CBAMCarbon Border Adjustment Mechanism: A Step towards Low-Carbon Economy

INTRODUCTION

Climate change is a global challenge that can be only be effectively addressed through international cooperation. On the other hand, the issue of climate fairness arises, as different countries have contributed differently to carbon emissions, and those most affected by climate change may be the least responsible for it. These factors make it difficult to reach meaningful international agreements on emissions reduction.

The European Union (“EU”) had been actively working on finalizing legislation for a proposed Border Carbon Adjustment (“BCA”) framework. In December 2022, the European Parliament and the Council of the EU reached a provisional agreement on the BCA framework as part of a larger agreement that included modifications to the EU Emissions Trading System.

This article examines EU’s Carbon Border Adjustment Mechanism (“CBAM”) which came into force on 16.05.2023 and shall be entering into its transitional phase on 01.10.2023. Essentially, the CBAM aims to address differences in carbon prices between domestic and imported goods and shall ensure that the carbon price of imports is equal to the carbon price of domestic production.

WHAT IS CBAM?

The CBAM is a policy tool designed to address carbon leakage and promote climate objectives in international trade. It is being considered by various countries and regional blocs as a means to ensure that carbon-intensive industries do not relocate to jurisdictions with less stringent climate policies, undermining global efforts to reduce greenhouse gas emissions.

The primary objective of the CBAM is to create a level playing field for domestic industries subject to carbon pricing by extending the carbon price to imports. It aims to prevent carbon leakage, which occurs when businesses move production to countries with laxer climate regulations, resulting in increased emissions outside the jurisdiction that implemented the carbon pricing policy.

The CBAM works by placing a carbon price or carbon cost on imported goods based on their embedded carbon content. This means that imported products would be subject to a carbon tax or have their emissions accounted for in some manner.

By internalizing the cost of carbon emissions in the price of imported goods, the CBAM seeks to incentivize foreign producers to reduce their carbon footprint and adopt cleaner technologies. Additionally, compliance mechanisms, trade dispute resolution, and alignment with international trade rules are crucial factors to address during the implementation process.

The EU has been a prominent proponent of the CBAM concept. In July 2021, the European Commission adopted a legislative package called “Fit for 55 in 2030 Package,” which included the introduction of a CBAM.

The CBAM has both proponents and critics. Supporters argue that it can help protect domestic industries, incentivize emission reductions globally, and provide a fair competition framework. Critics raise concerns about potential trade conflicts, administrative complexities, and potential impacts on developing countries’ exports.

BCA & TAXES

Several BCA strategies involve imposing charges on imported goods from industrial sectors that are projected to be most affected by unilateral climate policies. These sectors are commonly referred to as “emission-intensive, trade-exposed” industries. The intensity of greenhouse gas (“GHG”) emissions in an industry are influenced by two factors:

A. the direct emissions resulting from its manufacturing processes, such as CO2 emissions from cement or steel production, and

B. the indirect emissions arising from the inputs used in the manufacturing processes, like electricity and natural gas in steel, cement, and chemical production.

Industries classified as “emissions-intensive” would be affected by climate policies targeting both direct emissions during manufacturing and “upstream” emissions from suppliers, such as electricity generators, which could result in increased costs passed on to consumers. Emissions-intensive sectors are expected to face higher cost rises compared to less emissions-intensive sectors, assuming all other factors remain constant.

Trade-exposed industries are those facing stronger competition at the international level compared to other domestic industries. One possible way to measure a sector’s trade exposure is by comparing the combined value of its exports and imports with the value of its domestic production and imports. These sectors mainly encompassed chemical, paper, nonmetallic minerals (such as cement and glass), and primary metals (such as aluminum and steel) industries.

BCA mechanisms may incorporate provisions to exempt imports from countries with comparable climate policies to domestic ones. Additionally, they may consider excluding goods from less developed nations or materials from countries with low trade volumes of covered materials. The former could foster economic growth in the exporting country, while the latter could alleviate administrative burdens on the country implementing the BCA.

In essence, a BCA typically involves imposing a fee on imported goods based on the estimated GHG emissions associated with those goods, often referred to as their carbon or emissions content. The fee rate is usually determined by the domestic carbon price in the importing country, which can be a carbon tax, emissions fee, or a calculated implicit carbon price from regulatory programs or related policies.

