The European Carbon Border Adjustment Mechanism - will it become a reality?

Exporters in third countries and importers have to start preparing for the EU Carbon Border Adjustment Mechanism (CBAM). Companies importing iron, steel, cement, aluminium, fertilizers and electricity will be obliged to purchase so-called CBAM-certificates and pay the difference between the carbon price paid in the country of production and the price of carbon allowances in the EU ETS. Producers in third countries will be required to provide information concerning their emissions.

In detail:
Reducing greenhouse gas emissions is no easy Sunday afternoon walk and going alone only renders it more complicated. Even though a provisional deal for joint action on EU-level has now been reached, questions remain: Can the EU implement a WTO compatible CBAM? Additionally, will the EU achieve its objective if the CBAM does not survive multilateral criticism?

CBAM and the European Green Deal

Three years ago, in 2019, the European Union has set reaching carbon neutrality by 2050 as necessary and attainable objective, delivering on the commitments under the Paris Agreement. The European Green Deal is the overarching strategy, to be implemented by more than fifteen new laws or changes to existing legisla-tion, the so-called "Fit for 55" package. The goal is to reduce net greenhouse gas emissions by at least 55 % by 2030, compared to 1990 levels.

The "Fit for 55" package¹ foresees establishing the CBAM together with changes to the current EU Emissions Trading System (ETS). The CBAM should equalize the carbon price between domestic and foreign products.

In accordance with the applicable legislative procedure, the European Commission put forward a draft which is concurrently discussed by the European Parliament (EP) and the 27 Member States in the Council². The draft was welcomed by the EP's Environment, Public Health and Food Safety Committee (ENVI) but the EP rejected the proposal as not ambitious enough. Over several months, the EP and the Council negotiated a compromise version that was tentatively agreed in December 2022³.

Current situation: EU only reduction efforts

The EU has an Emissions Trading System (ETS) for more than fifteen years and CBAM is designed to function in parallel with this system, complementing it for imported goods.

The ETS puts a cap on the amount of greenhouse gases companies are allowed emit. Within the cap it is possible to buy emission allowances that can be traded with. Some of the allowances are auctioned, however, the rest of the allowances are given for free by the European Commission to certain sectors at risk of carbon leakage.

Carbon leakage refers to the problem of companies relocating their production offshore, to countries with fewer environmental protection. CBAM addresses this issue, i.e. that the greenhouse gas emissions reduction efforts of the EU are offset by increasing emissions outside its borders through relocation of production to non-EU countries (where policies applied to fight climate change are less ambitious than those of the EU) or increased imports of carbon-intensive products.

The EU accounts for some 8 percent of carbon dioxide emissions (without counting the emissions created by imports). It would be counterproductive and against the objective of the Paris Agreement to decrease emissions in the EU while importing more carbon-intensive products.

Future situation: Offsetting "imported" emissions

Under the CBAM, carbon pricing is done through the instrument of CBAM-certificates, similar to ETS certificates. "CBAM certificate" means a certificate in electronic format corresponding to one ton of embedded emissions in goods. Importers of certain energy-intensive goods have to buy CBAM-certificates in order to be allowed to import those goods into the EU. The required number of CBAM-certificates corresponds to the total embedded emissions of the imported goods.

The goods concerned are enumerated and are in the beginning limited to the most carbon-intensive sectors: iron and steel, cement, fertilisers, aluminium, electricity, and hydrogen, as well as some precursors and a limited number of downstream products. Indirect emissions would also be included in the regulation in a well-circumscribed manner. The EP wanted to be more ambitious and had to compromise while the Council compromised on some indirect emissions.

Over time, the free emission allowances to some EU producers under the ETS would gradually be phased out and the product scope of the ETS and CBAM would converge.

In the beginning, as of October 2023, CBAM would start with reporting obligations before requiring the purchase of certificates. Companies would need to register as "declarants" with the EU, to be able to import products covered by the CBAM. Declarants would need to submit annual declarations of their emissions to the national competent authorities of the Member States, from whom they would need to purchase certificates, reflecting the embedded emissions of the products they imported over the previous year.

The original plan was to phase out the free ETS allocations and end free allocations all together in 2035 and the CBAM to come into effect in January 2023, with a transition period until the end of 2026. The phasing in of CBAM will now take longer.

WTO compatibility and economic consequences

Plenty initiatives have been launched to tackle global warming, but manifold obstacles have remained in their way to realization, ranging from geopolitical circumstances to considerations of unilateral advantages. Suffice to say that a "G7 Carbon Club" was talked about but not even followed up, much less creating a single global emissions price.

As regards the economic consequences in the EU, the emissions-intensive industry considers that the lack of relief of the ETS burden for exports with the simultaneous expiry of the free allocation of certificates leads to imbalance and the increased risk of relocation of industries. While EU-based manufacturers of emission-intensive raw materials would be protected from imports originating in countries with lower carbon dioxide prices, the export of emission-intensive raw materials from the Union would hardly be economically viable, as the production costs would no longer be competitive in international comparison without free allocation of allowances.

With respect to political considerations, several countries have already voiced their concerns, ranging from CBAM violating trade agreements to decrying it as blatant protectionism. Brazil, South Africa, India and China have stressed the negative implications for developing countries.

In particular, many concerns have been voiced about the compatibility of CBAM with international law. However, a CBAM compatible with the General Agreement on Tariffs and Trade (GATT) is not per se impossible and could be justified on environmental grounds. The GATT compatibility of the CBAM depends mostly on its design and application; at the time of writing the December compromise draft was not yet published and may not reflect the ultimately adopted text. It could qualify as a border adjustable internal measure under GATT Article III or, if found to be discriminatory, could be justified under the general exceptions of GATT Article XX, relating to the conservation of exhaustible natural resources (GATT Article XX(g)) or necessity to protect human, animal or plant life or health (GATT Article XX (b)).

Under EU law, the legal basis of the CBAM is Article 192 para. 1 of the Treaty on the Functioning of the EU (TFEU), which allows the Union to take action in order to achieve to the environmental and climate objectives specified in Article 191 para.1 TFEU.

The adoption and implementation of CBAM will most likely result in legal chal-lenges in the EU and by third countries. We live in interesting times.

Prof. Dr Rainer Bierwagen
Gábor Báthory