What is the EU’s Carbon Border Adjustment Mechanism?

Background

Varying levels of ambition in different regions of the world can become a serious obstacle to upholding a stringent climate policy. A frequent concern in this context is that ambitious climate measures in some countries could be undermined by relocation of energy-intensive industries to regions with less strict climate targets, thus increasing emissions elsewhere. This is often called ‘carbon leakage’.

As energy only accounts for a relatively small fraction of production costs for most industries, empirical studies have found little evidence of carbon leakage. However, due to a lack of ambitious climate targets, the cost of abating emissions has been moderate for most firms until now. Depending on assumptions regarding climate targets, policies adopted, and economic and technological developments, modelling studies project future leakage rates of about 5% to 25%. That is, between 5% and 25% of emission reductions by frontrunners might be nullified by increasing emissions in other parts of the world. This could be of particular concern for energy-intensive and trade-exposed industries, such as steel, aluminum, cement, chemicals, glass, and pulp and paper.

The mere prospect of carbon leakage could severely undermine the implementation of ambitious climate targets. Policy makers might be hard-pressed to justify measures that would imperil the competitiveness of energy-intensive industries and result in job losses without effectively reducing global greenhouse gas emissions.

In the EU, energy-intensive firms are to some extent protected against leakage by the free allocation of emission permits. Firms in industries deemed at risk of carbon leakage (because they are either carbon-intensive or trade-exposed) receive emission permits free of charge. The number of permits is determined according to the benchmark of the 10% most efficient firms in the particular industry. This approach to addressing leakage is problematic, as it provides a de facto subsidy for energy-intensive products, thereby partially undermining the effect of the carbon pricing signal (there is still an incentive to use cleaner energy sources or production processes, but no incentive to lower emissions by reducing output). Furthermore, in light of the EU’s aim to achieve net-zero emissions by 2050, it seems unlikely that in the long run, sufficient permits will be available to compensate all firms at risk of carbon leakage.[1]

Taking a new approach to carbon leakage, the EU has announced it will implement a ‘carbon border adjustment mechanism’ (CBAM) as part of the EU Green Deal. In mid-July 2021, the European Commission put forth a proposal for the design of such a CBAM. This explainer provides a concise overview of the key design elements of the Commission’s proposal, and assesses its relevance for exporters from Israel.

Design Features of the EU CBAM

The EU CBAM is designed as a ‘notional permit trading scheme’. Importers are required to submit emission permits in proportion to the emissions generated for the production of the imported goods (so-called ‘embodied emissions’). However, in contrast to cap-and-trade schemes, the quantity of permits is not limited. Rather, permits are given out at a pre-defined price. This makes the proposed CBAM more like a tax or a levy than an emission trading scheme. One reason for this approach may be to provide an equivalent to the existing EU Emission Trading Scheme (ETS) and avoid the need to be adopted as a tax measure, which would require a unanimous vote by European Member States.

Key features of the CBAM design include:

1. Determining the number and price of permits to be submitted (i.e., sectors covered, scope of emissions, and methodologies to assess emissions ‘embodied’ in imports)
2. Rebates for EU exporters for the carbon costs incurred as a consequence of the EU ETS
3. Conditions for receiving exemptions from the CBAM
4. Use of revenues from pricing carbon for imports

Below is a summary of these features in the EU Commission’s CBAM proposal:

Determining the number and price of permits to be submitted

The proposal covers imports of iron and steel, aluminum, cement, fertilizers and electricity, with a view to including more sectors in future. Importers will have to comply with the CBAM as of 2023, with a three-year ramp-up period in which permits will be given out for free and only reporting will be required. From 2026 to 2035, requirements to submit emission permits will be gradually introduced, along with phasing out free emission permits for EU producers.

To determine the basis on which importers will need to submit CBAM permits, only emissions that occur directly within the production process (Scope 1) are considered in the proposal. Emissions from electricity inputs (Scope 2) and intermediate products and services (Scope 3) are excluded. Importers will be required to provide data on actual emissions, verified by an independent certification agency. If this information is not available, emissions will be calculated based on the average for comparable goods from the exporting country, or (in the case of missing country-level data) on the 10% most carbon-intensive installations for comparable products in the EU.

The price of CBAM permits will be determined by the average of EU ETS prices in the previous week. Permits are envisaged as tradable among importers. Banking of permits for more than one year ahead to hedge against future price increases will not be allowed, to prevent speculation.

