The European Union has developed the first import tax aimed at preventing climate change. The carbon border adjustment mechanism, or CBAM, supplements the bloc’s emissions trading system. It attempts to level the playing field for carbon pricing and, in doing so, will affect trade between the EU and the rest of the world. Supply chains will change, and companies will need accounting systems that measure carbon emissions accurately.
CBAM is part of a marketplace evolution that began in 2005 when the EU established the emissions trading system as a cornerstone of its climate change policy. The system is a cap-and-trade multilateral arrangement that sets an annual maximum amount of carbon dioxide that energy-intensive industries—oil, steel, aluminum, cement, paper and glass, power stations, and civil aviation—can emit.
According to the European Commission, the emissions trading system covers approximately 40% of the EU’s greenhouse gas emissions. Affected companies must reduce emissions annually or purchase an allowance for every excessive ton of carbon dioxide they emit per calendar year. Those allowances may be used to offset emissions or bought and sold. The cap decreases annually to ensure emission reductions.
However, because EU companies have stricter emissions standards that increase production costs compared to companies outside the emissions trading system limits, the CBAM will impose a carbon dioxide emissions tax on countries with lax emissions requirements. CBAM will ensure that the carbon profile of imported products equals that of EU production by accounting for embedded carbon emissions in non-EU countries.
The tariff doesn’t apply to Iceland, Norway, and Liechtenstein—countries outside the EU that already participate in the emissions trading system—or those such as Switzerland that link their own emissions trading system to the EU’s and adopt the same carbon price.
CBAM is designed to discourage companies from shifting EU production to countries with less stringent greenhouse gas controls or from purchasing products from countries that don’t levy carbon-usage taxes. It also aims to give other countries incentive to adopt cleaner industrial production.
“This will ensure a balanced treatment of such imports and is designed to encourage our partners in the world to join the EU’s climate effort,” said Jozef Sikela, the Czech Republic’s minister of industry and trade, after the provisional agreement last Dec. 13 to implement the CBAM.
Next Steps
CBAM won the endorsement of the European Parliament’s Committee on Environment, Public Health and Food Safety on Feb. 23, 2023, and there appear to be no significant obstacles to Parliament formally adopting it at this month’s plenary session.
If approved, it would go to the European Council for a vote and then be published in the Official Journal of the European Union. The tariffs would apply initially to carbon-material intensive products chosen strategically by the EU to strengthen the fight against global climate change.
The following industry sectors and products are expected to be affected: iron, steel, cement, fertilizer, aluminum, electricity, hydrogen, and iron or steel articles.
Once approved, the CBAM would be phased in over three years, starting Oct. 1. This aligns with the emissions trading system’s phase-out schedule of free allocation allowances in support of EU industry decarbonization. The permanent system will take effect on Jan. 1, 2026.
During the phase-in, the CBAM would apply only to the number of emissions not benefiting from the emissions trading system’s free allowances. This ensures producers of goods currently covered by the system don’t receive favorable treatment over foreign producers of the same goods covered by the CBAM.
The initial period will require EU importers of goods covered by CBAM to register with the relevant EU member state as an authorized declarant, and to report quarterly CBAM submissions by listing their imports that include greenhouse gas emissions, including direct and indirect emissions occurring during the production process of the imported goods. For any rebates and other forms of compensation, these reports must include:
- The quantity of each product expressed in megawatt-hours or tons;
- Total embedded emissions; and
- Any carbon price charged in the origin country for embedded emissions accounting.
This transition period will allow stakeholders—including importers, producers and authorities—to collect meaningful information about these embedded emissions and CBAM’s functionality so the methodology can be refined. This time also allows authorities to review the product scope and determine whether to add other downstream products, such as vehicles.
Once the permanent system is implemented, EU importers will need to declare the quantity of goods imported into the EU from the prior calendar year into the CBAM registry, quantifying their embedded greenhouse gases. They would do this by using the emissions trading system to buy and surrender so-called CBAM certificates to offset the difference between carbon prices paid in the country of production and the price of carbon allowances.
If the importer can prove that the carbon used to produce imported goods in the country of origin has already been reduced or paid for, the declarant could claim a reduction in the number of CBAM certificates to be surrendered equal to the carbon price applied in the origin country. The emissions trading system would ultimately determine the tax rate based on the weekly average auction price of emissions allowances; the payable tax would be offset by carbon emissions taxes in the exporter’s country.
Compliance Challenges
These operational adjustments and others required by companies shouldn’t be underestimated. Trade implications are sure to unfold between the EU and its trading partners, which may affect the supply chain.
To comply, companies may ship low-carbon goods to the EU or shift production of EU-destined merchandise to countries that have similar emissions requirements. Corporate capital expenditures also will have to consider upgrade costs and benefits compared to offsetting compliance costs in an ever-changing global regulatory environment. Finally, companies will need to estimate their carbon footprint by implementing carbon accounting methodologies.
These are some of the costs and complexities of mitigating climate change. As businesses take them on and the effects ripple, we will find out just how effective a continental climate change tax could be.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Author Information
Jodi Ader is a manager in RSM US LLP’s trade advisory services practice.
We’d love to hear your smart, original take: Write for us.