The Carbon Border Adjustment Mechanism (CBAM): A Key Component in the EU's Climate Neutrality Ambitions

As the world continues to grapple with the challenges of climate change, the European Union (EU) has taken a significant step towards achieving its ambitious goal of becoming the world's first climate-neutral continent by 2050. The EU's Carbon Border Adjustment Mechanism (CBAM) is a crucial component of this strategy, designed to address the risk of carbon leakage and promote a level playing field for EU industries.

The Carbon Border Adjustment Mechanism (CBAM) is a carbon tariff on carbon-intensive products imported to the European Union (EU). It is a tool envisioned by the EU to put a fair price on the carbon emitted while producing carbon-intensive goods. It is legislated as part of the European Green Deal and takes effect in 2026, with reporting starting in 2023. The CBAM proposal would require that imported goods face charges and requirements similar to those of domestically produced goods similar in carbon content. CBAM aims to align the carbon prices of goods imported into the EU with those made in the EU.

The CBAM will apply to a wide range of products and industries. It will initially apply to cement, iron and steel, aluminum, fertilizers, and electricity. Based on their carbon intensity and risk of carbon leakage, it may also apply to other sectors in the future, such as chemicals, paper, and glass.

Entities and industries subject to the CBAM import carbon-intensive products into the EU. Importers of goods under the CBAM will have to report the number of CO2 emissions embedded in the goods imported, i.e., they will have to obtain verified information on their products' carbon content, either from the producers or through an approved calculation methodology, and report this information to the EU. 

Non-compliant entities will not be authorized to import goods into the EU. The customs authorities of the EU member states are obliged to monitor the movement of goods and to deny the import of CBAM goods by non-registered declarants. However, Small and Medium Enterprises (SMEs) importing less than 5,000 tons of CO2 emissions from third countries per year will be excluded from the CBAM requirements. 

The Paris Agreement and the EU's Climate Ambitions

The Paris Agreement, signed by 195 countries, including the EU, aims to limit global warming to well below two °C and pursue efforts to limit it to 1.5°C above pre-industrial levels. As a leader in climate protection, the EU has set its targets to reduce greenhouse gas (GHG) emissions by 55% by 2030 compared to 1990. To achieve this, the EU introduced the European Green Deal, a comprehensive package of policies and initiatives to transform the EU's economy and society into climate-neutral.

The Carbon Border Adjustment Mechanism (CBAM)

The CBAM is a critical component of the EU's climate strategy, introduced as part of the "Fit for 55" package in July 2021. The mechanism is designed to address the risk of carbon leakage, where companies might shift production to countries with lower emission reduction requirements to avoid the costs of carbon pricing. The CBAM operates by imposing a charge on the embedded carbon content of certain imports from non-EU countries, equal to the charge levied on domestic goods under the EU's Emissions Trading System (ETS). This ensures that EU producers and importers of covered goods face the same carbon price, encouraging partner countries to decarbonize their production processes.

How Does CBAM Work?

Image source: Carbon Border Adjustment Mechanism

The Carbon Border Adjustment Mechanism (CBAM) is a policy tool designed to address carbon leakage, which occurs when companies move their production to countries with less stringent climate policies to avoid the costs associated with reducing greenhouse gas emissions.

The following is a breakdown of how it works:

CBAM, or the Carbon Border Adjustment Mechanism, is a proposed policy tool to address carbon leakage by imposing a carbon price on imports from countries with less stringent climate policies. 

Scope: CBAM would initially target specific sectors with high carbon emissions, such as steel, cement, fertilizers, aluminum, and electricity generation.

Carbon Price: Importers must purchase CBAM certificates corresponding to the carbon price in the EU's Emissions Trading System (ETS) for the imported goods.

Calculation: The number of CBAM certificates required would be based on the embedded emissions in the imported goods, considering the carbon price paid in the country of origin.

Exemptions: Goods from countries with climate policies deemed equivalent to the EU's would be exempt from CBAM.

Revenue: Revenue generated from CBAM would support climate action and the green transition in the EU and partner countries.