To implement this, a Government may charge a fee on imported products from another country, taking into account the estimated GHG emissions produced during the manufacturing process of the imported goods. These estimated emissions encompass both direct emissions from onsite processes and potentially indirect emissions related to the product’s manufacture, such as emissions from offsite electricity generation. Some proposed BCA frameworks also consider adjusting the import fee to reflect the climate policies and associated costs in the exporting country.

HOW WILL THE EU CBAM WORK?

Under the CBAM system, designed to comply with the World Trade Organisation (“WTO”) rules and regulations, and other international obligations of the EU, to ensure legal certainty and stability, the CBAM will be gradually phased in and initially applied to selected high-risk goods prone to carbon leakage, including iron, steel, cement, fertilizer, aluminum, hydrogen, and electricity generation.

During a transitional phase from 01.10.2023, to the end of 2025, importers will report emissions embedded in their goods subject to CBAM without facing financial adjustments, allowing time for the final system to be implemented.

Starting from its implementation in 2026, EU importers will purchase carbon certificates equivalent to the carbon price that would have been paid if the goods were produced under the EU’s carbon pricing rules. However, non-EU producers can deduct the cost of carbon already paid in a third country from the EU importer’s payment. This approach aims to mitigate the risk of carbon leakage and incentivize greener production processes in non-EU countries.

Upon the full operationalization of the definitive system in 2026, EU importers will annually declare the number of goods and the corresponding embedded emissions from the previous year and surrender the required amount of CBAM certificates. Over an eight-year period, CBAM will be gradually introduced as free allowances in the EU Emissions Trading System (“ETS”), replacing them with designated goods. Initially, only the most carbon-intensive products will fall under the CBAM scope, while low-carbon-intensive products within the scope will be exempt from the payment due to emissions levels below the EU ETS benchmark.

EFFECTS OF A CBAM

The implementation of CBAM can have several effects on reducing carbon leakage and influencing international trade:

1. Mitigating carbon leakage: As understood from hereinabove, CBAM aims to address the risk of carbon leakage by applying fees to carbon-intensive imports, incentivizing non-EU countries to adopt cleaner production methods. This helps create a level playing field and reduces the incentive for businesses to relocate to countries with weaker climate regulations.

2. Encouraging global emission reductions: CBAM provides economic incentives for non-EU countries to reduce their carbon footprint by potentially applying fees based on embedded carbon content. This promotes cleaner technologies and practices globally, contributing to global efforts in combating climate change.

3. Trade implications and tensions: The implementation of CBAM may have trade implications and could potentially lead to trade tensions and disputes. It is important to ensure that CBAM complies with international trade rules and engages in dialogue with trading partners to address concerns and minimize trade conflicts.

4. Market adjustments and competitiveness: CBAM may influence global supply chains and trade patterns as industries respond to the new cost implications. Businesses, both within and outside the EU, may seek to reduce carbon emissions to remain competitive in the EU market or gain an advantage in other markets with similar carbon border measures. This can lead to market adjustments, technological innovation, and investments in cleaner technologies.

5. Revenue generation and investment: CBAM has the potential to generate revenue for the implementing country through the collection of fees on imported goods. This revenue can be reinvested in domestic climate policies, renewable energy projects, or initiatives to support the transition to a low-carbon economy. It can contribute to financing climate-related measures and stimulate sustainable economic development.

In summary, the effects of CBAM on reducing carbon leakage and international trade depend on its design, implementation, and the response of different countries. It is crucial to strike a balance between climate objectives, trade considerations, and global cooperation to ensure the effectiveness and acceptance of CBAM on the international stage.

CHALLENGES IN IMPLEMENTING CBAM

The implementation of CBAM might gradually face several challenges that need to be addressed. Firstly, there is a need to develop a robust methodology for calculating the carbon content of imported goods, which involves gathering accurate emissions data and establishing guidelines for measuring emissions throughout the supply chain.

The administrative complexity of CBAM is also a significant challenge, as it requires setting up monitoring and reporting systems, verifying emissions data, and managing the issuance and trading of carbon certificates. This necessitates coordination among Government agencies, trade partners, and businesses.