Rebates for exporters

Applying the domestic carbon price on imports will level the playing field in the domestic market. However, export-oriented firms will still be disadvantaged in the world market compared to firms producing in regions with less stringent climate measures. It will therefore make sound economic sense to reimburse exporting EU firms for the carbon price they have already paid under the EU ETS. In this way, EU exports could help clean up global production by replacing goods that would otherwise be produced in other countries with higher carbon intensities.

However, even though WTO law permits reimbursing exporters for domestic taxes, this approach is considered unfeasible for traded permit schemes (since such schemes are regarded as regulations, which are not ‘adjustable’, unlike taxes). The EU Commission has made it clear from the start that it is seeking a WTO-compliant CBAM design. Therefore, the proposal does not include provisions to reimburse carbon costs borne under the EU ETS.

Exemptions

One rationale for exempting imports could be favorable treatment for low-income countries under the UNFCCC principle of ‘common but differentiated responsibilities and respective capabilities’. However, no such exemptions for low-income countries are included in the proposal. Even though energy-intensive products only constitute a small fraction of exports from low-income countries, being subject to the CBAM could substantially harm specific countries, especially if they are pursuing export-led development strategies to spur industrialization.

Imports could be exempted if they come from jurisdictions with stringent climate measures. The EU Commission proposes an exemption if importers can demonstrate that particular products have already been subject to a carbon price in the country of production, equivalent to the carbon price in the EU. For lower carbon prices, the levy would only be on the difference between the price in the country of origin and in the price in the EU.

Other policies to reduce emissions, such as performance standards or support for clean energy technologies, will not be eligible for exemption. This is probably due to the difficulty to assess equivalence of regulatory measures and the associated challenges with using this exemption in a non-discriminatory, WTO-compliant manner.

Use of revenues

Pricing carbon at the border yields public revenues. For the CBAM, the estimated revenues amount to about € 2 billion per year. In the run-up to the Commission’s proposal, civil society organizations frequently advocated for recycling those revenues back to countries whose imports will be subject to the CBAM in order to prevent inequitable outcomes, particularly in poor countries. Using CBAM revenues to expand climate finance could further lower these countries’ carbon intensity, thus reducing the risk of carbon leakage.

Energy-intensive industries in the EU, on the other hand, have called for recycling CBAM revenues in order to accelerate the deployment of low-carbon technologies and compensate industries for higher energy prices.

The Commission, however, proposes to use CBAM revenues as the EU’s own resource, for instance to pay back the debts incurred by providing relief for the economic consequences of the Covid-19 pandemic.

Implications for Israel

The EU is Israel’s most important trade partner, accounting for almost 22% of Israel’s exports (€11.5 billion) in 2020. Chemicals are among Israel’s most important exports to the EU, accounting for 44% of the total.

Even though most of Israel’s exports to the EU lie beyond the scope of the proposal, the CBAM may be expanded to include chemicals in the future. This could seriously affect the competitive market position of Israeli firms versus producers from the EU or from countries where production is less carbon-intensive than in Israel (but could improve their standing versus firms from other countries with a higher carbon intensity that export to the EU).

If Israel were to implement a domestic carbon price, domestic firms could benefit from an (at least partial) exemption from the EU CBAM. In such a case, Israeli firms would still experience higher energy costs resulting from the domestic carbon price. But the resulting revenues would accrue to the public budget of the Israeli government instead of to the EU, and could be used to provide relief for higher energy costs by, for instance, lowering corporate income taxes or upgrading public transportation and telecommunication infrastructure.

Summary and conclusions

The EU Commission proposes using a border mechanism to reduce the risk of carbon leakage. The proposed CBAM would require importers to submit permits that mirror the price of the EU ETS, in proportion to the emissions generated during the production of the imported goods. No rebates for EU exporters are envisioned. Exemptions would apply for countries with comparable carbon prices, but not for countries that use non-market climate policies or for low-income countries. Finally, revenues will accrue to the EU general budget as its ‘own resource’.

These design options are currently under discussion with key industries and trade partners. A decision on the implementation of CBAM will be taken jointly by the European Council (which represents the governments of EU member states), the European Parliament and the European Commission. Details of the implementation will likely depend on the ambition of key trading partners to achieve climate goals, and particularly the US and China. COP26, which took place in Glasgow in November 2021, has yielded some progress to align climate policies between different jurisdictions. Whether the EU’s main trading partners adopt more ambitious climate policies, which crucially determines the implementation details of the EU’s CBAM, remains to be seen.