The EU’s European Green Deal, announced in 2019, established a bold set of decarbonization targets: 55 percent carbon emissions reduction (vs. 1990 levels) by 2030 and climate neutrality by 2050. The Union has followed up on these goals with a suite of comprehensive climate-related policies.
This post will explore the details of one of those policies: the EU Carbon Border Adjustment Mechanism (CBAM). The CBAM creates a carbon tax on high-emitting products entering the EU with an eye toward reducing the emissions associated with those goods. We’ll cover how the CBAM will work, why it was adopted, and what businesses can do to prepare.
What is the EU Carbon Border Adjustment Mechanism (CBAM)? How will it Work?
Overview of the CBAM
The CBAM is a carbon tariff imposed on carbon-intensive products imported into the EU. Under the CBAM, companies will need to disclose annually the emissions embedded in their imports and ‘pay’ for those emissions with CBAM certificates.
The EU designed the CBAM to complement its current regional ‘cap and trade’ system, called the Emissions Trading System. To understand the CBAM, it’s helpful to first have a high-level understanding of the ETS. Under the ETS, the EU limits the amount of carbon emissions regulated companies can produce in the Union through a system of emissions allowances. Regulated companies acquire emissions allowances through grants or purchases. The number of allowances these companies possess determines the total quantity of regulated gasses (e.g., carbon dioxide) the companies can emit. If companies want to emit more than their allowances dictate, they must purchase additional allowances. The CBAM harnesses the same principles behind the ETS, but applies its carbon tax to goods entering the EU. Under the CBAM, importers will use certificates to pay for the carbon embedded in the products they import. These certificates will be priced using the weekly average price of auctioned ETS allowances. As of December 1, 2022, ETS certificates traded for €85.22 per metric ton of carbon dioxide equivalent (CO2e).
Emissions and sectors covered by the CBAM
The CBAM covers a set of sectors that the EU determined were both critical to regulating due to their high emissions and administratively feasible to manage. The covered industries are cement, iron and steel, aluminum, fertilizers, electricity, and hydrogen.
The provisional CBAM agreement requires importers to track carbon dioxide (CO2), nitrous oxide (N2O), and perfluorocarbons (PFCs) - the same gasses covered by the ETS. Importers will be assessed on both the “direct” and “indirect” emissions of these gasses embedded in their products. The agreement defines “direct” emissions as “emissions from the production processes of goods, including emissions from the production of heating and cooling consumed during the production processes.” Indirect emissions are “emissions from the production of electricity, which is consumed during the production processes of goods.” If you’re familiar with the Greenhouse Gas Protocol, you can loosely think of “direct” emissions as analogous to scope 1 emissions and “indirect” emissions as analogous to scope 2 emissions.
Embedded emissions will be reported on a carbon dioxide equivalent (CO2e) per ton basis, calculated by dividing the emissions from the production of goods by the total quantity of goods produced. Annex III of the CBAM agreement contains more detailed guidance on these calculations.
Exceptions to the CBAM
The provisional CBAM agreement allows for a reduced tariff on goods that have already been subject to carbon taxation in their country of origin (see Article 9). This carve-out is necessary to prevent those goods from being double-taxed (once in the country of origin and once at the EU border). In addition, CBAM does not apply to Iceland, Liechtenstein, Norway, or Switzerland.
Administration of the CBAM
The European Commission will be responsible for the centralized administration duties of the CBAM, while national agencies will handle much of the interaction with importers.
Why did the EU implement the CBAM?
The EU implemented the CBAM to help solve the issue of ‘carbon leakage,’ which is when production activity shifts away from a regulated region and toward less regulated regions.
Carbon leakage typically takes one of two forms. The first is when a business relocates production outside of the regulated region in order to avoid carbon taxes. The second is when imports from less-regulated regions replace products created within the regulated region due to the increased competitiveness of products from the less-regulated region.
Preventing carbon leakage has been a perennial challenge for the EU’s Emissions Trading System (ETS). The EU’s initial response to this issue was to create a system of free allowances, in which the EU grants emissions certificates to the industries that are most likely to be subject to carbon leakage. Though it has helped reduce leakage, this free allowance system has also inhibited the ability of the ETS to achieve its climate goals; companies with free allowances lack much of an incentive to reduce their emissions. However, eliminating the free allowances system without any mitigating policy would potentially open the floodgates to future leakage. The EU crafted the CBAM to solve this issue.
Under the CBAM, the EU will gradually phase out the free allowance system for domestic products while simultaneously phasing in a carbon tax for imported products. This dual motion will ensure that imports and Union goods are treated equivalently, increasing the pressure on industries to decarbonize while minimizing carbon leakage.
