Carbon border adjustment mechanism

Carbon Border Adjustment Mechanism

A carbon border adjustment mechanism (CBAM) is an environmental finance tool designed to equalize the price of carbon between domestic products and imports, aiming to prevent "carbon leakage." This phenomenon occurs when companies relocate carbon-intensive production to countries with less stringent climate policies to avoid higher carbon costs, undermining global efforts to reduce greenhouse gas emissions. The CBAM falls under the broader category of international trade policy. By imposing a levy on imported goods based on their embedded carbon emissions, a CBAM seeks to create a level playing field and encourage cleaner industrial production worldwide.

History and Origin

The concept of a carbon border adjustment mechanism gained prominence as countries and blocs, particularly the European Union (EU), intensified their climate change mitigation efforts. The EU, having implemented a robust Emissions Trading System (EU ETS), recognized the risk of carbon leakage. To address this, the EU enacted Regulation (EU) 2023/956 on May 10, 2023, establishing its Carbon Border Adjustment Mechanism. This landmark regulation, part of the EU's "Fit for 55" package, came into force in October 2023, with reporting obligations beginning immediately and financial implications starting from January 1, 2026. The gradual introduction of the CBAM aligns with the phasing out of free allowances under the EU ETS, aiming to support the decarbonization of EU industry and encourage similar climate action globally.²⁰, ²¹

Key Takeaways

• A Carbon Border Adjustment Mechanism (CBAM) imposes a carbon price on imported goods to prevent carbon leakage.
• It aims to level the playing field between domestic industries facing carbon costs and foreign producers.
• The EU's CBAM initially covers carbon-intensive goods such as cement, iron and steel, aluminum, fertilizers, electricity, and hydrogen.
• Importers are required to purchase CBAM certificates corresponding to the embedded emissions of imported products.
• The mechanism is intended to incentivize non-EU countries to adopt or strengthen their own carbon pricing policies.

Formula and Calculation

The calculation of the financial liability under a Carbon Border Adjustment Mechanism involves determining the embedded greenhouse gas emissions of imported goods and applying a carbon price. While specific formulas may vary by implementing jurisdiction, the general principle is to mirror the carbon cost that would have been incurred had the goods been produced under the domestic carbon pricing regime.

For the EU CBAM, the number of CBAM certificates to be surrendered corresponds to the total quantity of goods imported during a calendar year, multiplied by the embedded emissions of each good.¹⁹ The price of these CBAM certificates is pegged to the average weekly closing price of allowances under the EU Emissions Trading System.¹⁸

The embedded emissions for a given good are typically calculated based on:

$\text{Embedded Emissions (tonnes CO}_2\text{e)} = \text{Activity Data} \times \text{Emission Factor}$

Where:

• (\text{Activity Data}) refers to the amount of material or energy consumed in the production process (e.g., tonnes of clinker for cement).
• (\text{Emission Factor}) is the amount of CO(_2)e emitted per unit of activity data.

The total cost to the importer would then be:

$\text{CBAM Cost} = \text{Embedded Emissions} \times \text{Price per CBAM Certificate} - \text{Carbon Price Paid in Origin Country}$

Importers can claim a reduction in the number of CBAM certificates to be surrendered if a carbon price has already been paid in the country of origin for the declared emissions.¹⁷ This credit for carbon pricing abroad is a critical design feature to ensure fairness and prevent double taxation.¹⁶

Interpreting the Carbon Border Adjustment Mechanism

Interpreting the Carbon Border Adjustment Mechanism involves understanding its dual objectives: environmental protection and economic competitiveness. By placing a carbon price on imports, the CBAM ensures that EU producers, who bear costs under the EU Emissions Trading System, are not disadvantaged compared to those from countries with laxer climate policies. This mechanism helps to internalize the external cost of carbon emissions, making high-carbon products more expensive and thus encouraging consumers and producers to opt for lower-carbon alternatives.

The effectiveness of the CBAM can be gauged by its ability to reduce carbon leakage and to drive sustainable development in third countries. It creates economic incentives for non-EU nations to adopt their own carbon pricing schemes or invest in decarbonization technologies, as doing so would reduce the financial burden on their exporters when trading with the EU. The mechanism underscores a global shift towards integrating climate policy with trade policy.

Hypothetical Example

Consider a company, "GreenSteel EU," manufacturing steel in the European Union, subject to the EU Emissions Trading System, which currently prices carbon at €80 per tonne of CO(_2)e. A competitor, "CheapSteel Co.," located in a non-EU country with no carbon pricing mechanism, exports steel to the EU.

Let's assume:

• Production of one tonne of steel by GreenSteel EU results in 1.5 tonnes of embedded CO(_2)e emissions, costing GreenSteel EU €120 in carbon allowances.
• Production of one tonne of steel by CheapSteel Co. also results in 1.5 tonnes of embedded CO(_2)e emissions, but it pays no carbon price domestically.

