ICIS EU Carbon: Carbon Border Adjustment Mechanism – possible implementations and EUA market implications

This analysis has originally been published in an extended version for ICIS EU carbon subscribers on 24 November 2020 at 17:08 CET.

In December 2019, the idea of a Carbon Boarder Adjustment Mechanism (CBAM) was introduced by the European Commission as part of its Green Deal. With debates ongoing in the European Parliament, the concrete implementation of the measure remains unclear at this point. This Analyst Update gives an overview of possible ways of implementing a CBAM and an outlook on what we think the CBAM will most likely look like.

In short

The three ways of implementation currently discussed are a carbon tax on imports and domestic production, a customs duty on imports and the extension of the EU ETS. In our opinion the integration into the EU ETS seems to be the most likely option, as it appears the least challenging from an international trade law point of view, and would provide a level playing field for both domestic and foreign producers.

There is political will to phase out free allocation, but the question of potential export rebates remains open. If EU producers are no longer given free allocation, they fear that they will not be able to compete on international markets in the absence of support for export via rebates. There are however legal challenges with regards to rebates, leaving a question mark behind the feasibility of such a measure.

In theory, a CBAM would have no effect on the EUA market, but the individual measures require adaptations to the cap and free allocation. If well-designed, these adaptations would have no effect as they would equally reduce or increase supply and demand. If free allocation is phased out, these volumes would likely increase the auction supply. Depending on the specific implementation, however, both bearish and bullish effects are possible.

Main Points

• The idea of a CBAM was first presented by the European Commission in December 2019 as part of the EU Green Deal
• On 7 October 2020 rapporteur Yannick Jadot (Greens) presented a draft report in the Environment Committee of the European Parliament (ENVI), aiming for the introduction of a CBAM no later than 2023
  • The report will be voted upon in the ENVI committee by the end of January 2021, and a vote in the plenary is scheduled for March 2021
• The Commission is expected to publish an implementation proposal for a CBAM in June 2021

Analysis

Implementation options

• A CBAM could be implemented as a carbon tax, as a customs duty or as an extension to the EU ETS, all of which would require the calculation of carbon benchmarks for products to be covered by the measure
  • A carbon tax on both imports and domestic production would require a cap reduction
    • The surrender obligation for domestic producers would have to be reduced accordingly to avoid double taxation
    • A decision on taxes requires unanimity in the European Council to be adopted
  • A customs duty on imports would require increased international involvement
    • It would require the renegotiation of existing tariff arrangements under WTO trade rules or regional and bilateral trade agreements
    • A decision on customs duties requires unanimity in the European Council to be adopted as well
  • In the case of an extension of the EU ETS to imports, importers would have to buy allowances to cover their emissions or pay a levy based on the market price of allowances
    • The type of allowances accepted could be EUAs, a separate pool of virtual allowances or allowances from other established markets with clear emission caps
    • It would require a qualified majority vote in the European Council to be adopted
• While industrials often advocate a continuation of free allocation, lawmakers see a CBAM as a possibility to phase out free allowances in the long term – this raises the question of export support schemes to ensure a level playing field for domestic producers
  • Export rebates are discussed as an alternative to free allocation, but could bring about legal issues (see below)
  • The idea of export rebates is to pay back a part of the carbon cost of products from sectors covered by the EU ETS to keep these products competitive on international markets

Legal requirements

• A CBAM could be covered by exceptions from WTO rules, but including export rebates would likely mean that the measure would have to fully comply with the general international trade rules
  • Exceptions to international trade rules are defined under Art. XX of the WTO’s General Agreement on Tariffs and Trade (GATT)
    • The exceptions apply if a measure is “necessary to protect human, animal or plant life or health” (Art. XX b GATT) or “relating to the conservation of exhaustible natural resources […]” (Art. XX g GATT)
    • Since a CBAM on imports can be considered an environmental measure, it could be covered under these exceptions
  • Any CBAM incorporating export rebates would be likely to be covered by the more general Art. I, II, III GATT, since export rebates are primarily measures of protectionism
    • Under these rules, the CBAM must be a “non-discriminatory measure”
    • Any rebates exceeding a firm’s actual carbon costs could be viewed as illegal subsidies, thus increasing the risk of international legal action against the measure and retaliation measures by international trading partners
    • Another issue is the vague term of “likeliness” of products – depending on whether the (so far not clearly defined) legal definition includes carbon intensity of products, products may or may not have to be taxed equally, and a differentiation by the carbon content of a product might breach international trade rules

What would be the impact of a CBAM on the EU ETS?

