As Europe’s carbon price rises, a spectre is haunting European industry: the spectre of carbon leakage. As long as the EU has led the way globally in terms of climate policy, domestic energy and carbon-intensive producers have fretted about being undercut by competitors in jurisdictions that do not require emitters to pay a price on carbon.

Now, with European climate policy moving up a gear, as the bloc aims to achieve a 55% reduction in emissions by 2030, the EU is acting. The European Commission’s ‘Fit for 55’ package, unveiled on 14 July, includes a proposal for its long-discussed Carbon Border Adjustment Mechanism (CBAM, pronounced ‘see-bam’).

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The proposal has support from some member states, particularly France, and some NGOs and think tanks that see it as a means to improve the environmental effectiveness of EU climate policy. Trade-exposed carbon-intensive industries are cautiously supportive – assuming they continue to receive free allocations of EU allowances. Many believe this would amount to ‘double protection’, falling foul of World Trade Organisation (WTO) rules.

Calculating the carbon: a worker checks rolls of sheet aluminium at a factory in Wuhan, China. (Photo by STR/AFP via Getty Images)

During a press briefing in Brussels on the issue on 15 July 2021, Paolo Gentiloni, EU economy commissioner, said the CBAM had been “overall positively received” by other countries during the recent G20 meeting in Venice, Italy. Nonetheless, Europe’s trading partners have made hostile noises about the proposal, and the plan could hurl a hand grenade into international climate talks, especially given the CBAM’s potential negative impacts on some least-developed countries (LDCs).

However, these opinions could be academic since the sheer complexity of calculating carbon levies could torpedo the entire effort. Further, the Commission insists the proposal is compatible with WTO rules, but others are less convinced.

What a CBAM does

The CBAM would require importers of certain products to pay a charge reflecting the embedded carbon emissions of those products. After a pilot phase, running from 2023 to 2025, it would come into force in earnest from 2026, initially applying to imported iron, steel, aluminium, cement, fertilisers and electricity.

To comply with the mechanism, importers would be required to buy a CBAM certificate for each tonne of embedded carbon dioxide, with the price of those certificates linked to the EU allowance price, which recently moved above €50 ($59.19) a tonne for the first time. Revenues raised will be used to fund the administration of the CBAM, with any surplus going to the EU’s general budget.

Free allocations of allowances to affected sectors would gradually decline, with the proportion of an importer’s emissions covered by the CBAM rising by the same amount, until 2035, when the CBAM would cover 100% of embedded emissions.

If a non-EU producer can show it has already paid a carbon price for the production of the imported goods in a third country, that amount would be deducted from the levy paid by the EU importer.

The case for a CBAM

The mechanism would be “one of the few policies we have to say to producers outside the EU to either follow us and produce using the same standards we have … or, if not, [face a] tax,” said Mohammed Chahim, a Dutch Labour Party MEP, during a webinar in July organised by the European Council on Foreign Relations (ECFR). “It is a way to create a level playing field.”

It would also be a step towards addressing emissions based on consumption rather than production, said Chahim. At present, measures of emissions based on where goods and services are produced flatter rich countries that have outsourced much of their heavy industry to low and middle-income countries.

CBAM is a horribly complex, legally questionable and politically explosive instrument. Aaron Cosbey, International Institute for Sustainable Development

Such a mechanism is vital to encourage carbon-intensive industries, which receive 90% of their emissions allowances for free under the EU Emissions Trading System (ETS), to decarbonise, says Johanna Lehne from climate think tank E3G. However, such industries need some protection from carbon leakage, argues Aaron Cosbey, a senior associate at the International Institute for Sustainable Development in British Columbia, Canada. The alternative would be deindustrialisation, he believes.

“CBAM is an enabler of climate ambition,” says Cosbey. “At the same time, CBAM is a horribly complex, legally questionable and politically explosive instrument,” which, he suggests, the Commission would prefer it did not have to put in place.

EU industry responds

Some trade-exposed sectors, such as cement and fertilisers, have welcomed the proposals. “The EU must put a carbon border measure in place to ensure an international level playing field,” says Jacob Hansen, director general of industry group Fertilizers Europe. “Due to its high trade and energy intensity and the fact fertilisers are relatively simple products, the sector is well-suited for CBAM,” although he nonetheless called for continued free allocation of allowances.

