcast. The move has also faced opposition from other countries. Russia has said it could harm trade with the EU, and imports worth $7.6 billion could be at stake. Brazil, South Africa, India and China have voiced their “grave concern” about the introduction of the levy. The U.S. also initially warned against the introduction of a CBAM, but more recently seems to be warming to the idea.
How do investors view carbon pricing?
The discussions around the CBAM will likely be heated over the coming months, and the proposal may change. Even so, it has shown how regulation can be key in driving developments around carbon pricing. In the podcast, Patnaik called carbon pricing “the most efficient and effective” way to reduce greenhouse gas emissions: “It will force producers to bear the true costs of the operation.”
Investors are also concerned about companies’ exposure to climate risks. A carbon price would provide them a degree of certainty around that exposure, which is “really critical for investment decisions,” Patnaik told us.
Even as a proposal, the CBAM is leading corporate boards and management to prepare for questions from investors about the potential costs of emissions. Companies are creating or improving processes to assess their products’ carbon footprints. The pressure from investors is particularly acute when a company is seeking to raise money through a sustainability-linked bond or through an initial public offering, Linklaters’ Alekseyev said.
“It is not tenable to be presenting to investors and saying, ‘We have no idea what our carbon intensity is, and we have no idea how CBAM is going to affect us.’”