Carbon border adjustments in the EU and beyond

Introduction

In the push to a net-zero economy, many jurisdictions are introducing rules requiring goods produced in that jurisdiction to be produced in a way which emits less carbon. The potential problem with such rules is that, given current technology, this will tend to imply a higher cost of production, particularly for those products that are carbon-intensive, such as steel, cement, and aluminium. The argument against such regulations is that it will simply force production to move elsewhere, to a jurisdiction without equivalent regulations – so-called “carbon leakage.” This would not reduce the world’s overall carbon emissions but would instead reduce the manufacturing competitiveness of the jurisdictions imposing those rules.

The proffered solution to this problem is a "Carbon Border Adjustment Mechanism” (CBAM). This works by equalizing the higher price of goods produced using low-carbon methods with the lower price of imported goods. Instead of subsidizing the lower-carbon domestic production, the system works by imposing a tariff on the import of selected carbon-intensive goods imported into the regulated jurisdiction, where such import is from a jurisdiction that does not have an equivalent regulatory framework. There is also a need for any CBAM framework to be assessed alongside any applicable emissions trading systems, such as the European Union (EU) Emissions Trading System (ETS).

The EU has introduced its EU CBAM, designed to support the EU climate ambitions of achieving a net reduction of greenhouse gas (GHG) emissions of at least 55 percent by 2030 and of reaching climate neutrality by 2050 at the latest. This article discusses the scope of these rules and how the UK is looking to respond.

EU CBAM

The EU Commission lodged its CBAM proposal as part of the “Fit for 55 Package” under the European Green Deal (with a target of reducing EU emissions by at least 55 percent by 2030, to achieve a climate-neutral Europe by 2050). On May 10, 2023, EU Parliament and Council adopted the EU CBAM Regulation ((EU) 2023/956), which officially entered into force on May 17, 2023.

On August 17, 2023, the EU Commission adopted its implementing regulation (Commission Implementing Regulation ((EU) 2023/1773), laying down reporting obligations for the purposes of the EU CBAM during the transitional period (see below).

The EU CBAM Regulation covers a wide range of products, namely: iron and steel, cement, fertilizers, aluminium, electricity and hydrogen, as well as certain goods incorporated in their production and products into which these are incorporated (see Annex I of the EU CBAM Regulation) for the relevant CN codes.¹ The scope of EU CBAM will be gradually extended to all sectors covered by the EU ETS by 2030 and to include organic polymers and plastics.

The EU CBAM Regulation applies when products are released for free circulation (“imported”) into an EU Member State.² This aligns with other customs importation so that goods remaining in a customs warehouse would not fall under the EU CBAM Regulation until released from the warehouse.

Phased implementation

The EU CBAM is being implemented in two phases:

Phase 1 – Transitional Period (between October 1, 2023 and December 31, 2025)

During this period, importers of goods covered by the EU CBAM Regulations will only have to report greenhouse gas emissions (GHG) embedded in their imported goods (direct and indirect emissions), without paying any financial payments or adjustments. Verification of those emissions by an external third party will be purely voluntary.

Until the end of 2024, companies will have the choice of reporting in three ways: (a) full reporting under the new EU methodology (EU method); (b) reporting based on an equivalent method to the EU method (three options) or (c) reporting based on default reference values (only until July 2024). Only the EU method will be accepted from January 1, 2025.

Phase 2 – Full implementation (January 1, 2026 onwards)

In Phase 2, the EU CBAM will apply fully, imposing obligations to purchase EU CBAM certificates and to meet administrative and reporting requirements. Importers must submit an annual EU CBAM declaration containing the following information:

• The total quantity of each type of product covered by the EU CBAM Regulations imported in the previous calendar year;
• The total embedded emissions of these products;
• The total number of EU CBAM certificates to be surrendered, corresponding to the total embedded emissions; and
• Copies of verification reports issued by accredited verifiers.

  The EU CBAM declaration must be submitted by May 31 of the following year. The first EU CBAM declaration should therefore be submitted by May 31, 2027 for products imported in 2026.

Some considerations

Potential impact

The EU has published an analysis of the potential economic impact³ on its trading partners. It notes that, whilst there may be an impact on the main trading partners (which includes the UK and Turkey), this should not significantly impact on gross domestic product (GDP). In any event, it is anticipated that other jurisdictions (including the UK) will introduce their own CBAM rules, which should provide a level playing field (see below).

UK CBAM

The EU CBAM presents particular issues for the UK. The UK is one of the EU’s largest trading partners, both for imports and exports of the type of goods that are likely to be affected by a CBAM and, without action, the UK would potentially be affected by the economic effects of the EU CBAM.

It is also important to consider the position of Northern Ireland, which remains in the EU customs area for most purposes. At present, under the Windsor Framework, goods can pass freely between Northern Ireland and the EU but there are certain restrictions on the movements of goods between Northern Ireland and the rest of the UK, depending on whether the goods in question are intended to remain in Northern Ireland or not. This will present an additional set of difficulties if the EU CBAM is also to be imposed on the movement of goods between Northern Ireland and the rest of the UK, as well as the tracing of goods arriving direct from third countries into the UK to ensure they do not move to the EU without the appropriate CBAM charge.

Accordingly, on December 18, 2023, the UK announced its intention to introduce its own CBAM by 2027 (the UK CBAM). As with the EU CBAM, the charge applied will depend on the amount of carbon emitted in the production of the imported good, as well as any gap between the carbon price applied in the country of origin and the carbon price faced by UK producers. The specific products to be covered and the detailed design of the system are to be consulted on during 2024.

It is yet to be seen whether a UK CBAM which is similar to, but not the same as, the EU CBAM, will be sufficient for the EU to treat the UK’s system as equivalent such that the terms of the EU/UK Free Trade Agreement and the Windsor Framework will operate without restriction, or whether the EU would require additional reporting, information and possibly charges when a product transfers from the UK to the EU.

Further challenges

There is a potential tension between the EU CBAM and World Trade Organization (WTO) rules, which seek to prevent discrimination between similar products produced in the domestic jurisdiction and import jurisdictions. The EU will no doubt be braced to defend the mechanism against any suggestion that it is in breach of WTO rules.

Similarly, as other developed economies (including the UK) seek to impose their own CBAM (or equivalent) rules, it would be logical to assume that goods being moved between those jurisdictions would automatically be exempt from the EU CBAM on the basis they are coming from a jurisdiction with a similar system in place. However, it remains to be seen whether this would in fact be the case. It may be politically sensitive for the EU to recognize the UK’s different rules as being equivalent, in the same way is it will be politically sensitive for the UK to introduce the EU’s CBAM rules without amendment.