Carbon markets and taxonomy, where do we stand today?
1. What is the CBAM
In 2005, Europe set up the world's largest carbon market with the aim of controlling and limiting the amount of greenhouse gases emitted: the Emissions Trading System (ETS). Member states set a sliding scale on the amount of carbon on the market annually and then allocate them free of charge or by auction to companies, i.e. around 11,000 installations in 31 countries, around 45% of the EU's GHGs . The scheme aims to reward the most virtuous companies, which can sell their assets, and to penalise those that emit too much carbon, forced to buy allowances on the market.
Today, the EU is working on a new mechanism to complement the EU ETS: the Border Carbon Adjustment Mechanism (BCAM) or commonly known as the border carbon tax:
- In March 2022, the European Council reached an agreement on the regulatory text that frames it.
- On December 16 and 17, 2022, the EU agreed on new points covering, among other things, the expansion of the sectors impacted and an acceleration of the implementation of the mechanism with, among other things, more ambitious medium-term objectives.
For a quick reminder of the framework, the MACF text is part of the "Adjustment to Target 55" package proposed as part of the Green Deal for Europe, regulated by European climate law. The goal of the pact is to be the first climate-neutral continent by 2050, with an intermediate target of a 55% reduction in GHG emissions for Europe by 2030 compared to the base year 1990. In this article, we will see what the Border Carbon Adjustment Mechanism consists of and how it is closely linked to the EU ETS.
2. Why a new carbon scheme?
With the European Green Deal, the EU is showing its strong ambition to become a pioneer in the ecological transition. As a result, this desire is inevitably accompanied by highly restrictive regulations that sometimes penalize companies in the territory.
The main risk of this dissymmetry between the EU and the rest of the world (non-EU areas, European Economic Area and Switzerland) is the relocation and transfer of greenhouse gas emissions to countries with less stringent environmental requirements. Some companies would benefit from relocating their most emission-intensive activities to third countries (cost reduction) and some EU products would risk being replaced by more carbon-intensive imported products.
Themain objective of the carbon tax is therefore to prevent carbon leakage from the EU as well as to limit the transfer of responsibility for polluting emissions to these countries while the goods and services produced are destined for Europe. Not containing this leakage would significantly undermine the EU's GHG emission reduction efforts, since from a global perspective the real local reductions would be offset or even exceeded by the increase in relocated emissions.
Finally, by imposing this carbon adjustment mechanism at the borders, Europe also hopes to encourage its partner countries to introduce carbon policies that are just as ambitious as those of Europe in order to remain competitive on its market.
3. How does CBAM work?
The border carbon adjustment mechanism will require importing companies to purchase certificates, i.e. carbon allowances at the market price (the amount of which, expressed in €/tonne of CO2, is set each week by the ETS), depending on the goods imported, or to prove that the producer has already paid the corresponding amount.
In order to comply, importers will have to declare each year before 31 May the goods imported during the last 12 months, the carbon volume associated with them and justify their purchases of corresponding MACF certificates. The number of allowances purchased will have to correspond to the carbon density that the same product manufactured within the EU would have. Depending on the difference, the balance will be rebalanced, with a penalty if the company does not justify enough certificates and a deduction if it does.
Today, the OECD notes that there is little offshoring of carbon generated by the ETS. This may no longer be the case as Europe moves towards decarbonization to meet the Green Deal targets. Thus, the ultimate goal of the MACF is to replace the current system of allocation of free EU ETS allowances and to prevent possible carbon leakage. These free allowances will be progressively phased out and will disappear completely by 2034. At the same time, the allowances offered on the market will be reduced by 62% in 2030 compared to 2005, in contrast to the 43% reduction set before this new agreement, always with the objective of further accelerating the transition to the MACF.
Regarding the revenues collected by this new carbon tax, 75% of them will be dedicated to the EU budget to boost the European economy and make it more independent from other economies.
4. CBAM: who is concerned?
To ensure the implementation of the Carbon Border Adjustment Mechanism, the planned deployment is gradual across the sectors and emission categories taken into account (scopes 1, 2, 3). The products concerned will therefore evolve over the next few years. For the moment, the CBAM only affects direct emissions (scope 1) in the manufacture of products and concerns five of the most emitting sectors at risk in terms of carbon relocation. The sectors are as follows:
- Cement
- Aluminium
- Fertilizers
- Production of electrical energy
- Iron and steel
- Hydrogen
In December 2022, the European Union reached an agreement on the application of this tax on fuel, gas and heating oil, which will have a significant impact on households. It also adopted a broadening of the scope of the tax, which will address in a second phase the maritime sector, emissions from intra-European flights and waste incineration sites (still under discussion within the EU).
Among the sectors that would be interesting to see included in this MACF are the paper and cardboard and chemical industries. Together they contribute 8% of the European industrial sector's emissions.
To date, only primary products are targeted by the CBAM because they are easier to monitor from a carbon point of view, unlike the rest of the value chain, whose reporting complexity increases with the diversity of products. The risk of restricting CBAM to primary products is to create carbon leakage downstream of production, and thus limit the desired emission reduction outcomes. We will have to wait for the second phase of deployment and the results obtained to hope for a revision of the products covered by the CBAM and to push for a decarbonization of the broader value chain .
5. What are the next key dates for the CBAM?
Different phases have been defined for the deployment:
- 2023: Start of reporting for the companies concerned on the emissions from their imported products,
- 2026: Implementation of the MACF and coexistence with the EU ETS (free carbon allocation), possible updating of the scopes and industries covered,
- 2034: End of the free carbon allocation of the ETS and full transition to the MACF.
6. Some reservations about the CBAM
The complexity in monitoring and establishing the Border Carbon Adjustment Mechanism will reside in several important points, among which:
- The difficulty of carbon traceability (for example, tracking the origin of electricity consumed) and the costs of implementing carbon reporting. The EU gives companies three years to refine their carbon reporting.
- Dialogue with third countries on the measure to avoid potential trade retaliation. It is hoped that partner countries will be encouraged to introduce a similar carbon pricing system and/or invest in "greener" production technologies in order to facilitate trade under the MACF.
- The risk of an increase in the price of raw products but also of finished products. The impact is already measurable following the agreements of the end of 2022 which concerns in particular primary fossil fuels still largely consumed by households. The EU will have to justify how it will support the most vulnerable consumers facing the addition of carbon tax, through the redistribution of aid from its "Social Fund for Climate".
- The risk of a drop in European competitiveness for exports, as the MACF only applies to imports into the EU.
- The current limitation for the first phase of deployment to the scope 1 emissions of products.
As the planned deployment is gradual and subject to adjustment, the EU may, after evaluating the effects during the first phase of deployment (reporting of imported emissions from 2023), extend this carbon tax at the borders to several new sectors. It would be interesting and relevant toextend this tax to the emissions of scopes 2 and 3 of products that are not currently taken into account.
Conclusion
The MACF is an important step forward in the plan to decarbonise the European economy and make Europe carbon neutral by 2050.
While many issues will need to be refined and monitored during its deployment, the Border Carbon Adjustment Mechanism is encouraging because it shows that the EU is making progress on the issue ofcorporate carbon accountability, with more ambitious measures that involve actors outside the continent. The objectives set by the EU for 2050 are thus integrated into the global economy and could encourage more countries to follow the path of decarbonization in line with the challenges of the environmental transition.
Bibliography
1 - Carbon adjustment at borders - risks and opportunities for European industry
3 - Border carbon adjustment mechanism: Questions and answers
4 - Council agreement on the Carbon Border Adjustment Mechanism (CBAM)
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