Proposed EU Regulation of CBAM published

What you need to know

• On 14 July 2021, the European Commission released its detailed proposal for the Carbon Border Adjustment Mechanism, as part of the "fit for 55" package, which aims to reduce the EU's greenhouse gas emissions by 55 per cent compared to 1990 levels by 2030.
• The CBAM seeks to ensure that the import price of certain "high carbon" goods, such as iron and steel, reflects their carbon content. This is to ensure a level playing field for the European Union, which already applies a price on carbon through the EU Emissions Trading System.
• The CBAM seeks to prevent "carbon leakage" caused by the relocation of producers away from the EU, due to the increasing price of EU allowances as a result of the reduction in the total cap on emissions and the proposed phasing out of free allowances under the EU ETS.
• According to the Commission's proposal, only "authorised declarants" will be able to import certain goods covered by CBAM into the EU. Each year, authorised declarants will have to lodge a "CBAM declaration", outlining the total quantity of relevant goods imported during the calendar year and the embedded emissions for each good.
• For each tonne of carbon dioxide or equivalent emissions embedded in the imported goods, the authorised declarant must purchase and surrender one "CBAM Certificate". CBAM Certificates will be priced to match the cost of EU allowances under the EU ETS.
• To ensure that the price of CBAM Certificates reflects the price of carbon in the EU ETS, authorised declarants are unable to trade CBAM Certificates and are only allowed to roll them over for one year. Authorised declarants can, however, request that the national CBAM authority repurchases up to one-third of the previous calendar year's total CBAM Certificates.
• If an exporter has already paid a carbon price in its home country in connection with production of the goods, the number of CBAM Certificates required to be surrendered is reduced accordingly.
• The Commission proposes a three-year phase-in period for CBAM from 2023 to 2026. During the phase-in period, a simplified CBAM system will apply where authorised declarants will be required to report, but not pay.
• The CBAM proposal will need to go through the ordinary legislative procedure involving the European Parliament and the Council. This process will provide EU Member States with the opportunity to introduce significant changes.
• The CBAM has generated significant international interest and controversy, and could be subject to challenge from both inside and outside the EU. The G20 has endorsed a carbon price for the first time, and other countries are considering the impact very closely. The CBAM could eventually pave the way for international ETS linkages and global carbon pricing.

Introduction

On 14 July 2021, the European Commission (Commission) released its much anticipated legislative proposal for a Carbon Border Adjustment Mechanism (CBAM). The CBAM will operate as a levy on certain "carbon-intensive" goods that are imported into the European Union from countries that do not have a robust carbon pricing regime. The aim of CBAM is to reduce "carbon leakage" and ensure that the price of imports reflects more accurately their carbon content.

It is, in substance, a form of carbon pricing on the emissions embedded in certain imports into the EU. The goods covered are detailed in Annex I to the proposed regulation and include aluminium, cements, electrical energy, certain fertilisers, and iron and steel in various forms.

Background

In December 2019, the EU announced its plan to introduce the CBAM as part of the European Green Deal, under which Europe aims to be the first climate-neutral continent by 2050. Following this, in March 2021, the European Parliament adopted a resolution supporting the introduction of a WTO-compatible CBAM.¹

The draft CBAM regulation released on 14 July 2021 forms part of a wider package of measures announced by the Commission to cut the EU's greenhouse gas (GHG) emissions by 55 per cent compared to 1990 levels by 2030.

The CBAM is designed to address the risk that the EU's attempts to reduce GHG emissions could be undermined by a lack of climate action in non-EU countries. The CBAM seeks to prevent what is known as "carbon leakage", which occurs when EU industries relocate production to other countries with less stringent climate policies, or when EU products are replaced by more carbon-intensive imports. Without the CBAM, it is said that suppliers of carbon-intensive goods in jurisdictions with no carbon tax would have a unit cost advantage over comparable EU-produced goods.