Umbrella group BusinessEurope has also given the CBAM a cautious welcome. In a June letter to European Commission President Ursula von der Leyen, director-general Markus Beyrer described it as “an opportunity … to strengthen the EU approach against carbon leakage”. However, the organisation also called for participation by sectors to be on a voluntary basis, for no “abrupt decrease” in the free allocation of allowances, and compensation for carbon costs faced by EU companies when exporting to third countries.

Lehne at E3G agrees some sort of phase out of free allocations is sensible, given the CBAM is an untested mechanism. A gradual approach would also make the mechanism an easier sell politically. “However, it is critical the time period is defined very clearly and is limited,” she adds. The proposed ten-year transition period from 2026 means the EU “would lose another decade of action on industry decarbonisation”, she adds.

An administrative nightmare

Setting levels at which carbon border levies would be imposed ranges from the straightforward to the fiendishly complicated. For commodities such as electricity or fertiliser, the calculation is relatively simple, but for the carbon ‘embedded’ in manufactured goods, with hundreds of components from different countries, it is almost impossible.

The Commission has started simple, targeting a small number of sectors that produce commodities. According to its proposal, an exporter would be required to verify the carbon intensity of its product, and the difference between the emissions produced and the average emissions of the equivalent product in the EU would be subject to the CBAM. If an exporter cannot provide verified data, the EU would assume the product has an emissions intensity equivalent to the average of the worst 10% of EU companies in that sector.

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The logic is that this process would incentivise exporters into the EU to reduce their emissions intensity and, crucially, verify they have done so. However, the system would create challenges for poorer countries, particularly LDCs, which “already face some of the highest costs to trade in the world”, states a recent report from the Institute for European Environmental Policy. The proposal would also add a considerable regulatory burden on EU companies.

However, for all the complexity, in a world without a global carbon price, and where different countries are moving at different speeds to decarbonise their economies, this is a challenge many want addressed.

“The architecture to start to assess the carbon content of goods and create some kind of rigorous verification system around this is really important,” says Lehne at E3G. Understanding how much carbon has been emitted throughout supply chains, and where it is traded, is a vital component of moving to net zero. While getting the standards and systems in place to achieve full transparency will be a long process, “this is the direction of travel”, she adds.

Trade law hell

Understanding the carbon intensity of goods entering the EU is only one problem: the other is aligning the CBAM with trade law, as overseen by the WTO. If the CBAM is judged to have fallen foul of WTO rules, EU trading partners will be within their rights to introduce retaliatory measures, jeopardising the entire exercise.

The mechanism would also be open to a challenge if the revenues went into the EU’s general budget, as opposed to being used for specific environmental purposes.

Perhaps more serious problems lie with a secondary objective of the CBAM: encouraging EU trading partners to price carbon. By exempting (or reducing) the carbon levy depending on the exporting country’s climate policy, the CBAM could violate WTO most-favoured nation rules designed to prevent discrimination based on the country of origin.

“Theoretically, there is a way around, using Article 20” of the General Agreement on Tariffs and Trade, but the bar is very high to use that approach,” says Shuting Pomerlau, a climate policy analyst at the Niskanen Center, a Washington, DC-based think tank. Article 20 grants exceptions to measures “to protect human, animal or plant life or health” or “relating to the conservation of exhaustible natural resources”.

This is an environmental policy tool, not a tax or a tariff, it is in line with international trading rules. Paolo Gentiloni, EU economy commissioner

Meanwhile, exemptions for certain countries, such as LDCs, raises the risk that carbon-intensive goods are shipped through them to avoid the CBAM. “Transhipping would be a huge problem,” says Pomerleau. Equally, they could become “high-carbon havens”, where companies choose to build carbon-intensive manufacturing facilities.

There are ways to design a border adjustment mechanism that is WTO compliant, says Pomerleau, pointing to value-added taxes. Here, import taxes are matched by export rebates. “WTO rules allow border adjustment for an indirect [cost], such as carbon, as long as what is charged on imports and rebated on exports is not higher than that faced by domestic producers,” she says. “Better policy design would avoid differential treatment.”

