EU Climate Action: Political Agreement on EU Carbon Border Adjustment Mechanism (CBAM)

EU Climate Action: Political Agreement on EU Carbon Border Adjustment Mechanism (CBAM)

What you need to know

  • In December 2022, a political agreement was reached at EU level on the introduction of an EU Carbon Border Adjustment Mechanism (“CBAM”). The final text of the CBAM Regulation is expected to be finalised in the coming months, in parallel with the reformed EU Emissions Trading System (“ETS”).
  • The CBAM will introduce a carbon tariff on imports in emission-intensive sectors (cement, iron and steel, aluminium, fertilisers and electricity) which currently benefit from free allowances under ETS and has been extended to include hydrogen. In the future, the scope of the CBAM may be extended to other industry sectors, such as organic chemicals and polymers. The aim is to cover all ETS industry sectors by 2030.
  • The CBAM is intended to apply from 1 October 2023, with a transitional period, during which importers will only be subject to a reporting requirement limited to direct emissions embedded in EU imports. Indirect emissions will only be covered only after the end of the transitional period.
  • After the transitional period ends (which is expected to be in 2026), EU imports will be subject to a carbon tariff: importers will be required to purchase and surrender so-called “CBAM Certificates”. The carbon tariff will be equal to the carbon price paid by EU producers under the ETS rules.
  • The length of the transitional period and the exact timing of full application of the CBAM is intended to run in parallel with the gradual phasing out of the system of free allowances under the ETS, and may therefore be subject to change.
  • Companies active in the EU, particularly those active in the industry sectors covered by the CBAM, will need to assess the immediate and direct impact on their business and the need to comply with the CBAM reporting requirement as of 1 October 2023. The direct and indirect cost of the EU carbon tariff on imports and value chains – expected to apply from 2026 – will also need to be assessed as companies may want to re-think their trade strategies.

Recap

Our first CBAM alert of 16 July 2021 outlined the European Commission’s proposal to establish a CBAM introducing a carbon tariff on imports of steel, cement, fertilisers, aluminium, electricity and hydrogen. The CBAM seeks to ensure that the carbon price of imports is equivalent to the carbon price of domestic production. In doing so, the CBAM seeks to reduce the risk of carbon leakage and to encourage non-EU producers to reduce emissions while ensuring a level playing field for EU industry.

Recent developments

In December 2022, the EU reached a provisional political agreement on the reform of the ETS and the establishment of the CBAM. Both instruments form part of the “Fit-for-55” package of measures underpinning the EU’s Green Deal strategy to cut greenhouse gas emissions (“GHG”) by at least 55% by 2030 and achieve climate neutrality (i.e. net zero emissions) by 2050.

Given the close link between the new CBAM and the reform of the ETS, several aspects of the CBAM must still be clarified and agreed. Following the political agreement, the final text of the CBAM Regulation must be formally approved by the Council and the European Parliament before its publication in the Official Journal of the European Union.

Although the final text of the CBAM Regulation is yet to be finalised and formally adopted, it has been agreed that the CBAM will initially apply to imports of cement, iron and steel, aluminium, fertilisers, electricity and hydrogen, which are all considered to be emission-intensive sectors. From October 2023, importers in those sectors will be required to report on their emissions. From 2026, importers in those sectors will be required to purchase CBAM Certificates at a price equivalent to the weekly carbon price under the ETS.

Wider context and interaction with EU ETS

Since the introduction of the ETS in 2005, emissions in the EU have decreased by approximately 40% in the main industries covered which are power and heat generation, energy-intensive industrial sectors and aviation.

Under the ETS, emitters must obtain emission allowances to meet certain emission targets and can do so in the most cost-effective manner. Companies can either take measures to reduce emissions or purchase emission allowances in the carbon market, taking into account the relative cost of each option and in particular the price of carbon. By creating supply and demand for emission allowances, the ETS establishes a carbon price for them.

The average EU carbon price has increased significantly in recent years. EU companies today pay around EUR 80 to emit one tonne of CO₂ in the ETS sectors. High carbon prices should encourage companies to reduce their emissions; however, it may also lead to carbon leakage when EU production moves to non-EU countries with less stringent climate requirements or when EU products are replaced by more carbon-intensive imports.

The ETS works with a mechanism of free allowances for sectors considered to be at high risk of carbon leakage. This mechanism has attracted criticism over the years as it may disincentivise sectors from taking any long-term action to decarbonise.

In line with its Green Deal ambitions, the European Commission presented a legislative proposal in 2021 to strengthen the ETS regime. Under the proposal, maritime transport is brought within the scope of the ETS and the current ETS sectors are subject to more ambitious emission reduction targets.

Under the reformed ETS, the risk of carbon leakage is still addressed through free allocation of ETS allowances. However, the ETS reform aims to gradually reduce the number of free allowances, over a nine year period (2026-2034), so that this system is progressively replaced by the CBAM.

Key features of the CBAM

The press releases issued by the Council, the European Parliament, and the European Commission all highlight the key features of the CBAM on which a (provisional) political agreement has been reached. The principal elements of the European Commission’s proposal appear to have been maintained, subject to a few changes (see further below). However, certain important aspects of the CBAM are yet to be clarified.