Industries most affected

The CBAM proposal covers imported goods from energy-intensive sectors that are considered to be at high risk of carbon leakage, and so will affect industries whose exports consist of, or are made from, goods listed in Annex I to the proposed CBAM regulation.

Annex I lists the following sectors:

• Cement
• Electricity
• Fertilisers
• Iron and steel
• Aluminium

To identify the goods within these sectors, the CBAM regulation uses Combined Nomenclature (CN) codes, which are widely used for classifying goods and determining customs duty.

As the CBAM is imposed upon CN-coded goods, it will apply to the products listed in Annex I only, and not downstream goods containing those products (which will have different CN codes). As such, commentators have suggested that the CBAM may inadvertently lead to the relocation of assembly-related manufacturing options to avoid the CBAM. This may fall under the circumvention provisions in Article 27, which seek to review and manage any changes in the patterns of trade.

Details of the proposal

Overview

The CBAM applies to certain goods which are imported into the EU from countries outside the EU, other than those excluded countries listed in Annex II (currently, Iceland, Liechtenstein, Norway and Switzerland).²

Broadly, the CBAM will apply to Annex I listed goods within the cement, electricity, fertiliser, iron and steel and aluminium sectors.

The CBAM will therefore apply to the majority of exporters to the EU, including Australia, New Zealand, Russia, US, UK, China and India.

Additional countries can be added to Annex II, and thereby excluded from the CBAM, if such countries are in the future fully integrated into, or linked to, the EU ETS.

Authorised declarants

National competent authorities will administer the CBAM regime. Any person may apply to its national CBAM authority for authorisation to import goods. Once authorised, the importer becomes known as an "authorised declarant". Only authorised declarants can import goods covered by the CBAM into the EU.

The national CBAM authority will require declarants to demonstrate their financial and operational capacity to fulfil their CBAM obligations, and will not approve entities which have been involved in serious or repeated infringements of customs legislation and taxation rules during the preceding five years.

CBAM declaration

Each year, by 31 May, an authorised declarant must lodge a "CBAM declaration" with its national CBAM authority. The CBAM declaration must contain (1) the total quantity of each type of good imported during the preceding calendar year,³ (2) the total embedded emissions,⁴  and (3) the total number of CBAM Certificates to be surrendered.⁵

The "embedded emissions"⁶ of a particular good are the direct emissions released during the production of the good, calculated using the formulas in Annex III. Where the actual embedded emissions cannot be adequately determined, then default values should be used in accordance with Annex III.

Indirect emissions (for example, carbon emissions from the electricity used to produce the good) are not currently caught by the CBAM; however, the proposed regulation includes a review clause, which anticipates that CBAM will be extended to indirect emissions in the future.

To strengthen the integrity of the CBAM declarations, embedded declared emissions should be verified by an accredited verifier. The 31 May date was selected to fall after the EU ETS reporting cycle, to maximise the availability of accredited verifiers to perform this work.

Purchase and surrender of CBAM Certificates

In order to import covered goods into the EU, authorised declarants must purchase and surrender "CBAM Certificates". The national CBAM authority will sell CBAM Certificates to authorised declarants at a price equivalent to the average of the closing prices of all auctions of EU ETS allowances during the relevant calendar week. At the same time as making the CBAM declaration (that is, by 31 May), authorised declarants must surrender CBAM Certificates equal to the verified embedded emissions outlined in the CBAM declaration.

For each tonne of carbon dioxide or equivalent (CO2e) emissions embedded in imported goods, an authorised declarant must purchase and surrender one CBAM Certificate. Unlike the EU ETS, which operates on a "cap", there is no cap on the number of CBAM Certificates an authorised declarant can purchase.

In addition to this end-of-year reconciliation, the draft CBAM regulation proposes that authorised declarants must ensure that, at the end of each quarter, their registered accounts hold CBAM Certificates covering at least 80 per cent of the embedded emissions in goods they have imported so far that year. This is, in effect, a quarterly reconciliation to ensure that authorised declarants do not fall behind with the purchase of CBAM Certificates.

