Much the same as explained in our In Detail article on the EU Emissions Trading System (ETS), emitting carbon dioxide creates negative externalities for society and for the environment and the full cost is not bore by the polluter if left to their own designs. As a result, final goods and services not accounting for the societal price of its production implicitly incentivises the polluter to produce more of what is bad for society. This is why the EU implemented an ETS in 2000 – to ensure that polluters paid for their cost on society within the EU.
But what if the polluter decides to just… pollute on the other side of the border?
In such a case where the emitter opens shop in a country that does not have a carbon price, they are then left to emit with no repercussions once again. What’s more, they can even sell their goods and services back to the EU and have a leg up on producers in the EU who are bound by the ETS carbon price, essentially shifting emissions around, rather than eliminating them. This is what is known as carbon leakage.
So, what to do?
Europe needed to find a way to subject imported goods to the same carbon costs borne by EU producers. Call it ‘a mechanism to adjust the price at the border based on the carbon emissions generated to produce a good or service’, or more simply, a Carbon Border Adjustment Mechanism. This is how, As part of the Green Deal, the EU passed CBAM into law in 2023.
How will CBAM work?
CBAM is a levy that will be imposed on imports to the EU and is related to the ‘embedded carbon’, or in other words, the carbon that was emitted to produce that good or service. The levy reflects the ETS price of carbon, aiming to even the playing field for producers in the EU that are subject to the emission trading system and to disincentive them to move to the other side of the border. At the same time, it also incentivises foreign international companies to decarbonise to compete in the EU market. But how does it do that?
Well, today it doesn’t. CBAM is currently in the so-called “transitional phase” whereby, importers must report emissions, but no tariff is levied. This phase will last from 2023 to 2025. Starting from 2026 CBAM will enter into full effect. A tariff will begin to be levied where importers have to pay a price equal to the ETS price for embedded emissions. This equalises the equation.
Yet, this sounds a lot simpler than it actually is. There are a lot of moving parts to impose a tax on carbon from countries outside the EU’s jurisdiction. For example, how can you quantify and verify the emissions for an international product? Who pays? And who and what is covered by CBAM?
How do we count embedded emissions under CBAM?
This is a tough task. It is one thing to count emissions for EU-produced goods and services where the producer themselves is held responsible for reporting their emissions and obtaining the required ETS certificates. But it is much harder to get them from producers outside the EU that do not have the same reporting standards and stringency.
Under CBAM, importers in the EU – the ones sourcing goods and services from abroad – will be responsible for collecting so-called ’real data’ on goods and services production that they are importing. This data is to be used to quantify the emissions that a supplier in a foreign country may have emitted to produce it, therefore giving a quantification of the emissions. This data, though, is not easy to come by. Many suppliers do not have it, others are hesitant to share it. But while suppliers might be unwilling to provide the data, the importers will be the ones receiving the stick. They can be held accountable for the collected data, leading to penalties.
Meanwhile, National Competent Authorities (NCAs) are responsible for aiding in the data collection process Despite them all not yet being fully operational, the European Commission is offering technical assistance both to EU Member States and third countries for the implementation process.
From January 2025 onwards, third-country operators will be able to provide information directly to the European Commission through the operator’s portal of the CBAM Registry. This enables direct reporting, thus reducing administrative burden and restricts access to sensitive data only to authorities. In such cases, operators can decide whether they want to share data with importers or not, or directly share with the Commission details on their installations and the embedded emissions in the resulting goods.
The actual process of calculating emissions, though, is more complex than we can get across here and is explained in detail in Annex III of the CBAM legislation. In addition, the secondary legislation that clarifies the rules on a raft of policies – such as calculating embedded emissions, customs costs and so on -are still under preparation and will be out just in time before the definitive regime kicks in in 2026.
Who pays and what for?
We have discussed the price to be paid for emissions but not actually who will be paying what..
Once again, according to EU policy, the importers are the ones who pay the price – it is not actually the supplier from the foreign producer. The importer of any products covered by CBAM are obliged to register with their national competent authorities (NCA) from whom they will be able to buy CBAM certificates. Some similarities with ETS certificates exist, but the biggest differences are that they are neither tradeable nor bankable. This allows certificates to constantly reflect the ETS evolution: being priced based on the weekly average auction price of ETS allowances which is a Euro figure per tonne of CO2 emitted. This is why it will be important for importers to have collected proper data on the embedded emissions of their imported products.
Once CBAM comes into full effect, an emissions declaration is made to the NCA and the importer then has to surrender the corresponding number of certificates that they purchased. Too few, and the importer must buy more.
There are, of course, exemptions. For international products being imported from a country where they were already subject to a carbon price, the importer is able to remove those emissions from the declaration. What is more, any import up to €150 is exempt and only a handful of industries are covered by CBAM as of now.
How will the revenues collected under CBAM be redistributed?
At this stage, it is not yet clear how the revenues generated by the carbon border adjustment mechanism will be used. The Member state will be collecting revenues stemming from the sale of certificates, as per the Regulation. In its proposal on the long-term budget and the NextGenerationEU – the Commission wishes to allocate 75% of the total CBAM revenues -an expected €1.5 billion per year starting in 2028 – to the EU budget.
For some analysts, reinvesting the money into EU industries might break compliance with World Trade Organization (WTO) rules. Other stakeholders suggest using the revenues to support climate change mitigation and adaptation in the least developed and developing countries as a contribution towards the broader objectives of the Paris Agreement.
Who and what does CBAM cover?
