The Carbon Border Adjustment Mechanism (CBAM) explained

Summary

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The Carbon Border Adjustment Mechanism (CBAM) is a carbon tariff on carbon intensive products imported into the EU. By paying a price for the embedded carbon emissions generated during the production of certain goods imported into the EU, the CBAM will ensure the carbon price of imports is equivalent to the carbon price of domestic production. This will ensure that the EU’s climate objectives are not undermined by moving production to jurisdictions with less stringent requirements. A transitional period with mandatory quarterly reports but no tariffs started in 2023. The legislation will take effect in January 2026. CBAM currently applies to a list of products from the following cement, iron and steel, aluminum, fertilizers, electricity and hydrogen. Product-specific methodologies define how emissions need to be calculated to ensure comparability.

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Background

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The EU emissions trading scheme (ETS) is the EU’s carbon market. It works by setting an absolute limit to the amount of Greenhouse Gases (GHGs) that companies within certain sectors are allowed to emit per year. This limit is reduced over time. Companies must monitor their emissions and have enough certificates to cover them which they either buy or get for free (so-called ‘allowances’). This is called a cap and trade model. [1]

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The CBAM can be understood as a supplementary measure to the EU ETS. It works by imposing tariffs on carbon that was emitted during the production of goods that are imported into the EU. These tariffs are determined by the EU ETS, effectively equalizing the price of importing into the EU and producing within the EU.

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The CBAM is supposed to prevent so-called carbon leakage, a phenomenon where either EU companies move their production to places with lower or no existing carbon regulations, effectively circumventing the charge, or where they switch to buying from non-EU countries with less strict regulations. By targeting imported products, CBAM attempts to eliminate this behavior, and create a level playing-field between EU producers subject to the ETS and foreign producers [2]. The legal basis for CBAN is the Regulation (EU) 2023/956 and it is a central part of the European Green Deal [3].

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Prior to CBAM, the above mentioned free carbon certificates (allowances) were given to emission-intensive sectors, in order to avoid carbon leakage through offshoring. However, this free-allowance practice was always meant to be transitional. It has been decided that allowances will gradually be phased out until 2034 and that “until the end of the phase-out, CBAM will only apply to the proportion of emissions that does not benefit from free allowances under the ETS”. [4]

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A key challenge in the introduction of the CBAM was to design it in accordance with the World Trade Organizations (WTO) trade rules. A differentiation between low-carbon and high-carbon products otherwise alike would violate the WTO’s free trade principle of ‘non-discrimination’. [4]

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This is achieved in part by fading-out of free allowances, and also by taking into account carbon taxes that have already been paid in the product’s country of origin. This practice could incentivize trading partners of the EU to implement their own measures to avoid payments to the EU. A first hint that this incentive is strong enough to warrant action, is that China plans to set emission standards for key products, going into effect in 2027. [5]

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However, some have warned that the EUs trading partners might introduce countermeasures such as their own import tariffs, indicating that a trade war could be a consequence of CBAM. [4]  Additional debate exists around the high burden for developing countries to comply with CBAM, with some calls for the EU to provide adequate support. [6]

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Implementation

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The regulation officially came into force in May 2023. A transitional period started in October 2023. This period is supposed to help companies adjust to the reporting that is required and to potentially refine the policy. Companies importing CBAM goods must submit quarterly reports detailing the emissions created by producing the products. In Annex I of the CBAM Regulation, all products that are covered by CBAM are listed with their Combined Nomenclature (CN) code [7]. The six product groups are meant to facilitate communication. For example, there are products made from iron and steel that do not fall under CBAM if their CN codes are not listed.

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During the transition phase, no price has to be paid for the embedded emissions of imported products. Starting in January 2026, companies will have to start acquiring certificates for importing products. Additionally, importers need to be so-called ‘authorised CBAM declarants’ by then. Authorisation can be applied for via the CBAM register. [8,9] From 2026 until 2034, CBAM will gradually expand to include all industries covered by the EU ETS.

