A spotlight on the EU's proposed Carbon Border Adjustment Mechanism

The EU’s planned introduction of a Carbon Border Adjustment Mechanism (CBAM) regulating domestic carbon intensive production could tackle the longstanding issue of carbon leakage (where production shifts to countries with less stringent climate policy) particularly for internationally traded sectors such as steel.

The EU Emissions Trading Scheme (ETS), introduced in 2005 was the world’s first emissions trading system. It is a market based system regulating high carbon intensive sectors by capping emissions using tradeable permits to set a carbon price to incentivise carbon intensive sectors to reduce emissions.

While this was intended to be an efficient market-based system to cut carbon emissions, it has not been effective in practice. One key reason has been the process of grandfathering, where companies within the ETS have been provided with free allowances to put them on a level playing field with competitors from less regulated markets . This has supressed demand for trading permits and weakened the carbon pricing signal required to incentivise high carbon intensive sectors such as steel to decarbonise. For example, ArcelorMittal had allowances allocated covering 85% of their Scope 1 Emissions and 90.5% of their Scope 2 emissions in 2019, needing a small number of allowances to cover their shortfall.

The next trading period (2021-2030) of the EU ETS will have more ambitious CO2 emissions targets for 2030, rising from a 40% reduction by 2030 to 55% from 1995 reference levels with a steeper decline in the cap between 2026-2030. Accompanied by fewer free allowances, this should result in a higher carbon price and costs to industry. Tightening regulation has resulted in a rally in carbon prices within the ETS and strengthened the regulatory price signal. However, the carbon price is not high enough to incentivise the type of shift to low carbon technologies needed to align to Paris goals. This is particularly the case for sectors such as steel where the cost of developing and deploying new technologies remains high.

The CBAM may provide an elegant solution to this problem, potentially imposing a tax on carbon intensive goods coming into the EU mirroring the carbon prices within the EU ETS. This should remove the issue of carbon leakage and the need to shield companies regulated within the ETS. In addition, to ensure competitiveness globally there have been calls for the EU commission to also consider as part of the mechanism an export rebate for European companies, providing they can demonstrate their positive impact on climate and compatibility with WTO rules. The EU is also keen that the CBAM creates incentives for industries in the EU and other trading partners to produce clean (green) and competitive products.

The CBAM is being devised in the context of not just carbon regulation but also the EU’s tax agenda of enabling fair and sustainable growth through the European Green deal, which is in turn supporting the EU’s digital agenda, the New Industrial Strategy for Europe and the Capital Markets Union. Tax revenues from CBAM are estimated to be in the range of €5 to 14 bn a year depending on the scope and design of the new instrument.

This could reduce the EU’s current high dependence on labour taxes which contribute to 50% of overall tax revenue in the EU-27. Environmental taxes currently contribute 6% and have become important for EU tax policies for sending the right price signals to support the green transition as well as implementing the polluter pays principle.

However, although the EU Parliament has endorsed the CBAM, the smooth passage for its introduction and effectiveness remain a concern. Although WTO consistency remains the EU objective, potential remains for trade disputes which the WTO will not be able to address. Companies within the ETS will continue to lobby to retain carbon allowances while maintaining protection from international competition from less regulated markets and will argue that the CBAM will not provide sufficient incentives to decarbonise. While the EU are leading in introducing this mechanism, it is not clear whether other countries such as the US will adopt the same approach, given the lack of standardisation of a carbon price within the US.

The CBAM provides a regulatory step forward and is part of the ammunition to address decarbonisation for the European steel sector and send a signal to competitors in less regulated markets, still leaving scope for even tougher regulatory sticks such as outright bans of “dirty” steel – a regulatory tool that has worked in the autos sector. It does, however, have to be accompanied by “carrots” such as preferential public procurement policies for green steel, subsidised financing packages for investment to drive and de-risk deployment of early stage technologies and drive momentum to decarbonise.

Back to latest thinking