Brief: EU Carbon Border Adjustment Mechanism (CBAM)

Policy: The European Union’s carbon tariff, known as the Carbon Border Adjustment Mechanism (CBAM),[1] was imposed to protect against “carbon leakage” and ensure that trade with countries with weaker carbon standards do not undermine EU pollution standards. It also aims to provide an incentive for domestic consumers to buy imports from countries that have imposed a carbon tax. The introduction of the CBAM is a key initiative in the EU’s Green Deal and aligns with the phase-out of free allowances under the EU’s carbon cap-and-trade system, known as the Emissions Trading System (ETS).

Protect against carbon leakage: Carbon leakage occurs when imports from countries with lower emissions standards replace EU products or EU companies move carbon-intensive production to countries with lower emissions standards.

The CBAM will put a price on the carbon that is emitted during the production of certain goods that are imported into the EU. The price adjustment for imports intended to equalize the price of carbon between EU domestic products and imports. Imports from countries participating in the ETS are exempt from the CBAM.

The CBAM is designed to protect European manufacturers while pushing other countries to follow EU on taxing emissions. It provides an incentive for producing countries to remain competitive in the EU market by either imposing a domestic tax on carbon emissions, or reducing carbon emissions in their industrial manufacturing.

Concerns over competitiveness: Some EU manufacturers are concerned that the CBAM will hurt competitiveness by causing them to pay more to buy imported raw materials. It will have strategic and financial implications for businesses, including administrative burden for EU importers. Less than 5% of global emissions are subject to direct carbon prices high enough to reach the goals in the Paris Agreement.

CBAM and EU Green Deal: The CBAM is a key initiative in the EU’s Green Deal, which is a set of policy initiatives to reduce GHG emissions by at least 55 percent below 1990 levels by 2030, known as Fit for 55, and become climate neutral by 2050. The Green Deal aims to reconfigure every industry with a focus on carbon-intensive industries such as steel and cement; protect biodiversity and natural habitats; promote technologies, such as battery production, to compete with Asian suppliers; and impose sustainable investment goals for banks, money managers and insurers.[2]

The Fit for 55 plan includes CBAM and reform of EU’s ETS. Reform of ETS will expand ETS to cover additional sectors, including shipping; reduce the quantity of tradable allowances, and phase out the annual allocation of free allowances by 2034.

The changes to make program more stringent will increase the price of allowances and increase the risk of “carbon leakage. They increased permit prices by more than 10 times in five years and more than 100 euros ($106) per ton in February 2023. Technical challenges in how to measure the amount of carbon embedded in a product and determining how to credit carbon fees paid in countries outside the bloc.

Implementation: The CBAM will be implemented over six years through a “transitional period” from October 1, 2023 to December 31, 2025 followed by a “definitive period” during which the tax takes effect.

Transitional period and reporting: The “transitional period” is data collection stage and learning period for importers, producers, and authorities. This will allow the European Commission to collect information on embedded emissions, refine the methodology for when the tax takes effect in 2026, and allow importers and manufacturers to better understand the emissions in their products.

The first report is due January 31, 2024 for the period of October 1, 2023 to December 31, 2023. (The first report applies to importers of cement, iron, steel, aluminum, fertilizers, electricity, and hydrogen.)

Definitive period and carbon tax: With the “definitive period,” registered CBAM importers will be required to make annual declarations of the quantity of goods imported into the EU in the preceding year and the embedded GHG emissions of the goods. The will be required to buy and surrender CBAM certificates to offset embedded emissions unless the product is subject to a carbon pricing system that is similar to the ETS.

In 2026, companies will be required to pay a carbon tax on the imports. They will receive a reduction for any tax already paid in the producing country. The carbon import tax will be reduced by any carbon tax already paid in the country of origin. This offsetting is done to avoid violating WTO rules on the nondiscriminatory treatment of goods. The CBAM certificate prices will be phased-in in parallel with the phase-out of the allocation of free allowances under the ETS from 2026 to 2034.

Impact on international trade: The CBAM will have a significant impact on international trade, as EU is prominent in global supply chains. The CBAM could change trade patterns with carbon-intensive products shifted to countries without carbon tariffs[3] The tariff is deemed to comply with WTO rules[4] that require the nondiscriminatory treatment of goods through the most-favored-nation and national-treatment principles.

The EU argues that the CBAM does not discriminate among foreign products with the same carbon emissions; does not treat imports differently than domestic goods; and is external adjustment for decarbonisation costs incurred internally by EU-based companies. No costs incurred by US-based producers, as no carbon price in the United States. It complies with Article 6 of the 2015 Paris Agreement.

International reaction: The U.S. government asked for U.S. steel and aluminum exports to be exempt from the CBAM. The EU argued that U.S. exemption would not comply with WTO rules against discrimination. It also criticized U.S. green subsidies as a violation of WTO competition rules.

Other countries called the CBAM a “trade weapon.” Trading partners, including Russia and China, have called it a trade barrier, although China is planning to broaden its emissions trading market. Notably, the CBAM pushed Turkey, the largest source of EU steel imports, to ratify the Paris Agreement on Climate Change.

A carbon import tax could lead to the development of a “carbon club” or “climate club” of nations and help eliminate “free-riding” on the efforts of other nations.