Under the CBAM, when CheapSteel Co. imports one tonne of steel into the EU, the EU importer would be required to purchase CBAM certificates for 1.5 tonnes of CO(_2)e. If the CBAM certificate price is also €80 per tonne of CO(_2)e (pegged to the EU ETS price), the importer would pay €120. This effectively brings the carbon cost of imported steel in line with domestically produced steel, ensuring fair market access and competition. If CheapSteel Co.'s home country later implemented a carbon tax of, say, €40 per tonne, the EU importer would then only pay the difference, or €60 (€80 - €40), per tonne of CO(_2)e.

Practical Applications

The Carbon Border Adjustment Mechanism has significant practical applications across several carbon-intensive sectors, including iron and steel, cement, fertilizers, aluminum, hydrogen, and electricity. For businesses ¹⁴, ¹⁵engaged in international trade, particularly those exporting these goods to the European Union, understanding and complying with the CBAM is crucial. It directly influences supply chain management, as companies must accurately track and report the embedded emissions of their products.

The mechanism ¹³incentivizes companies globally to invest in cleaner production processes. For instance, in the aluminum sector, which is highly energy-intensive, the CBAM encourages the adoption of renewable energy sources to reduce emissions. Furthermore, it¹¹, ¹² can drive innovation in industries like hydrogen manufacturing, boosting the market for "green hydrogen" produced with a lower carbon footprint. The CBAM also p¹⁰rompts non-EU countries to consider implementing their own carbon pricing schemes to avoid their exporters paying the full CBAM charge upon entry into the EU, thus fostering a broader global movement towards decarbonization.

Limitations⁹ and Criticisms

Despite its stated goals, the Carbon Border Adjustment Mechanism faces several limitations and criticisms, particularly concerning its potential economic impact on developing countries and its compatibility with international trade rules. Critics argue that the CBAM could disproportionately burden less developed economies, which often rely on carbon-intensive industries and may lack the financial and technological resources to transition quickly to low-carbon production methods.

Some analyses ⁷, ⁸suggest that the CBAM could lead to increased costs for non-EU producers, potentially impacting their competitiveness and market access in the EU. For example, a ⁶report by the Centre for Science and Environment (CSE) claimed that the CBAM could impose a significant additional tax burden on carbon-intensive goods from countries like India. Concerns have a⁵lso been raised regarding the CBAM's alignment with World Trade Organization (WTO) rules, particularly principles of non-discrimination, although the EU maintains its compliance. Furthermore, th⁴e administrative burden of calculating and reporting embedded emissions could be substantial for businesses, especially smaller enterprises in developing nations. An IMF working ³paper notes that while Border Carbon Adjustments are effective in addressing carbon leakage, design details are critical, and they alone do not solve the "free-rider problem" in carbon pricing.

Carbon Bord²er Adjustment Mechanism vs. Emissions Trading System

While both the Carbon Border Adjustment Mechanism (CBAM) and an Emissions Trading System (ETS) are tools for carbon pricing, they operate differently and address distinct aspects of climate policy. An Emissions trading system, like the EU ETS, is a domestic or regional cap-and-trade scheme that sets a limit on the total amount of certain greenhouse gas emissions that can be emitted by industries within its jurisdiction. Companies covered by the ETS must acquire and surrender allowances for their emissions; these allowances can be traded on a market, creating a carbon price. The primary goal of an ETS is to drive domestic decarbonization by making pollution costly.

In contrast, a Carbon Border Adjustment Mechanism is an external measure. It applies a carbon price to imported goods that originate from countries without an equivalent carbon pricing mechanism. The main purpose of the CBAM is to prevent "carbon leakage"—the relocation of carbon-intensive production to regions with less stringent environmental regulations—which could undermine the effectiveness of domestic carbon pricing policies like an ETS. The CBAM acts as a border tariff, ensuring that imported products face similar carbon costs to those produced domestically, thereby maintaining the competitiveness of local industries. Essentially, an ETS regulates emissions within a territory, while a CBAM addresses the carbon content of goods entering that territory.

FAQs

What is carbon leakage?

Carbon leakage is the phenomenon where companies move their carbon-intensive production from countries with strict climate policies and high carbon costs to countries with looser regulations and lower costs. This relocation can offset the environmental benefits achieved by the stricter policies, as global emissions may not decrease or could even increase.

Which products are covered by the EU CBAM?

Initially, the European Union's Carbon Border Adjustment Mechanism covers imports of certain carbon-intensive goods and selected precursors, including cement, iron and steel, aluminum, fertilizers, electricity, and hydrogen. The EU plans to assess and potentially expand the coverage by 2030.

How does the C¹BAM affect businesses outside the EU?

Businesses outside the EU that export covered goods to the EU will need to provide data on the embedded greenhouse gas emissions of their products. Importers in the EU will then be required to purchase CBAM certificates corresponding to these emissions, effectively increasing the cost of goods from countries without a comparable carbon pricing scheme. This incentivizes non-EU producers to decarbonize their operations or for their home countries to adopt their own carbon pricing policies.

Will the CBAM increase costs for consumers?

The CBAM aims to internalize the cost of carbon emissions. For products covered by the mechanism, importers face additional costs, which could potentially be passed on to consumers in the form of higher prices for imported goods. However, it also creates an incentive for producers to reduce their emissions, which could lead to lower carbon costs over time. The overall economic impact on consumers is subject to various market dynamics and supply chain adjustments.