The EU’s Carbon Border Adjustment Mechanism: An Overview

Introduction

The EU Carbon Border Adjustment Mechanism (“CBAM”) entered into force on 5 June 2023. It aims to reduce carbon emissions and also discourage producers from moving their production outside the EU by incentivising the decarbonisation of non-EU production processes. CBAM aims to mirror the EU’s carbon pricing system and ensure that imported goods meet similar environmental standards as those produced within the EU.

This Law-Now outlines the various important aspects of CBAM, in a practical and effective way to assist you in determining if and how it could affect you and your supply chain.

Additionally, the European Commission (“EC”) is currently consulting on its Draft Implementing Regulation (“DIR”). The main points set out in the proposal are also summarised below.

Background

CBAM applies to imports into the EU of certain high-carbon commodities. EU importers are subject to CBAM based on their individual merits, considering factors such as the carbon content of imported goods, efforts to reduce emissions at the producing company or country level, and the carbon price paid in the country of origin.

CBAM is intrinsically linked to the EU Emissions Trading System (“ETS”), which is already applicable to EU production. As EU Member States already adhere to strict obligations under ETS, CBAM was introduced to level the playing field between EU and non-EU production. CBAM seeks to ensure that companies are not relocating their operations to non-EU countries with less ambitious carbon policies to evade their EU obligations (so-called “carbon leakage”).

Who does CBAM apply to?

CBAM primarily targets carbon-intensive sectors that are at high risk of carbon leakage and will apply to a large number of industries. Its application will materially affect importers and extra-EU producers of in-scope products. CBAM currently sets out the following as in-scope products:

• cement
• iron and steel,
• aluminium,
• fertilisers,
• electricity, and
• hydrogen.

In-scope products are in basic form and identified with their respective CN codes in the Annex I of the CBAM Regulation. Some derivatives and precursors of these products are also listed.

The obligations under CBAM encompass direct carbon emissions associated with the production of CBAM goods at the installation level. Some indirect emissions, such as those from electricity used in the production of CBAM goods, are partially included within the scope for certain products: namely cement, fertilisers, and electricity, but not for the others.

CBAM allows for the potential expansion of its scope during the full implementation phase after 2025. As such, the list of products and industries subject to CBAM may change and grow following the transitional period.

Transitional phase

CBAM will take effect starting 1 October 2023, initially without financial obligations, and will enter into a transitional phase lasting until January 2026. The objective of this transitional phase is three-fold: to gather vital information from stakeholders, lay the foundation for CBAM implementation, and create awareness about the authorised CBAM declarant status.

There are two things that companies must do during this phase:

• register as an authorised CBAM declarant with the relevant national competent authority in the relevant EU Member State of establishment via CBAM Registry - starting from October 2023, and
• submit a quarterly CBAM report to the Transitional Registry, detailing the previous quarter’s imported goods quantity, total direct and indirect embedded emissions, and the carbon price paid in the origin country.

See below for information on the reporting obligations for the transitional phase currently proposed in the DIR.

The last report of this transition phase, covering the period up to 31 December 2025, is to be submitted by 31 January 2026.

Full implementation phase

The phasing-out of free allowances under the ETS will take place in parallel with the phasing-in of CBAM in the period 2026-2034. The allocation of free allowances under ETS to CBAM-covered sectors will gradually decrease from 2026, when CBAM is fully implemented, until it is completely phased out by 2034. The allocation percentages of free allowances will be as follows: 100% until the end of 2025 to 14% in 2033. Starting from 2034, no free allocations will be granted.

By 31 May of each year, and for the first time in 2027 for the year 2026, each authorised CBAM declarant shall use the CBAM registry to:

• submit a CBAM declaration the quantity of goods and their embedded GHG emissions imported into the EU for the previous calendar year (CO2, nitrous oxide or perfluorocarbon emissions), and
• surrender the total number of CBAM certificates equivalent to the verified declared embedded emissions.

CBAM requires an accredited verifier to validate the declaration, a process that mirrors the EU ETS practice. Verification reports produced should also be submitted to the CBAM Registry.

Authorised CBAM declarants will be able to buy CBAM certificates from Member States through the Common Central Platform. The EC will set the price of CBAM certificates considering the average of closing prices of EU ETS allowances on the auction platform expressed in EUR/tonne of CO2 emitted.  Unlike the EU ETS system, the Common Central Platform does not permit the trading of CBAM certificates among importers.

