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Carbon must have its price - Exploring the proposed EU Carbon Border Adjustment Mechanism

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The EU’s ‘Fit for 55’ package of proposals, adopted in July, includes a new Carbon Border Adjustment Mechanism (“CBAM”).

The package as a whole is intended to reduce EU greenhouse gas (“GHG”) emissions by at least 55% by 2030, compared to 1990 levels, which is considered crucial to the EU’s goal of becoming climate-neutral by 2050.

The CBAM is a levy on the import into the EU of certain carbon-intensive products and will work in a similar way to the EU’s Emissions Trading Scheme (“ETS”) which was launched in 2005.

The proposal is for the CBAM to apply initially to imports of cement, iron, steel, aluminium, fertilisers and electricity. Importers of these products into the EU will be required to buy carbon certificates to cover the embedded emissions of carbon dioxide, nitrous oxide and perfluorocarbons, with the price of certificates corresponding to the ETS price which would have been paid had the goods been produced in the EU.

Why is this being proposed?

The key objective of the CBAM is to address the risk of what is termed ‘carbon leakage’.

The ETS sets a cap on the total amount of certain GHGs which can be emitted by ‘installations’ (‘installations’ being units where activities are carried out which are covered by the ETS, such as producing aluminium or steel). Under the ETS, installations buy or receive free emissions allowances within the cap which they can trade with one another (a ‘cap and trade’ system). On a yearly basis an installation must surrender enough allowances to cover its emissions or it will be subject to fines.

However, as the ETS only applies to EU countries and EEA-EFTA states (being Iceland, Liechtenstein and Norway), the EU is concerned with ‘carbon leakage’ i.e. businesses transferring production to other countries with less stringent emissions policies or importing more carbon-intensive products from overseas. This would undermine the effectiveness of the EU’s emission mitigation policies. By introducing a carbon levy on imports linked to the ETS price, the EU hopes to disincentivise such activity and thereby reduce global emissions.

A related objective of the CBAM, intended to benefit EU producers, is to level the playing field between EU producers and overseas producers importing into the EU. The aim is to ensure equivalent carbon pricing for imports and domestic products, which should in time remove the competitive advantage that producers who operate in countries which do not have equivalent carbon pricing systems currently enjoy (noting that the CBAM does not initially cover exactly the same products as the ETS, but the intention is that it will over time).

From a monetary perspective, the EU expects to raise nearly €10 billion a year from the CBAM once it is fully up and running. The EU has been under some pressure to generate its ‘own resources’ to repay the cost of its €750 billion recovery fund – money which has been borrowed to support its Member States as a result of the pandemic. Although expected CBAM revenues represent a modest amount in this context, they have been earmarked as ‘own resources’ for the purpose of helping to repay this debt.

How would the CBAM work?

As explained in the EU’s recent proposal document, the European Commission considered a number of options as to how the CBAM could work in practice. One option discussed was an import carbon tax, to be paid by the importer when products enter the EU. However, despite the continuing references in the press to a “carbon border tax”, this is not the option the EU have chosen to implement and they have been keen to emphasise that the CBAM is an environmental policy tool, not a tariff or a tax.

Instead, the option the EU are proposing to implement requires, similar to the system of allowances under the EU ETS, the surrendering of certificates by importers based on the emission intensity of products they import into the EU, with the certificates purchased at a price corresponding to the average price of ETS allowances calculated on a weekly basis. Importers of material products will declare emissions based on actual emissions embedded in the product and surrender a corresponding number of certificates on a yearly basis. For electricity, the CBAM will be applied based on the carbon emission factor (i.e. applying set conversion factors to determine the amount of CO2 emissions associated with the electricity) with the possibility for importers to demonstrate lower emissions.

Importers can claim a reduction of the CBAM for any carbon price paid in the country of production, which may incentivise some countries to introduce their own carbon pricing measures.

Unlike the ETS, the CBAM is not a ‘cap and trade’ system – such a system would not work as a cap on imports would restrict trade flows and allowing importers to carry forward and trade CBAM certificates could result in situations where the certificates no longer reflected the evolution of the ETS price.

National authorities will be responsible for authorising registration of importers into the CBAM system, as well as reviewing and verifying emissions declarations and selling CBAM certificates.

An importer who fails to surrender a sufficient number of CBAM certificates corresponding to the emissions embedded in their relevant imported goods will be subject to penalties identical to the penalties applied under the ETS.

Interaction with free allowances

Currently one of the main ways carbon leakage is addressed is by the issue of free allowances. As the name suggests, some sectors at high risk of carbon leakage, such as aviation, are handed free allowances under the ETS to alleviate the competitive pressure. The intention is to phase out these free allowances on the basis that they weaken the price signal that the system would otherwise provide for on a full trading (auctioning) basis and diminish the incentives for these sectors to invest in further reductions of GHG emissions.

In order to ensure that importers are treated in an even-handed way compared to EU producers, the CBAM will only apply to the proportion of emissions that do not benefit from free allowances under the ETS (which will increase as free allowances are phased out).

What has the reaction been?

The EU’s proposal for a CBAM has triggered a strong response from some of the EU’s main trading partners, including Russia and China. Russia calculates that it stands to lose $7.6 billion from it, whilst China has said that tackling climate change should be a shared responsibility and not an excuse for attacking other countries or trade barriers. However, in a sign that the CBAM could have the desired effect of encouraging other countries to introduce their own policies, China has recently taken steps to introduce its own carbon pricing measures and has launched a national emissions trading scheme for the energy sector. Carbon border levies are also being considered by the UK, the US and Canada.

In addition to the concerns raised by the EU’s trading partners, there have been some concerns raised within the EU relating to the impact on value chains, the reliance on imports of raw materials and the distributional impact across countries, especially developing countries.

What next?

The CBAM still faces months of negotiation in Brussels before it can become law. However, unlike some of the other measures in the EU’s green legislative agenda, the CBAM has broad backing from European industry leaders who see it as a means of protecting the EU from foreign competitors.

The current proposal document is open for feedback until 14 September 2021. The feedback received will likely dictate the initial next steps. If the proposal does go ahead, the EU Commission intends to implement it through a regulation, which will be ‘directly applicable’ i.e. it will come into force without any action on the part of Member States. This will ensure uniformity and consistent application across the EU – given a key purpose of the CBAM is to create a level playing field, any difference in approach between Members States could incentivise non-EU producers to import into countries with the least stringent regimes.

The timeline in the current proposal contemplates importers having to report emissions embedded in their goods (without any financial consequences) in a transitional phase starting in 2023 and finishing at the end of 2025. The CBAM system would then become fully operational in 2026.

How to get in touch

If you would like to discuss the implications of the CBAM or any other aspect of the EU’s green agenda for your business, please get in touch.