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The table below describes the entities involved, as well as their respective roles and responsibilities within the CBAM framework. [10]

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Operators need to monitor (attributed to each CBAM good) direct emissions of the products they produce, as well as quantities of, and already embedded emissions within specific input materials which are themselves CBAM goods (‘precursor materials’). For this, operators have to request emissions data from the producer of said precursor materials or may use default values to a limited extent. Additionally, they need to monitor indirect emissions released from the generation of electricity needed for the production of the CBAM goods.

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Declarants (importers) need to report the embedded emissions and the carbon price due already abroad for imported goods during that quarter of a calendar year, detailing direct and indirect emissions. All this information is based on information from the operator. The declarant needs to submit the report no later than one month after each quarter of a calendar year. Amendments to a report are possible for another month after the submission deadline, although this deadline can be extended by the competent authority. Tiered penalties (Tier 1: 10 - 50€, Tier 2: >50€)  per tonne of unreported emissions may apply if a report is not submitted, incomplete or inaccurate. [7] 

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Calculation

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In order to ensure that the calculated emissions are accurate and comparable, a detailed methodology has been developed [11]. We will not dive into the specifics at this point but instead provide a rough overview. For all CBAM products, the relevant greenhouse gases, system boundaries, and calculation approaches have been defined. Notably, only CO2 is considered with the exception of N2O in the case of fertilizers and PFCs in the case of aluminum. Direct emissions are always included while indirect emissions from electricity or purchased heat are included only in some cases. Calculations are supposed to be based on actual emissions but default values can be used to a limited extent.

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The results are summarized in the table below which is taken from the FAQ.

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The concept of embedded emissions used by CBAM is based on a product carbon footprint (PCF). However, the system boundaries are more narrow and more strictly defined than is usually the case. This is because CBAM is intended to cover the same emissions as would be covered by the EU ETS if the production took place in the EU. As a consequence, activities such as mining and transport of raw materials which are commonly considered in a PCF or LCA study are disregarded. This is illustrated below.

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Ultimately, operators calculating emissions need to make sure they are applying the right methodologies and data sources as well as collect data in line with their requirements. Only then can results be used for CBAM.

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How to approach CBAM

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CBAM promises to be one of the most impactful but also one of the most challenging EU regulations in the ESG space so far. Especially the data collection on the operator side can be extremely time consuming and complex. So far, they are left with little support. At forward earth, we are building AI-powered software solutions that can automate and simplify this process significantly. In the next CBAM article we will deep dive into the challenges for aluminum, iron and steel industries and how our solution can solve these challenges in a time and cost-efficient manner. 

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Sources

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[1] https://kpmg.com/xx/en/home/insights/2022/05/cbam-and-ets.html#:~:text=The%20CBAM%2C%20which%20is%20a,prices%20in%20the%20exporting%20country

[2] https://www.europarl.europa.eu/RegData/etudes/ATAG/2023/754626/EPRS_ATA(2023)754626_EN.pdf

[3] https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:32023R0956

[4] https://www.cleanenergywire.org/factsheets/emission-reduction-panacea-or-recipe-trade-war-eus-carbon-border-tax-debate

[5] https://economictimes.indiatimes.com/industry/renewables/china-plans-new-carbon-measurement-standards-to-boost-climate-efforts/articleshow/110747222.cms?utm_source=contentofinterest&utm_medium=text&utm_campaign=cppst

[6] https://en.wikipedia.org/wiki/Carbon_Border_Adjustment_Mechanism

[7] https://www.dehst.de/EN/CBAM/participating-in-cbam/participating-in-cbam_node.html

[8] https://www.dehst.de/EN/CBAM/understanding-cbam/understanding-cbam_node.html

[9] https://www.dlapiper.com/en/insights/publications/2023/11/the-carbon-border-adjustment-mechanism-cbam-and-compliance-obligations-in-germany#:~:text=Each%20importer%20established%20in%20a,in%20accordance%20with%20Article%2014

[10] https://taxation-customs.ec.europa.eu/system/files/2023-11/CBAM%20Guidance_EU%20231121%20for%20web_0.pdf

[11] https://taxation-customs.ec.europa.eu/document/download/2980287c-dca2-4a4b-aff3-db6374806cf7_en?filename=Guidance%20document%20on%20CBAM%20implementation%20for%20installation%20operators%20outside%20the%20EU.pdf

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