What are the potential impacts of the CBAM?
Below we highlight four impacts of the CBAM that stakeholders worldwide should be aware of:
- The CBAM solidifies the EU’s position at the vanguard of climate regulation. The EU has already established itself as a leading player in carbon markets with the ETS and in reporting with the Corporate Sustainability Reporting Directive (CSRD) and the Sustainable Finance Disclosures Regulation (SFDR). The CBAM marks one more step in that direction.
- The CBAM continues the EU’s trend of ‘exporting’ Union standards to the rest of the world. Just as the EU’s General Data Protection Regulation (GDPR) caused companies throughout the world to double down on their data privacy policies and controls, so too will the CBAM cause producers globally to focus on the embedded emissions of their goods. Being competitive when selling into the EU market will increasingly require being low-carbon.
- Carbon-intensive products may get more expensive. As the EU phases out its policy of free allowances under the ETS domestically and the CBAM imposes tariffs on imports, products with high levels of embedded emissions may increase in price. In particular, products from developing and ‘least developed’ countries may become less competitive if those nations lack the resources to accurately measure and/or decarbonize their domestic industries. The EU has acknowledged this risk and pledged to provide technical and, in some cases, financial support for these countries.
- Companies will increasingly rely on sophisticated reporting and disclosure technology. The requirement for importers to disclose the carbon emissions embedded in their products will require accurate and reliable accounting tools that create minimal additional overhead. Software platforms will enable companies to track and disclose product emissions in compliance with CBAM rules.
Timeline for adoption and implementation of the CBAM
The CBAM will enter its transitional phase in October 2023 and its permanent phase in 2026. See below for a detailed timeline.
December 13, 2022: The European Council and European Parliament reached a political agreement on the CBAM. Before October 2023, these two bodies will officially adopt the CBAM, and the Commission will craft detailed implementation guidelines in consultation with the expert-led CBAM Committee.
October 1, 2023: The CBAM will officially enter its transitional phase. During this phase, companies will need to report on the emissions embedded in imported products on a quarterly basis, but will not pay for those emissions. The EU will commission a review of the CBAM to assess its efficacy and the potential inclusion of additional sectors and goods not currently covered.
January 1, 2026: The CBAM will enter into its permanent phase. Importers will need to disclose and pay for the emissions embedded in their goods using CBAM certificates. At first, importers will only be responsible for paying for a fraction of the embedded carbon in imports. This fraction will scale up as ETS free allowances are phased out, a process that will finish in 2034.
January 1, 2028: Deadline for the Commission to prepare its first biannual report on the functioning of the CBAM, including updates on carbon leakage, inflation, and the effects of the CBAM on least developed countries.
2034: First year in which importers will be responsible for paying for 100% of the carbon embedded in imported products.
How can businesses prepare for the CBAM?
Companies can prepare for the CBAM by taking the following steps:
- Conduct an initial impact assessment: Evaluate which products made by your company will be covered by the CBAM and which of those products are sold into the EU. Begin to understand how much of your company’s business may be affected by the CBAM.
- Establish a governance structure for CBAM compliance: Assign responsibility for CBAM compliance to an appropriate stakeholder. Ensure that they are appropriately empowered to meet reporting and compliance obligations.
- Collect data on embedded emissions: Establish clear roles and responsibilities within your organization, including collecting information from external parties (e.g., suppliers), processing data, and tracking regulatory developments. Ensure that relevant employees understand the core principles of carbon accounting. Decide whether the company will use manual processes or software solutions to manage emissions data.
- Consider strategies to increase competitiveness in the EU: Companies selling products with lower emissions intensity will incur lower costs under the CBAM. Evaluate whether the costs imposed by the CBAM create opportunities for your company to engage in ROI-positive decarbonization activities.
Simplifying Compliance with Carbon Accounting Software
The CBAM represents a major step forward for the EU. Its implementation will allow the EU to more effectively achieve its own climate goals, while also forcing companies around the world to start measuring and reporting on the emissions contained within their products. The CBAM reinforces the EU’s commitment to carbon disclosure as a key method of advancing the fight against climate change.
Understanding the CBAM will be critical for any covered company that seeks to import products into the EU. At face value, compliance can feel intimidating. But software solutions, like Persefoni’s carbon accounting platform, can greatly simplify the process, allowing companies to reliably and accurately track the emissions associated with their products.
If you’re interested in learning more about disclosure requirements throughout the world, you can check out our primer: Carbon Disclosure Mandates are Coming.