As mentioned, CBAM only covers a handful of carbon-intensive industries for the time being. The sectors include cement, aluminium, electricity, fertilisers, iron, steel and hydrogen. However, more could be added to the list before or after the definitive regime is in place.
The European Commission’s Executive Vice-President for Prosperity and Industry Strategy, Stéphane Séjourné, signalled in his hearing to the European Parliament that he wants to add more sectors to the list, expanding the coverage to other industries but also downstream products, to help safeguard the competitiveness of European industry. Adding to the interlinkages with the ETS, by 2030 CBAM should include all sectors covered by the ETS in Europe, significantly broadening its scope.
Regarding the who, we begin to touch on the element of incentivising foreign countries to adopt carbon pricing and exemptions. For example, imports from the four non-EU countries that are a part of the European Economic Area – Switzerland, Liechtenstein, Norway and Iceland – are exempt from CBAM, as they are part of the EU ETS.
On the other end of the spectrum, goods produced in big emitting countries like China and the United States without carbon pricing would be subject to CBAM. This measure aims to strengthen the competitiveness of the EU producers, that face unfair competition from third countries where industrial processes are highly dependent on carbon intensive fuels, and do not account for the environmental impact of their products. While this has triggered the ire of some countries that have accused the EU of protectionism and discriminatory market access, the CBAM compliance with WTO rules has been proven.
Lastly, developing nations could be adversely affected by CBAM due to limited institutional support at home, technical inability to quantify and/or reduce emissions. In this regard, to continue to ensure the access of these economies to the European marketplace, the EU offers guidance, technical support and capacity building tailored to the specific needs of CBAM implementation.
In addition, the EU offers support for the greening the industries and energy systems of these countries through its Global Gateway programme, as well as multiple regional partnerships and initiatives The EU has also committed to help countries introduce or enhance their carbon pricing systems. The interest from third countries has been significant, showing the importance of climate diplomacy.
What are the power sector’s views on CBAM?
The European power sector has welcomed the introduction of CBAM, as a crucial instrument complementing the EU ETS – delivering emissions reductions across Europe, while encouraging third countries to decarbonise.
In addition, Eurelectric has supported the inclusion of the electricity industry in CBAM’s scope from the onset, despite being different in nature than physical goods, such as aluminium, fertilisers and so on. Importers of electrons from non-EU countries do not stop at the border to present customs officials with the paperwork on the transported quantities. Instead, electricity continuously flows between countries through interconnectors, ensuring the supply and demand are met at any point in time in all the markets that are coupled to EU countries. The UK, Ukraine, Moldova, Türkiye as well as the Balkan countries, are among the constituencies that exchange electricity with the EU. They will be subject to CBAM, but the Regulation allows for some exemptions that still need to be further clarified before the definite phase starts.
The first option at hand to avoid being subject to the CBAM levy is to implement the EU ETS, or link with the EU ETS in the respective third country. However, this is a politically sensitive option, as it would imply accepting and implementing the EU rules, without being part of the EU. Nonetheless, ETS linking is the optimal solution for any country exploring the development of its carbon market, as it will bring liquidity into the system.
In its latest position on the future of the EU ETS architecture, Eurelectric has called for the linking of the EU and UK ETS systems before COP30. This measure will improve both the functioning of the respective electricity markets and carbon markets. In addition, Eurelectric has called on the EU Commission to prepare “roadmaps for linking” to ensure that third countries have visibility on milestones and what is expected from them, should they wish to go in this direction.
But the role of electricity in CBAM goes beyond power exchanges between countries. In Europe, energy intensive industries are decarbonising by replacing fossil-based heat processes with electrified options, using increasingly carbon-free electricity. Yet, they are facing increased competition from producers in third countries – such as China and the United States – that still rely heavily on fossil fuels in their production processes. Thus, it is important for CBAM to account for both direct and indirect emissions in simple and complex goods. This would ensure that all emissions embedded in the production process are accounted for, therefore reducing the risk for competitive distortions and increasing the pressure on third countries to decarbonise their power generation.
What’s the future of the EU Carbon Border Adjustment Mechanism?
As we are only in the initial phase of CBAM, it is important to know what is coming next. Right now, we remain in the transitional phase, as mentioned. In this phase, importers of the six carbon-intensive products mentioned above are responsible for reporting embedded emissions. This phase started in October 2023 and comes to an end at the end of 2025. It is an important part of the implementation of such a complex regime, as it enables a smooth transition for the sectors involved.
As of 2026, the definitive regime will be in place where these initial importers will begin purchasing CBAM certificates to cover their embedded emissions. As of 2030, the importers of all products covered by the EU ETS will be brought into the definitive regime and as of 2034, free allowances like those provided in the ETS will be phased out.
Importantly, several review phases are foreseen as the system continues to develop, to ensure its fitness to deliver on the objectives and adjust aspects where it is still lacking effects. One of these areas is a solution for exports – where goods produced in Europe and subject to carbon prices still face competition on global markets from manufacturers that do not have similar climate and environmental standards.
As more and more countries hopefully adopt their own carbon pricing systems, it is possible that there could become an internal market for countries with a carbon price with enough economic power to force laggards to also start pricing their carbon emissions. The ultimate objective of a CBAM is for it to become obsolete due to omnipresent carbon pricing. However, such a future is far off and a difficult one to manifest. For now, this is just one step towards a decarbonised Europe and a fair competition for local manufacturers vis-à-vis producers from constituencies with laxer climate legislation.
Source – Eurelectric