The 14th of July 2021 was a very significant date in terms of EU environmental policy. The European Commission published a series of proposals to revise EU legislation with the aim of reducing the greenhouse gas (GHG) emissions of the European Union by at least 55 percent by 2030.

Within a package of 13 legislative proposals on climate, energy, and transport, the European Commission proposed to reform the current EU Emissions Trading System and to implement a Carbon Border Adjustment Mechanism (hereinafter referred to as CBAM). Both proposals were formally adopted in April this year.

In order to comprehend the purpose of the CBAM, it is fundamental to understand the functioning and limitations of the EU Emissions Trading System. The EU Emissions Trading System, often referred to as EU ETS, is a carbon market based on the principle of “cap and trade” which has operated since 2005. The maximum volume of GHG emissions that can be emitted by the power plants, industry factories, and the aviation sector covered by the EU ETS is yearly defined with a cap of emissions allowances. Each emission allowance gives participants the right to emit 1 tonne of carbon dioxide (CO2e) equivalent. Companies participating in the EU ETS can trade their emissions allowances in an auction if they have an excess or a deficit of allowances to cover the GHG emissions resulting from their installations.

Emissions allowances or carbon permits are freely allocated to certain sectors which are considered at high risk of being relocated outside the European Union. The purpose of the EU ETS is to decrease the overall GHG emissions of the European Union over time by reducing the cap based on an annual rate called the linear reduction factor. As part of the agreement on the revision of the EU ETS, the linear reduction factor will be raised to 4.3 percent for the period 2024-2027 and to 4.4 percent for the period 2028-2030. As a point of reference, the total number of allowances in circulation in the EU ETS in 2022 was 1,134,794,738 allowances.

According to the European Commission, the EU ETS has reduced emissions from power generation and energy-intensive industries by nearly 43 percent in the past 16 years. However, the fact that some of the allowances are freely allocated does not give an incentive to participating companies to reduce their carbon emissions. In order to cope with this issue, the EU ETS has been structured in different phases to gradually replace the free allocation of emissions allowances by the auction system of trading carbon permits.

As the free emissions allowances are phased out in the EU ETS, there is a risk of production being relocated outside the European Union, creating an incentive to import products from countries with lighter environmental regulations. The CBAM regulation adopted by the European Union intends to address this issue, also known, as carbon leakage.

In the first stage, the CBAM applies to goods whose production is at a higher risk of being relocated, such as iron and steel, aluminium, hydrogen, electricity, cement, and fertilisers. However, it is expected that the scope of the CBAM will be broadened to cover other products related to activities subject to the EU ETS.

From October 2023, EU companies importing these goods from outside the European Union will need to report the embedded emissions in those products. During the first phase of the implementation of the CBAM, importing companies will only need to report quarterly on the total embedded direct and indirect emissions produced through the manufacturing chain. However, from January 2026, importing companies will need to purchase CBAM certificates to cover the reported emissions unless the products have been imported from a country with a similar system to the EU ETS. The price of the CBAM certificates will be based on a weekly average price of the EU ETS emissions allowances, which is defined on a daily basis.

While the EU ETS sets a cap on the total number of emissions allowances issued within the system, the CBAM does not establish a limit on the number of products that can be imported into the European Union. On the other hand, the EU ETS applies to the installations producing certain products in the European Union while the CBAM covers specific imported goods defined by their CN codes.

Finding the right balance between environmental efforts and business competitiveness can be challenging. In the absence of the CBAM, EU manufacturers facing carbon pricing are at a disadvantage compared to companies operating in countries without an emission trading system equivalent to the EU ETS. Ultimately, the CBAM intends to ensure equal treatment between domestic and imported products and to incentivise other countries to develop their own emissions trading systems.

What will be the impact for non-EU companies exporting to the European Union?

In this context, EU importers are likely to start reviewing their global supply chain, monitor and request information on GHG emissions from imported products, and consider the financial implications of CBAM in their procurement strategy. EU importers may also face supply chain disruptions for incorrect classification of CN codes or lack of information in the CBAM declaration. This will have an effect on their trading partners around the globe for those products covered by the CBAM in the short and long term.

While the companies responsible for the reporting and purchasing of CBAM certificates are the EU importers of goods covered by the CBAM, it is in the interest of non-EU exporters to lower the emissions embedded in those products. As per the CBAM regulation, when actual emissions cannot be adequately determined, default values can be considered. However, default values may be higher than real data and include emissions which were not actually generated.

EU importers are likely to choose non-EU producers which manage their carbon emissions.  As it happens with other legislation, it is expected that EU importers will prefer working with foreign companies that help them to remain compliant and reduce their operational costs.

Since other countries are currently developing or are expected to develop emission trading systems, non-EU producers can use this opportunity to stay ahead of future regulation in the countries where they operate. Moreover, they can also remain competitive by tracking their emissions, implementing an emissions reduction strategy and using more efficient technologies during the production processes.

Reporting and compliance with CBAM obligations are likely to be based on digital processes. Having the information centralised in a reporting platform minimises the administrative burden for business partners and authorities’ procedures. Additionally, non-EU exporters will need to consider within their business strategy that the price of their products will be higher for EU importers provided that these products have not been subjected to carbon pricing in the country of origin.

In brief, the CBAM is a legal instrument with strong environmental ambitions and financial consequences for EU importers and non-EU exporters. At the same time, the CBAM brings an opportunity for non-EU producers to make progress in their decarbonisation journey. Since other countries are planning to develop similar mechanisms, implementing an appropriate strategy on time is key to remain competitive.

Iris de Orte Júlvez has a background in law and economics and holds more than 10 years of international experience in legal, compliance and finance. Iris also has a specialization in sustainability, holding a Master’s degree in Sustainability and Corporate Social Responsibility, she is currently writing a PhD on the impacts of technology in the three pillars of sustainability and working as Chief Compliance Officer at D-Carbonize.

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