The proposal for a Carbon Border Adjustment Mechanism fails the ambition and equity tests

Analysis

The proposal for a Carbon Border Adjustment Mechanism (CBAM) is likely the most contentious element of the Fit for 55 package, with significant ramifications not only internally in the EU but beyond its borders. It is a long-discussed idea whose time has finally come as part of European Commission President von der Leyen’s European Green Deal grand bargain.

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This article is part of our dossier "The EU's Fit-for-55 package: The European Green Deal's fitness test".

 

But to succeed it must pass two acid tests. First, domestic ambition: will the CBAM support the acceleration of EU climate action, especially in the energy intensive industries around which it has been designed? Second, international equity: will the CBAM ensure that producers in lower income and climate vulnerable countries are not disadvantaged? The current proposal largely fails on both counts, and its advocates will need to address both in the legislative process over the coming years if the measure is to be successfully implemented.

The CBAM’s domestic ambition test

The proposal aims to address long-held concerns over carbon leakage. It does so, in essence, by requiring EU importers to pay a carbon price at the border – by purchasing CBAM certificates covering the scope one emissions embedded in their imports – equivalent to that faced by EU producers under the EU Emissions Trading Scheme (ETS). If third country producers can demonstrate that they have already paid a carbon price, then the corresponding cost can be deducted by the EU importer.

Until now the EU’s response to carbon leakage concerns has been to allocate ETS allowances to energy intensive industries for free. While there has been little to no evidence of carbon leakage actually occurring to date, the strengthened 2030 emission reduction target (and consequent decrease in the total number of ETS allowances) will likely increase the risk in the years ahead. The Commission has presented the CBAM as an alternative approach to free allowances to manage this increased risk.

While it is hoped that the CBAM will encourage the use of carbon pricing among international trading partners, it is the removal of free allowances that is critical to strengthening the EU’s domestic climate ambition. As the Commission notes, ‘free allocation… weakens the price signal that the system provides for the installations receiving it compared to full auctioning.’ The CBAM’s key ambition test is therefore the extent to which it enables a rapid phase-out of free allowances and thus the full application of the polluter pays principle across EU industry.

The proposed mechanism is focused on five sectors initially – aluminium, cement, chemical fertilisers, electricity and iron/steel – considered among those at highest risk of carbon leakage and easier to include in a CBAM than more complex products. Importantly, EU producers in these sectors receive generous free allowances, covering some 80 percent of allowances in the steel sector, for example. But rather than accelerate their phase-out, the proposal seems to prolong them.

An initial transition period of three years is foreseen, during which importers in these sectors are only required to submit information on their imports’ emissions, meaning no change to free allocation at all in this time. Thereafter, the requirement to pay for emissions at the border would be phased-in over ten full years, from 2026 to 2035. Each year EU producers would progressively lose 10 percent of their free allowances, with importers having to buy an equivalent number of CBAM certificates.

This approach ensures consistency with WTO rules, avoiding ‘double-protection’ for EU industries. But it means that even by 2030 the free allocation to these sectors would still only have been reduced by about half. This is in stark contrast to the Commission’s parallel proposed extension of the ETS to the transport and buildings sector, that will expose EU households to a full carbon price many years sooner.

It's clear that energy intensive industries are deeply attached to their free allowances, with some sectors outright opposed to their replacement by a CBAM. To get a sense of how hard this debate will be fought, we need only look at the way last-minute industry lobbying of MEPs saw a clear commitment to ending free allocation stripped-out of the European Parliament’s resolution on a CBAM earlier this year.

And we can expect further industry complaints from EU exporters, who claim that without free allowances they will lose out when selling in markets with weaker climate regulation, and want their carbon price rebated to level the playing field. The Commission’s proposal does not include export rebates, and rightly so, not least as they are very likely incompatible with WTO rules (which only allow rebates for taxes like VAT, whereas ETS allowances are considered an environmental charge) – but this won’t stop the ferocious lobbying.

Without a far faster phase-out of free allowances, many stakeholders may wonder whether the huge internal battle the CBAM proposal will spark in the EU is really worth it.

The CBAM’s international equity test

But the battle over the CBAM will draw in the EU’s trading partners too, several of whom have been outspoken in their criticism. These include Russia, which will be among the worst impacted in terms of the value of EU imports, and whose economic development minister has suggested the measure will be challenged at the WTO.