To ensure that the price of CBAM Certificates reflects the price of carbon in the EU ETS, authorised declarants are unable to trade CBAM Certificates (unlike the EU ETS) and are only allowed to "bank" and roll them over for one year.⁷  However, to help importers optimise their CBAM Certificate costs, an authorised declarant can request that the national CBAM authority repurchases excess CBAM Certificates on its account.

The national CBAM authority can only repurchase up to one-third of the total CBAM Certificates purchased by the authorised declarant during the previous calendar year. Any additional CBAM Certificates which were purchased in the preceding calendar year and not repurchased will be cancelled by the national CBAM authority by 30 June each year.

This structure therefore enables authorised declarants to enter into a degree of CBAM Certificate price hedging; however, given the limitation on buyback, this will come with a degree of risk of cancellation.

Carbon price paid in country of origin

An authorised declarant may, in its CBAM declaration, claim a reduction in the number of CBAM Certificates to be surrendered corresponding to the carbon price already paid for those emissions in the country of production.

If an exporter has already paid a carbon price in its home country in connection with production of the goods, the number of CBAM Certificates required to be surrendered is reduced accordingly. In this way, the CBAM aims to create a level playing field for carbon pricing while supporting the use of carbon pricing elsewhere in the world.

An example of a country of origin which could benefit from these provisions is the UK, which recently established a stand-alone UK ETS following its departure from the EU. China also has also established a national ETS, which is due to commence trading imminently.

How will CBAM interact with the EU ETS?

Carbon leakage is currently addressed in the EU ETS through (1) the granting of free allowances to those sectors considered to be at risk of carbon leakage and (2) financial measures to compensate for indirect emission costs incurred from GHG emission costs passed on in electricity prices.

The CBAM seeks to replace these existing mechanisms by addressing the risk of carbon leakage in a different way, namely by ensuring equivalent carbon pricing for imports and domestic products.

The Commission proposes that there should be a gradual transition from the current system of free allowances under the EU ETS to the CBAM, with the CBAM being progressively phased in, while free allowances in sectors covered by the CBAM are phased out.

The draft CBAM regulation contains a "coordination" provision, which provides that the number of CBAM Certificates surrendered shall be adjusted to reflect the extent to which EU ETS allowances are allocated free of charge to EU installations producing Annex I goods. The same provision gives the Commission the power to adopt implementing acts to create an appropriate calculation methodology.

Penalties for non-compliance

An authorised declarant who fails to surrender, by 31 May each year, CBAM Certificates corresponding to the emissions embedded in goods imported during the previous year will be liable to pay a penalty. The penalty amount is identical to the excess emissions penalty under the EU ETS.

As is typical for emissions-related legislation, payment of the penalty does not release the authorised declarant from its obligation to surrender CBAM Certificates (so the penalty is a true penalty, in addition to compliance costs).

A penalty similarly applies to those importing covered goods who have failed to apply to be an authorised declarant. The regulation allows EU Member States the option of applying additional administrative and criminal sanctions for failure to comply with CBAM legislation in accordance with national rules.

When will the CBAM commence?

The proposed commencement date for the full CBAM system is 1 January 2026. However, an initial three-year transitional or pilot phase is proposed for the CBAM, starting in 2023 and finishing at the end of 2025.

During this period, a simplified CBAM system will apply, in which importers will report emissions embedded in their goods without paying for CBAM Certificates. The aim of this transition is to enable EU and non-EU businesses, as well as national CBAM authorities, to prepare for CBAM.

Next steps for the Commission's proposal

Following publication of the detailed proposal for the CBAM, it will need to go through the ordinary legislative procedure, which involves being reviewed and modified by the European Parliament and the Council. This process will provide Member States with the opportunity to introduce significant changes.

