Navigating the European Union Carbon Border Adjustment Mechanism
“Carbon must have its price – because nature cannot pay the price anymore”, President of the European Commission, Ursula von der Leyen declared, speaking about the Carbon Border Adjustment Mechanism (CBAM). CBAM has been devised by the European Commission to provide a level playing field for incumbents and counter carbon leakage i.e., businesses relocating production outside the European Union to avoid carbon costs. Trade exposed emissions intensive industries in the EU are currently shielded from the full impact of the EU Emissions Trading System (EU ETS) through the provision of free allocation and the inclusion of a carbon leakage exposure factor in free allocation calculations. EU’s intent is to gradually phase out EU ETS free allocation and replace it with CBAM. Basic materials from the cement, iron and steel, aluminium and fertilisers sectors and electricity will be subject to CBAM. In effect for these materials, the EU will move from a production based climate action policy towards a consumption based one. The cost brought about by CBAM would be aligned to the EU ETS and with take into consideration climate policies in the jurisdictions importing into the EU. Broadly speaking, emissions from CBAM covered materials used or processed within the EU will be penalised uniformly, irrespective of the country of origin, albeit using different policy levers. The revenue generated from CBAM would go to the European Union.
In theory, successful deployment of CBAM would allow the EU and member states to implement stringent climate action policies to drive industrial decarbonisation locally. It will also force importers into the EU to at least create and disclose GHG inventories and perhaps, even reduce emissions. According to EUROFER, the EU imported 21.2 million tonnes of finished steel products in 2020. World Steel Association’s policy paper declared that in 2020, on average, each tonne of steel production resulted in 1.85 tonnes of carbon dioxide emissions. This suggests that EU policy has the potential to facilitate a global reduction in industrial carbon dioxide emissions.
However, EU ETS is yet to result in any significant industrial decarbonisation in Europe and a new mechanism associated closely with the EU ETS is unlikely to produce results overnight. There are risks associated with CBAM and the European Commission is not blind to them. Resource shuffling, as witnessed in the Californian Border Adjustment Mechanism for electricity, could result in rerouting of lower emissions intensity products into the EU, thereby undermining carbon leakage protection. Economic impact on the least developed countries importing into the EU could be detrimental and any exemptions could impact the system.
The market reaction to CBAM would determine the extent of industrial decarbonisation within Europe and globally. With the establishment of a level playing field in the EU, will further policy levers be needed to drive industrial decarbonisation, or will pressure from stakeholders lead to the creation of a so called ‘green’ commodities market? Will customers pay high prices to cover emissions costs, or will they want to pay for high prices to cover decarbonisation costs instead? Will the level playing field extend to cover EU exports? Will the EU incumbents face disruption from alternate materials and new business models? Will other countries such as the USA and Canada follow suit? Will this lead to a flurry of emissions and other ESG disclosures to maintain market confidence?