Excess CBAM certificates remaining on an account of a declarant in the CBAM Registry after the certificates have been surrendered can be sold back to the Member State where that authorised CBAM declarant is established. The repurchase order for CBAM certificates is capped at one-third of the total number of certificates initially purchased.

Timeline

The implementation of the CBAM will occur progressively over several years. The initial phase focuses on establishing reporting obligations from October 2023 to 2025. From 2026 onwards, the CBAM will be phased in gradually while concurrently phasing out free allocation under the EU ETS. By 2035, the CBAM will be fully implemented.

Calculation methodology

The current calculation method provided under CBAM evaluates the production emissions of imported goods, deducting free EU ETS allocation emissions. This value is then multiplied by the total tonnes of imports and average weekly EU ETS price, resulting in the CBAM declaration obligation. Finally, any respective similar carbon duties paid in the origin country are subtracted for adjustment.

Draft Implementing Regulation

The EC published the DIR in June 2023 outlining detailed rules for reporting obligations during the CBAM transitional period. The DIR expands on the reporting obligation under the CBAM regulation, which runs from 1 October 2023 to 31 December 2025. The public consultation open until 11 July 2023 invites feedback specifically on the proposed CBAM implementing rules.

The DIR is only at proposal stage and will need to be adopted by the EC after consulting the CBAM Committee, consisting of experts from EU Member States, before it enters into force. However, it offers helpful insight into the reporting obligations for the fast-approaching October start date, as well as the provisional methodology for calculating embedded emissions.

Reporting obligation

During the transitional phase, EU importers must report emissions linked to their in-scope imports without making any financial adjustments. This period aims to help businesses prepare and gather necessary information for defining the final methodology by 2026. Penalties apply for failure to report or correction of inaccurate reports.

Calculation methodology

The proposed DIR allows flexibility in calculating imported emissions. For the first year, businesses can choose to use the EU methodology, or other methods provided that they ensure similar coverage and accuracy.

The EU methodology provided under the DIR specifies the calculation methodology for direct emissions and foresees two approaches. One approach involves calculating emissions from source streams based on data acquired through measurement systems and laboratory analyses. The other involves continuously measuring the concentration of relevant greenhouse gases.

Until 31 July 2024, importers can opt for alternative calculation methods when:

• the requisite information from third-countries operators is incomplete, but a CBAM declarant must indicate and reference in its CBAM report the methodology followed, or
• other methods are available that provide comparable accuracy, such as methods used under monitoring, reporting and verification systems (“MRV”) or carbon pricing scheme at the installation level, etc.

The EC is creating a dedicated CBAM IT tool and comprehensive resources to assist businesses with their reporting responsibilities during the transitional phase. The methodology is still being refined to ensure accuracy and fairness.

Horizon scanning: What’s next?

A review of the current in-scope products is scheduled for 2025, possibly extending the list of in-scope products and indirect emissions. The consultation on the EU’s 2040 emissions target included queries about CBAM extension. Any further extension is most likely to include products at risk of carbon border leakage and high CO2 emissions. However, this will likely lead to increased uncertainty in supply chains who will only be experiencing their first year of reporting and purchasing CBAM certificates for the original in-scope products in practice.

From 2026, the gradual phase-in of CBAM and the phase-out of free allocation under the ETS will commence. This balanced transition aims to allow businesses time to adapt, replacing free allocations with CBAM for emissions exceeding the set amounts.

Between 2026 to 2033, CBAM will be partially phased in, with gradually increasing coverage. This phased implementation will ensure that companies have time to adjust their operations and emissions management strategies. From 2035 onwards, CBAM will be fully phased in, covering all eligible emissions.

It is therefore crucial for companies potentially falling within the CBAM framework to closely monitor developments. To proactively prepare, consider the following actions now:

• if you are an importer, assess the potential direct cost impact and explore mitigation strategies,
• assess your distribution channels to determine the extent to which CBAM applies to you,
• evaluate opportunities to reduce emissions,
• for non-EU producers, identify how it will affect you,
• for all stakeholders, be aware of similar proposals in relevant markets e.g. the UK,
• track the debate at WTO level on CBAM and similar measures.

Keeping up to date with changes can help companies navigate evolving carbon pricing and compliance requirements effectively.