Future developments

While only a proposal, the draft CBAM regulation also contains a reporting and review mechanism. Here, the draft CBAM regulation obliges the Commission to report before the end of the transitional period on the application of the CBAM, with a view to extending the scope of CBAM to indirect emissions and goods other than those listed in Annex I.

How might the proposal be challenged?

The CBAM is controversial outside the EU. Commentators have already started to map out potential challenges to it. In principle, these challenges follow two distinct routes:

• that the CBAM breaches international obligations; and/or
• that the CBAM breaches EU domestic law.

The main international route would be a WTO challenge by another WTO member government. As the WTO dispute settlement process is a government-to-government process, business would need to either lobby a government to bring a WTO Dispute Settlement Understanding (DSU) case, or, in certain jurisdictions, use formal processes (e.g. section 301 of the U.S. Trade Act of 1974) to stimulate a government to bring a case that it would not otherwise bring.

The obvious candidates are countries such as Brazil, India, Australia, China and Russia, all of which will be affected by the CBAM.

The WTO DSU process is currently functioning poorly since the US has refused to appoint new Appellate Body (AB) members, so the AB cannot function. This may have influenced the EU's decision to publish the draft regulation at this time, and until new AB members are appointed the prospect of the CBAM being held, definitively, to be incompatible with WTO obligations appears slim.

As to the chances of any action being successful, the EU has seemingly put a lot of effort into making the CBAM as compatible with the WTO as it can. Briefly, the EU appears to have considered:

• Article I of the GATT, by linking it to the ETS;
• Article III, by making the CBAM applicable to all third countries; and
• the introductory clause of Article XX, by permitting credit if third countries impose carbon duties, and allowing individual producers to vary their carbon-intensity scores.

It may be possible to envisage a "less restrictive alternative", but generally a high degree of compliance is shown to such measures.

However, the CBAM may also conflict with obligations in bilateral investment treaties, or investor protection chapters in free trade agreements that the EU has entered into with third countries. These rights are fact- and treaty-specific and so each needs to be explored further.

As to the EU domestic route, in order to challenge regulations, natural or legal persons will have to establish standing before the EU Courts of Justice, and, generally speaking, measures of general application such as regulations are very difficult, but not impossible, to challenge. Again, the individual circumstances will need to be taken into account.

There is also a chance that the CBAM is challenged indirectly, via the so-called preliminary reference ruling mechanism, for example during the course of national enforcement proceedings. In any event, a challenge before the EU courts requires a final legal act, so no challenge to the Commission's proposal is possible. Also important to note is that an EU court challenge will not usually have suspensory effect.

In addition to these legal challenges, it is not out of the question that third countries adversely impacted by the CBAM will take unilateral retaliatory measures to counteract its effect. These could include the imposition of import tariffs on EU-produced goods.

Our next CBAM alert will analyse future directions and industry response concerning the proposed CBAM Regulation

1. European Parliament resolution of 10 March 2021 "Towards a WTO-compatible EU carbon border adjustment mechanism". See: https://www.europarl.europa.eu/doceo/document/TA-9-2021-0071_EN.html
2. European Commission, Proposal for a Regulation of the European Parliament and of the Council establishing a Carbon Border Adjustment
3. Mechanism (Brussels, 2021, COM(2021) 564 final), Article 2(1).
4. Expressed in megawatt hours for electricity and in tonnes for other goods.
5. Expressed in tonnes of CO2e emissions per megawatt hour of electricity or for other goods in tonnes of CO2e emissions per tonne of each type of good, calculated in accordance with Article 7.
6. This should correspond to the total embedded emissions calculated in (2), less (i) any reduction due on the account of the carbon price paid in a country of origin in accordance with Article 9 and (ii) any adjustment necessary of the extent to which EU ETS allowances are allocated free of charge in accordance with Article 31.
7. Being emissions from the production of electricity, heating and cooling, which are emitted during the production processes of goods.
   This appears to be the position articulated in Article 24 (Cancellation of CBAM Certificates); however this is not entirely clear.