• A CBAM on imports could, with the appropriate calculation of carbon intensities, create a level playing field for European markets
  • Without any measures to support exports, products included in the EU ETS would however be less competitive on markets outside the EU if free allocation is indeed phased out
• In case of a carbon tax on imports and domestic production the EU ETS cap would have to be reduced, since part of the carbon cost would be paid through the carbon tax instead of EUAs – this would not be the case for a customs duty that would apply to imports only
• If the CBAM is implemented as an extension of the EU ETS, the cap would have to be raised to account for additional demand through imports

Who advocates which position?

Industry

• In general, carbon intensive industrial sectors like metals, steel, and chemicals and fertilizers are rather critical of a CBAM
  • They argue that the introduction of a CBAM without export rebates while phasing out free allocation would jeopardize industry’s international competitiveness
  • Some sectors (e.g. the Chemicals sector) have expressed doubts that a fair calculation of carbon intensity benchmarks is even possible given the variety of products in the sector

EU legislators

• Currently, positions on the political side still differ
  • During a consideration of the draft report by the ENVI committee held on 28 October, most MEPs involved agreed that free allocation should be gradually phased out and all industrial sectors should be integrated into a CBAM in the long run, starting with the carbon intensive sectors such as energy, steel, chemicals and fertilizers
  • The export rebates often demanded by the industry continue to be the subject of intense debate
    • The Committee on Economic and Monetary Affairs (ECON) advocates the introduction of export rebates while free allocation should be progressively phased out following an appropriate transition period
    • The European Parliament Committee on Industry, Research and Energy (ITRE) recommends inclusion of export rebates in the mechanism should at least be considered
    • According to the amendments tabled in the ENVI committee, MEPs from the European Left are the only ones who strictly oppose export rebates
  • The Committee opinions as well as the draft report in ENVI fall short of specifying implementation details
    • The ECON Committee recommends an extension of the ETS and the inclusion of imports and exports
    • The ITRE committee favours a sector-by-sector introduction, starting with those sectors facing the highest risk of carbon leakage
    • The ENVI committee advocates a sector-by-sector introduction, starting with the carbon intensive sectors like energy, steel, chemicals and fertilizers
• The European Commission, having put forward the idea of a CBAM, so far has not given any details on how it is planning to implement the measure
  • A proposal by the Commission is expected in June 2021

What we think the CBAM will look like

• The option to extend the EU ETS seems to be the most likely solution
  • It adheres closely to the mechanism faced by domestic producers
  • Therefore, it provides the lowest risk of breaching international trade law and retaliation measures from international trade partners
• The CBAM will most likely start with only a few sectors involved, probably the most carbon intensive, and later extend to all other sectors included in the EU ETS
  • We currently expect the introduction by 2023 envisaged by ENVI rapporteur Jadot to come to early – 2024 appears to be a more likely target
• Free allocation is likely to be phased out and may be replaced by export rebates – but legal hurdles around this instrument remain
• We currently expect the carbon intensity of a product to be calculated using a default value based on the average carbon intensity, including indirect emissions
  • Companies may be given the possibility to show that their product is less carbon-intensive than the default value, or that the carbon price is higher in the country of origin
  • Companies would only have to pay the difference between their domestic carbon price and the respective price on imports into the EU

Sebastian Rilling is Analyst – EU Power & Carbon Markets. He can be reached at Sebastian.Rilling@icis.com
Rica Schäfer is Junior Analyst – EU Power & Carbon Markets. She can be reached at Rica.Schaefer@icis.com

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