More concerning from the perspective of multilateral climate diplomacy, the BASIC countries (Brazil, South Africa, India and China) have led critiques suggesting that an EU CBAM would be coercive and/or punitive, violating both the UNFCCC principle of ‘common but differentiated responsibilities’ (under which developed countries should lead the way in fighting climate change), and the ‘nationally-determined’ spirit of the Paris Agreement.

But many lower income and climate vulnerable countries – especially from Africa – are likely to be impacted too. As recent analysis by IEEP et al finds, while some of these countries’ exports may only constitute a very small share of EU imports, the impact may nonetheless be significant where the country has a relatively high export dependence on the EU, and relatively high carbon intensity of production.

As shown in the tables below, for aluminium this means countries like Mozambique – for whom the metal makes up over a fifth of exports, 87 percent of which is destined for the EU – Cameroon and Ghana. For iron and steel, it means countries like Zimbabwe – for whom those products comprise 13 percent of exports, 25 percent of which is sold to the EU – and Zambia. For fertilisers, North African countries like Algeria and Egypt, as well as Trinidad and Tobago, and for electricity Morocco, will also be significantly affected.

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BASIC countries shown for comparison in green. GHG/GDP shown as an illustration of potential differences in carbon intensity of production among countries. Source: IEEP et al.

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BASIC countries shown for comparison in green. GHG/GDP shown as an illustration of potential differences in carbon intensity of production among countries. Source: IEEP et al.

One of the challenges for producers in such countries will be verifying the emissions embodied in their products, likely a significant technical burden for low-income countries that already face some of the highest barriers to trade in the world. Where producers are unable to do so, the proposal requires importers to use the average value for comparable goods from the exporting country. But where that is not available, emissions would be assumed equivalent to the 10 percent worst performing installations in the EU – a relatively punitive benchmark.

Two options have been widely discussed in the literature to address concerns about impacts on lower income countries – exemptions and recycling of revenues – yet the Commission’s proposal includes neither. Exemptions are likely WTO-compatible for Least Developed Countries, but pose the risk of leaving them stranded with carbon intensive production methods as the rest of the world races towards a net zero economy.

A far more important issue for such countries, therefore, is the use of the CBAM’s revenues, which could be used to support the modernisation of their supply chains, and would be welcomed by many stakeholders in such countries. Even with its limited initial scope, the CBAM is projected to generate €9.1bn per year by 2030, €2.1 billion of which will be collected at the border, with the rest accruing to Member States from the gradual phasing-out of free allowances to EU producers.

The Commission proposes that all revenues should be kept for the EU’s own budget, helping – albeit fractionally – to repay the EU’s €750 billion Next Generation EU debt. Yet recycling carbon pricing revenues to address equity concerns is a tried and tested EU method, at least internally. The Modernisation Fund uses a share of ETS revenues to support the energy transition in lower-income Member States, for example, and the proposed extension of the ETS includes a substantial Social Climate Fund to compensate vulnerable citizens. The CBAM proposal however suggests that this principle stops at the EU’s borders.

This will be hard for climate vulnerable countries to swallow. They are least responsible for the climate crisis, yet worst impacted by it. There is little justification for requiring their producers to compete on a level playing field with EU producers without the financial and technical support to do so, especially when developed countries have still not delivered on the $100 billion per year climate finance commitment that was due by 2020.

In that context, €2.1 billion may seem a modest amount, but it would still nearly double the Commission’s current annual climate finance contribution. On this, the European Parliament is on the right side of the argument, their resolution calling for part of the CBAM revenues to be used to increase the EU’s international climate finance contributions.

A serious CBAM proposal has been a long-time coming, and with tough internal and external debates to navigate, there’s no guarantee it will ever ultimately be adopted. Those Member States and MEPs who want to make it a tool of meaningful climate action will need to show that it is enabling more effective climate policy at home, by pushing for a faster phase-out of free allowances than currently foreseen. And to ensure that it proceeds while building and not undermining trust in multilateral climate action, they should insist that a substantive share of CBAM proceeds should be used to boost international climate finance. COP26 would be the ideal moment for such a gesture of good faith.