European Commission outlines plan for carbon border adjustment mechanism

Under the proposed rules, EU importers will have to buy carbon certificates corresponding to the carbon price that would have been paid, had the goods been produced under the EU's carbon pricing rules. If a non-EU producer can show that they have already paid a price for the carbon used in the production of the imported goods in a third country, the corresponding cost can be fully deducted for the EU importer.

The plan is part of a ‘Fit for 55’ package of proposals as part of the EU’s ‘green deal’ designed to reduce net greenhouse gas emissions by at least 55% by 2030, compared to 1990 levels. It follows a resolution from the European Parliament in March advocating for the introduction of a WTO-compatible CBAM.The Commission is proposing a transitional period for the CBAM from 2023 to 2025 whereby importers will have to report emissions embedded in their goods but will not have to pay anything. It proposes that the system should become fully operational in 2026. After that time EU importers will have to make annual declarations of the quantity of goods and the amount of embedded emissions in the total goods they imported into the EU in the preceding year, and surrender the corresponding amount of CBAM certificates.

The CBAM is designed to prevent ‘carbon leakage’ under the EU’s existing carbon pricing mechanism – the EU emissions trading scheme (ETS).

The ETS caps the total amount of certain greenhouse gases that can be emitted by businesses covered by the system. The cap is reduced over time with the aim that total emissions fall. Companies receive or buy emission allowances, which they can trade with one another as needed. After each year a company must surrender enough allowances to cover all its emissions.

However, the ETS only covers emissions generated by businesses operating within the EU and those operating linked systems such as the European Economic Area countries and Switzerland. It does not cover emissions embedded in imported goods and services.

The CBAM is designed to ensure that European emission reductions contribute to a global emissions decline, instead of pushing carbon-intensive production outside Europe. It also aims to encourage other countries to introduce similar mechanisms.

“The CBAM addresses a flaw within the current ETS whereby free allowances are given in some sectors in order to ensure that EU industry is not at a competitive disadvantage from imports from countries where there are fewer controls on emissions,” said Steven Porter, a tax expert at Pinsent Masons, the law firm behind Out-Law. “Free allowances may help reduce competitive disadvantages but do nothing to reduce global emissions.”

In order to ensure a level playing field between EU and non-EU businesses, until they are completely phased out in 2035, the CBAM will apply only to the proportion of emissions that does not benefit from free allowances under the EU ETS.

The ETS currently applies to power and heat generation and energy-intensive industry sectors including oil refineries and steel works and the production of iron, aluminium, metals, cement, lime, glass, ceramics, pulp, paper, cardboard, acids, and bulk organic chemicals. It also covers some commercial aviation.

As part of its package of reforms, the Commission is also proposing changes to the ETS. It proposes further lowering the overall emission cap and increasing its annual rate of reduction.

Under the proposals, the ETS will be gradually expanded from 2023 to 2025 to cover the shipping industry and free emissions for aviation will be phased out. A tax on maritime and aviation fuels is also proposed.

The Commission is also proposing a separate new emissions trading system for fuel distribution for road transport and buildings.

The UK left the EU’s ETS after Brexit and set up its own very similar UK scheme.

“Non-EU countries such as the UK and the US will be looking closely at the European Commission proposals and may want to introduce their own CBAM,” Porter said.

Dr Totis Kotsonis, a trade and subsidies expert at Pinsent Masons, said that countries which are more likely to be affected by the introduction of the CBAM will also be monitoring carefully as the proposals make their way through the EU’s legislative processes.. 

“We know already that countries which are most likely to be affected by the introduction of CBAM argue that the initiative is a protectionist measure which will discriminate against foreign producers and as such be inconsistent with WTO rules,” Kotsonis said. “Accordingly, potential challenges under the WTO dispute resolution mechanisms remain a real possibility if CBAM is ultimately implemented. At the same time, the EU has been very much aware of the need to ensure that a carbon import levy is WTO compliant. The Commission proposals arguably do a lot to address such concerns.”

“More specifically, the phasing in of the CBAM and the phasing out of free allocations under a revised ETS should, in principle, ensure compliance, with the general GATT obligation not to treat domestic and foreign producers differently,” Kotsonis said. “However, it is important to keep in mind that the publication of the proposals is just the start of a long legislative process and it is likely that the proposals will be amended further before they may become law. We already know that a number of EU member states are concerned with the Commission’s proposals and how these might affect domestic industries. Ultimately, the EU needs to be careful: any additional measures that limit the effects of the revised ETS on domestic producers can then fall foul of WTO rules to the extent that there is asymmetry between the position of domestic producers and importers.”