Faced with the continuing escalation of greenhouse gas (GHG) emissions and extreme changes in the global climate, policy makers worldwide are beginning to take targeted action. In the EU, the “Fit for 55” package of climate measures (an element of the Green Deal) is a roadmap for reducing CO2 emissions (and other specified harmful emissions) by 50% (as compared to the 1990 levels) by 2030 and achieving carbon neutrality by 2055. As part of this package, on 14 July 2021, the European Commission proposed the adoption of a Carbon Border Adjustment Mechanism (CBAM)—essentially a carbon pricing framework—that aims to discourage the use of carbon-intensive processes and encourage manufacturers, within and outside the EU, to operate more sustainably using clean industrial production processes.
In mid-December 2022, the Council of the European Union, the European Parliament and the European Commission reached a provisional agreement on the adoption of the CBAM regulation and released a preliminary regulation document. The agreement still must be confirmed by ambassadors of the member states and the European Parliament and formally adopted by both institutions before it becomes a binding legal requirement.
The introduction of CBAM is expected to have substantial implications for importers into the EU, regardless of whether they are EU-established, including additional costs and administrative obligations.
This article summarises the key features of CBAM and how it will operate in practice.
Overview of CBAM
CBAM targets the import of products in carbon-intensive industries and is designed to put a fair price on carbon emitted during the manufacturing of such products entering the EU. As the move towards carbon neutrality means more stringent controls and measures being introduced in the EU, there is concern about “carbon leakage.” Carbon leakage can arise where a business using a high-emission industrial process moves its facilities from the EU to a jurisdiction whose environmental laws have not been developed and in so doing, sidesteps EU environmental regulations, but then ships the products back to the EU. In addition, absent the CBAM measures, imports from jurisdictions with less stringent environmental/climate standards could be produced cheaper and would have a competitive advantage in the EU market, thus undermining the benefit of the EU environmental measures.
CBAM will apply to “covered products” imported into the EU from countries outside the EU, unless the non-EU country already participates in the EU Emission Trading System (ETS) (e.g., countries that are part of the European Economic Area, such as Iceland, Liechtenstein and Norway) or if the country links its emission trading system to the ETS and adopts the same carbon price as that paid under the ETS (e.g., Switzerland). Initially, CBAM will apply to imports of products from the following high CO2 emission industries (which are also most prone to carbon leakage):
- Hydrogen, along with downstream products.
It is anticipated that the organic chemicals and polymer sectors will be added to the covered list before CBAM is fully operational, as the European Commission has signalled that it will revisit the covered product groups before the transition period concludes to decide whether other products should be included.
Both direct and indirect emissions will fall within the scope of CBAM. Direct emissions are those arising from manufacturing CBAM-covered products and indirect emissions are those arising from electricity used in manufacturing covered products.
Under CBAM, charges will be levied based on the amount of embedded GHG in an imported product, thus protecting clean EU industry and encouraging importers to adopt environmentally friendly production methods.
A certificate system will be used to cover the embedded emissions in imported products, under which EU importers will have to purchase CBAM certificates corresponding to the embedded emissions of those products. The certificate price will be based on the ETS allowance price. For sectors covered by CBAM, the free ETS allowances will be phased out starting in 2026.
CBAM will be phased in gradually over a three-year period, with transitional reporting requirements initially applying to imports of certain carbon-intensive products from 1 October 2023, followed by operation of the full measures from 1 January 2026. During the transitional phase, importers will only be required to report on the GHG embedded in their imports, but once the full system becomes effective, importers will have to declare the quantity of covered imported goods, as well as the embedded GHG, and then surrender the corresponding number of CBAM certificates.
Mechanics of CBAM
It is important to reiterate that CBAM charges are envisioned to be implemented in 2026, and until then, affected companies will only be subject to a reporting requirement. During the transitional phase, which starts on 1 October, companies will be required to file quarterly CBAM reports with an EU or a national CBAM authority. The CBAM report will list the covered imported items broken down into specific categories, i.e., emissions per product type, per producer and per country. GHG levels will be expressed in tonnes and in direct/indirect emissions. As explained above, additional charges will be levied on imported goods, depending on the embedded GHGs in products released for free circulation on the EU market.
The declarant (i.e., the party responsible for importing the products into the EU) will have to calculate the “embedded emission levels” and pay the CBAM levy. If the importer is not established in the EU, they will need to appoint an EU-established declarant to carry out the importer’s CBAM obligations.
As from 1 January 2026, a CBAM licence will be required to import covered products, and importers of such products will be required to purchase and surrender CBAM certificates for the embedded emissions of the products at a price equivalent to that established for ETS allowances. In addition, an annual declaration will have to be submitted to the CBAM registry (which will be set up by the European Commission) by 31 May of the following year specifying the product, country, producer, quantity and direct/indirect embedded emissions, as well as a copy of the verification report issued by an accredited verifier.
The price of the CBAM certificates will be linked to the ETS, which is a price determined by the market. Starting in 2026, importers will be able to purchase certificates from the CBAM authority, with the price based on the weekly average of the ETS price. If the ETS price is low, it will be possible to bulk purchase certificates, but unused certificates will not be able to be sold on the open market; instead, they will have to be surrendered to the CBAM authority and the price for which they were sold will be refunded. Importers will need to have sufficient certificates to cover the cost of CBAM charges.
If an imported product is subject to carbon levies in the country of origin, this levy will be able to be deducted from the CBAM levy when the product is released for free circulation in the EU.
Companies that are unable to provide accurate data will be charged CBAM levies at a default rate based on the 10% worst emitting producers in the region from which the goods are imported. Essentially, CBAM should encourage importers to submit accurate data to avoid the severe default levies.
The submitted figures will have to be verified by a third party.
Penalties will apply for noncompliance with CBAM and may include suspension of a licence.
What should companies do?
The transitional period that starts in October 2023 will give importers some time to adapt to the new requirements but affected companies should begin now to assess the goods they import to identify those covered by CBAM. They should liaise with their non-EU suppliers and let them know that GHG emission data will be required for reporting purposes as from October. Non-EU suppliers will need to work with importers if they realistically wish to continue selling to customers in the EU.
Importers are likely to have challenges in fully understanding what data is required and how it should be sourced. Hopefully, the implementing act for CBAM—once published—will be accompanied by guidance. Given the complexity of CBAM, it is anticipated that there will be significant opportunities for early adopters and for those EU companies that migrate to importing low GHG emission products.