These concerns are misplaced, suggested Gentiloni. The pricing of carbon under the CBAM will “mirror the EU Emissions Trading System to ensure fair and equal treatment for EU and imported products”, he told reporters. “As free allowances are phased out, CBAM will be phased in.”

He added in defence of the Commission’s proposal: “This is an environmental policy tool, not a tax or a tariff, it is in line with international trading rules, will apply to products not countries” and does not fall foul of WTO country of origin rules.

A climate diplomacy controversy

Even if this is the case, the CBAM still risks throwing a spanner in global climate diplomacy. By exempting jurisdictions with equivalent climate policies, the CBAM is intended to encourage more ambitious climate action.

However, given the sectors covered, companies across the Atlantic are unlikely to be captured by the CBAM, at least initially. The Biden Administration has raised the prospect of introducing its own carbon border levy, but with one eye on the COP26 climate talks, US Climate Envoy John Kerry has warned a CBAM should be a “last resort”.

More affected countries have been more outspoken. In June, Russian Deputy Prime Minister Alexander Novak warned the EU’s plans could clash with global trade rules and called for a compromise. Russia would face the largest costs under Commission proposals (see bar chart below). Similarly, Fei Shengchao, Minister Counsellor at the Mission of China to the EU, has called for “more consultation and discussion”. In addition, the G77 developing country grouping joined with China with “strong language against protectionism in this context” at a UN Framework Convention on Climate Change meeting in May, says Lehne at E3G.

Emily Lydgate, an international trade law specialist at the University of Sussex in the UK, believes the mechanism risks undermining rather than encouraging international cooperation on climate. By taking, as a starting point, the view that all exporters should face the same carbon costs as EU producers, it fails to recognise the concept of ‘common but differentiated responsibilities’ – a shibboleth of the international climate talks that requires the rich world to bear much of the costs of addressing climate change. “This is going to raise issues at the COP,” said Lydgate in the ECFR webinar.

“At a minimum, it imposes a huge new administrative burden on climate allies,” she says, adding that other members of the “net-zero club”, such as the UK or Canada, would qualify for an exemption. “CBAM is a high-risk proposal that could implode,” she says.

Gentiloni suggested it was normal that there was "attention, curiosity and concern at a global level", but insisted there was "great interest" at the G20 on how countries can cooperate on carbon pricing. "We stand ready to discuss CBAM in the context of the WTO and COP," he said.

Climate ambition and global cooperation should go "hand-in-hand", said Gentiloni, but insisted the EU couldn't wait "years and years" for a global carbon price. As with other measures, the EU was showing the way with the CBAM and, if it works, it "will help reach global agreement" on carbon pricing, he added.

Redirecting revenues collected by the CBAM back to LDCs to help fund their decarbonisation could reduce opposition, suggests Tim Gore, head of the Low Carbon and Circular Economy Programme at the Institute for European Environmental Policy. “If you look at the EU’s approach to carbon pricing domestically, this is a tried and tested method: if you want to increase social and political acceptability of carbon pricing, you use the revenues to support the most vulnerable parts of society,” he says.

Where do we go from here?

The Commission proposal is just the beginning of the EU’s co-decision process, which also involves the European Parliament and the 27 member states. The Parliament expressed its initial views in a report published in February that, among other things, called for the CBAM to cover all sectors included in the EU ETS and for revenues to support the objectives of the Green Deal.

That is the only way that we are going to ensure that trade policy works in conjunction with climate policy. Johanna Lehne, E3G

Stakeholders have suggested various means by which some of the issues with the CBAM might be resolved. For example, LDC opposition could be ameliorated by offering technical support, capacity building and climate finance to help carbon-intensive producers decarbonise. The EU may also use the length of the consultation and policymaking process to push the issue beyond COP26, to avoid difficult negotiations at this critical juncture.

“There are competing narratives on this even in the EU,” says Gore. “Some stakeholders hope the EU will never need to implement this – it is about encouraging the rest of the world to increase carbon pricing.”

However, others see this as a model for green trade. “Eventually, we do need some means of actually tracking the carbon intensity of different products,” says Lehne. “That is the only way that we are going to ensure that trade policy works in conjunction with climate policy.”