Phasing-in: CBAM will gradually be phased in to allow international partners to adapt and ensure compatibility with World Trade Organization (WTO) rules.

CBAM aims to create a level playing field for EU producers and encourage trading partners to adopt more ambitious climate policies, thereby reducing global greenhouse gas emissions.

How does CBAM align with EU ETS?

The Carbon Border Adjustment Mechanism (CBAM) aligns with the EU Emissions Trading System (ETS) by complementing and expanding the scope of the existing ETS to prevent carbon leakage and reduce greenhouse gas emissions. The CBAM is designed to impose a charge on the embedded carbon content of certain imported goods, ensuring that imports' carbon cost is equivalent to domestic production within the EU. 

This mechanism aims to level the playing field for EU producers and importers by replacing the free ETS allowances granted to high-risk EU producers with an equivalent carbon price on imports. Additionally, the CBAM will gradually phase out free allowances under the EU ETS by 2034, further aligning with the goals of decarbonizing industries in the EU. The CBAM's phased implementation, starting with a reporting obligation from October 2023 and full implementation by 2026, is intended to address carbon leakage and promote cleaner industrial processes globally, in line with the EU's climate objectives.

Affected Products and Implementation Timeline

The CBAM will initially affect goods imported from non-EU countries that are particularly carbon-intensive, such as cement, electricity, fertilizers, aluminum, iron, steel, and hydrogen. The mechanism came into effect on October 1, 2023, with a transitional phase from October 2023 to December 2025, during which importers will be subject to a reporting obligation without financial obligations. From January 1, 2026, only registered declarants will be allowed to import CBAM goods, and importers will be obliged to purchase sufficient emission allowances for imported embedded emissions.

Implications and Opportunities for Businesses

The CBAM presents significant implications for businesses, particularly those that consume products covered within the scope of the EU ETS. Companies must prepare for the reporting obligations and the potential for significant additional costs due to the emissions occurring in geographies without commensurate low-carbon policies. However, the CBAM also offers opportunities for companies to review their supply chains, make conscious cost versus carbon trade-offs, and ensure the resilience of their pricing models to the proposed changes.

Companies must do the following from 2026/2027 onward:

• Starting January 1, 2026, only registered declarants can import CBAM goods. Importers must apply for authorization to register from January 1, 2025.
• Importers must purchase sufficient emission allowances for the embedded emissions in the imported CBAM goods during the year.
• CBAM declarations compare the amount of imported embedded emissions to the amount of emission allowances bought. If too few certificates are acquired, financial sanctions may be imposed.
• Companies must determine the direct and indirect CO2e emissions of the imported CBAM goods using actual or default values (for electricity only). If using actual values, a certified body must verify and test the emissions.
• Companies must prepare and submit an annual CBAM declaration by May 31 of the following year, detailing the CBAM goods imported, associated CO2e emissions, and the emission allowances acquired.
• Companies should start preparing to adapt to these upcoming CBAM requirements, ensuring they meet the expected monitoring, verification, and reporting standards.

Conclusion

The Carbon Border Adjustment Mechanism is critical to achieving the EU's climate neutrality ambitions. By addressing the risk of carbon leakage and promoting a level playing field for EU industries, the CBAM demonstrates the EU's commitment to leading the global effort to combat climate change. As the mechanism comes into effect, businesses will need to adapt to the new reporting obligations and consider their decarbonization strategies to ensure compliance with upcoming legislation and to prepare for a low-carbon future.

If you're a business that imports carbon-intensive products into the EU or is affected by the CBAM in any way, we encourage you to take the time to understand the intricacies of this policy and how it may impact your operations. It's crucial to stay informed about the reporting obligations, the potential for significant additional costs, and the opportunities to review your supply chains and make conscious cost versus carbon trade-offs.

We invite you to contact us to learn more about the CBAM and how it may affect your business. Our team is dedicated to providing expert guidance and support to help you navigate the complexities of this policy and ensure compliance with upcoming legislation.