Ensuring compliance with WTO rules and avoiding accusations of protectionism is crucial. CBAM measures must be carefully designed to be compatible with international trade agreements and avoid discrimination against specific countries or products.

Access to accurate and reliable emissions data, both domestically and from foreign producers, is vital for effective CBAM implementation. This may require addressing data availability, transparency, and harmonization issues across different jurisdictions.

Cooperation with trading partners is essential for successful CBAM implementation. Engaging in dialogue, sharing information, and seeking mutually beneficial solutions can help build consensus and prevent potential trade conflicts.

It is also important to consider the potential impact on developing countries heavily reliant on exports of carbon-intensive goods. Support and assistance should be provided to these countries to facilitate their transition to cleaner production methods and prevent disproportionate burdens on their economies.

CBAM may affect the competitiveness of industries, both domestically and internationally. To mitigate market distortions and ensure fairness, measures such as exemptions for low-carbon-intensive products or transitional periods can be considered. Comprehensive planning, international collaboration, and ongoing evaluation are necessary to address these challenges and ensure the effectiveness and fairness of CBAM implementation.

IMPACT OF CBAM ON INDIA & MEASURES TO MITIGATE THE IMPACT

i. Impact

The implementation of CBAM is expected to have negative implications for India’s exports, particularly in the metals sector, such as iron, steel, and aluminum products, which will face increased scrutiny and potential carbon levies ranging from 19.8% to 52.7% when exporting to the EU.

India’s products are characterized by higher carbon intensity compared to the EU and many other countries, primarily due to the significant reliance on coal for energy consumption. With approximately 75% of power generation coming from coal-fired plants in India, direct and indirect emissions from sectors like iron, steel, and aluminum are of concern, as they may result in higher carbon tariffs imposed by the EU.

The risk to India’s export competitiveness extends beyond the metals sector, potentially impacting other industries such as refined petroleum products, organic chemicals, pharma medicaments, and textiles, which are among the top goods imported by the EU from India.

Since India does not have a domestic carbon pricing system in place, there is a greater risk of reduced export competitiveness compared to countries that already have such systems, as they may be subject to lower carbon taxes or exemptions.

Therefore, the CBAM implementation poses challenges for India’s export sector, particularly in carbon-intensive industries, with potentially adverse effects on export volumes, competitiveness, and additional costs incurred due to carbon tariffs imposed by the EU.

ii. Measures

India can take several measures to address the challenges posed by CBAM.  Firstly, the Government can introduce a Decarbonization Principle, incorporating carbon efficiency objectives into existing schemes such as the National Steel Policy and the Production Linked Incentive (PLI) scheme. This would ensure that carbon reduction is a key consideration in industrial development.

Negotiating with the EU is another important step. India can engage in discussions to have its energy taxes recognized as equivalent to a carbon price, making its exports less susceptible to CBAM. Emphasizing that India’s tax on coal internalizes the costs of carbon emissions can be a compelling argument in this regard.

India should also seek technology transfer and financing assistance from the EU to enhance the carbon efficiency of its production sector. Proposing the allocation of a portion of CBAM revenue to support India’s climate commitments can help facilitate this transfer and collaboration.

Preparing for the CBAM system is crucial, and India can follow the examples of China and Russia by establishing a Carbon Trading System. This would provide a mechanism for managing and regulating carbon emissions and create incentives for greener production practices.

AMLEGALS REMARKS

The CBAM has the potential to incentivize countries to adopt more ambitious climate policies by mitigating the risk of carbon leakage and leveling the playing field for industries that have made efforts to reduce their emissions. By aligning the costs of carbon across borders, CBAM can encourage more equitable distribution of climate action and discourage free-riding on the efforts of others.

While the CBAM introduces complexities and potential trade implications, it presents an opportunity for the EU to strengthen its climate leadership and promote the transition to a low-carbon economy. By encouraging other countries to align their climate policies with EU standards, CBAM can incentivize global efforts to reduce GHG emissions and accelerate the adoption of sustainable practices.

– Team AMLEGALS assisted by Ms. Shivangi Banerjee (Intern)