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When a government puts in place ambitious climate policies involving strict carbon emissions regulations, there is always a risk that a company moves its operations. It's called 'carbon leakage' in climate parlance. Some companies could flee to another country or even another continent to avoid strict emission laws or carbon taxes.
The problem of course is that if big emitters leave, then the carbon is still emitted somewhere else. The regulation is then less effective in actually driving down emissions globally. Also, the companies that are left face a loss in competitiveness as there is no longer a level playing field, in particular because they see higher costs for carbon-intensive resources that are difficult to substitute - such as clinker for cement.
Pricing carbon at the border through a fiscal adjustment is a policy instrument which can redress the loss in competitiveness that the companies who are left face. Essentially, it makes a price adjustment on any product that arrives at the border, to take into account its environmental damage and the gap in climate policy ambition between countries. The price adjustment drives up the cost of that product, and as a result evens the playing field.
Why is this being discussed right now? The European Union is tightening its CO2 emission reduction targets, from 40% to 55% by 2030, compared with 1990 levels. To reach this, it is necessary to make adjustments across many sectors and institutions and put in place stricter requirements on emission reductions, including taking measures to address carbon leakage and reduce the impact on European company competitiveness.
One such instrument is the EU Carbon Border Adjustment Mechanism (CBAM), which ensures that companies in the EU - who have to comply with increasingly stringent emission reduction regulation - are not at an unfair advantage vis-à-vis competitors outside the EU who sell goods to Europe.
So how will this work in practice? The implementation of CBAM at the EU level is expected to become an alternative to the EU ETS, which until now has provided free allocation of emissions allowances to emissions-intensive facilities that are deemed at risk of carbon leakage when exposed to the full EU carbon price. Based on a preliminary draft of the EU ETS reform, sectors and subsectors covered by CBAM should no longer receive this free allocation. CBAM aims to regulate the embedded emissions (direct and indirect) released during the production of specific products that are imported into the EU territory from sectors such as electricity, cement, fertilizers, iron, steel and aluminum. This leaked draft published in June 2021 reflects the EU's latest thinking, but could be subject to change in the final proposal.
Companies importing goods from the sectors covered by the CBAM will need to surrender CBAM certificates equivalent to each tonne of CO2 embedded in the imported product at prices mirroring the EU ETS price. Under the existing draft, a country or jurisdiction which has a carbon pricing scheme (like a carbon tax or ETS), or otherwise places strict emission reduction obligations on specific sectors, could get an exception to the CBAM. For example, they could be allowed a reduction in the number of certificates to be surrendered.
Until now, the concept of CBAM had been discussed extensively in the literature, but - with the exception of California - has not been implemented because of its complexity. Though California has a carbon price for several emissions-intensive sectors, only imported electricity has CBAM-like measures in place.
The inclusion of a CBAM proposal in the EU Fit-for-55 legislative package would broaden the application of CBAM beyond electricity. Aside from likely geopolitical strife, practical challenges so far include a clear definition of the scope and coverage, methodologies for the calculation of carbon emissions at a process or product level, and - most importantly - the compatibility of the measure with the rules of the World Trade Organization (WTO). CBAM must be applied equally to all similar or like1 products regardless of the country of origin and should not hinder international trade law principles, such as most favored-nation and national treatment. This is no easy task.
Interestingly, CBAM has been around as a policy option since 2008 when the EU tried to require intercontinental flights to surrender emission allowances based on the amount of carbon dioxide emitted during flights to and from the EU. This measure faced staunch opposition from over 20 countries, and it forced the EU to withdraw the measure. CBAM was also recently discussed at the G7 summit and was even included in Mexico's 2015 Nationally Determined Contribution (NDC).
Even though the details are still to be defined, we suggest that companies in the named sectors start assessing which parts of their supply chains might be exposed to the CBAM and explore alternative sources. Perhaps they should ask their non-EU suppliers to improve their carbon accounting and to reduce their emissions to decrease future exposure to the regulation? Perhaps they should lobby their governments to implement stricter climate change laws, so the border tax disappears?
The CBAM has caused increasing concerns within industry associations, civil society and government representatives across the world. Some see it as a green protectionism measure. Others see it as a powerful tool to push climate laggards to step up their climate ambition with trade partners. As the third largest trading block in the world, the successful implementation of CBAM by the EU could have far reaching consequences for greater climate action worldwide.
1 A “like" product under the CBAM preliminary draft refers to a product that is identical in all aspects to another product and whose characteristics closely resemble each other.
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