1. Scope

The CBAM Regulation will apply to imports of all goods listed in Annex I of the Regulation within the cement, iron and steel, aluminium, fertiliser, electricity and hydrogen sectors. The hydrogen sector was not part of the European Commission’s initial proposal, but was brought into scope by the European Parliament. It was also agreed that “some precursors” and a “limited number of downstream products“, such as screws and bolts and similar articles of iron or steel, will be covered, although no further detail has been provided at this stage.

Before the end of the transitional period in 2026, the European Commission will assess whether to extend the CBAM to other industry sectors, such as organic chemicals and polymers. The aim is to cover all ETS industry sectors by 2030.

The CBAM will concern imports from all third countries, except those listed in Annex II of the Regulation. The CBAM proposal currently excludes imports from Iceland, Liechtenstein, Norway and Switzerland. Additional countries may be added to the list of exclusions, in particular where such countries are in the future integrated into, or linked to, the EU ETS or an equivalent mechanism.

2. Transitional period

As foreseen in the European Commission’s proposal, the CBAM Regulation will apply in a “simplified” form during an initial transitional period to avoid major trade disruptions. From 1 October 2023, importers of goods listed in Annex I will require an import authorisation and such “authorised declarants” will be required to make a CBAM Declaration reporting on: the total quantity of imported goods; the total embedded GHG emissions in such goods; and the corresponding total number of CBAM Certificates.

The CBAM Regulation will cover direct emissions from the production of the imported goods, as proposed by the European Commission. Indirect emissions (e.g. scope 2 emissions such as energy consumption for production) will also be covered, but only after the transitional period, and “under certain conditions” and in a “well-circumscribed manner“, which is yet to be published.

The length of the transitional period and the exact timing of the full application of the CBAM is closely linked to the gradual phasing out of free allowances under the ETS and may therefore be subject to change.

3. CBAM Certificates and carbon pricing

On 1 January 2026, the CBAM is envisaged to be fully applicable. Authorised declarants will be required to purchase and surrender CBAM Certificates at a price equivalent to the weekly ETS carbon price. The authorised declarant will be required to surrender CBAM Certificates in a number equal to the embedded emissions reported in the CBAM Declaration.

The CBAM aims to complement the ETS and is designed to apply in tandem with the phasing out of ETS free allowances. As such, importers will be required to surrender CBAM Certificates only to the extent that EU producers no longer benefit from ETS free allowances for the same goods. This coordination mechanism between the ETS and the CBAM is intended to ensure compliance with World Trade Organisation (“WTO”) rules.

As envisaged in the European Commission’s proposal, authorised declarants will be entitled to adjust the carbon tariff to take into account the carbon price paid in the country of production. Authorised declarants will therefore only be required to surrender CBAM Certificates for the proportion of emissions not already covered.

4. CBAM rebate for exports

The European Commission’s proposal envisaged that the CBAM would apply only to EU imports, without addressing the scenario of EU-produced goods destined for export outside the EU. European stakeholders have challenged this approach and called on EU co-legislators to consider the possibility of a mechanism to refund the carbon price paid in the EU to ensure that EU exports remain competitive in the global market. However, the European Commission has expressed concerns that such export rebates may undermine the EU’s climate objectives and may be viewed as a subsidy to domestic production which could raise concerns under WTO rules. Discussions on this issue appear to be ongoing in view of the Council’s statement that “further work is also required on measures to prevent carbon leakage on exports“.

5. Governance

Under the European Commission’s proposal, EU Member States would be primarily responsible for the implementation of the CBAM (e.g. issuance of import authorisations, sale of CBAM Certificates etc.), including its enforcement. However, it has reportedly been agreed that governance of the CBAM will be “more centralised” with the European Commission taking on most of the administrative tasks.

Possible implications

Several aspects of the CBAM are still under discussion, as the CBAM Regulation will need to apply in close connection with the reformed ETS. Both legal instruments will need to be adopted in parallel and require approval by the Council and the European Parliament.

The full legal implications of the CBAM will become clear only upon adoption and publication of the final text. For instance, the precise impact of the CBAM on the entire value chain is as yet unclear as its application to precursors and downstream products is yet to be determined.” It also unclear at this stage whether EU exports may benefit from a form of compensation.

The recent extension of the CBAM’s scope to cover the hydrogen sector has also raised a number of important concerns, with the hydrogen industry seeking greater clarity on the proposals. This extension appears to be designed to deter the EU from becoming overly reliant on hydrogen imports and, in particular, the import of “grey hydrogen” produced from fossil fuels. There is no detail as yet as to whether the CBAM will extend to all hydrogen production pathways, including electrolysis and natural gas reforming (with carbon capture and storage). The industry has called for hydrogen and all hydrogen carriers to be treated equally under the CBAM and the ETS to avoid distortion of competition.

Companies active in the EU, particularly those active in the industry sectors covered by the CBAM, will need to assess the immediate and direct impact on their business and, in particular, the need to comply with the CBAM reporting/data collection requirement which is expected to start from 1 October 2023. The direct and indirect cost of the EU carbon tariff on imports and value chains – which is expected to apply from 2026 – will also need to be assessed as companies may want to re-think their trade strategies.

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