No level playing field

Europe's carbon levy will accelerate adoption of carbon pricing, but not everyone will win

Earlier this week, the European Parliament reached a preliminary agreement with the Council to impose the world’s first levy on carbon intensive products entering the EU.

The policy is likely to accelerate the global adoption of carbon pricing as an instrument of decarbonisation. However, as this article demonstrates, there will be winners and losers. Those countries able and willing to expend the political capital to implement an explicit price on carbon are likely to benefit from those that cannot.

The levy, otherwise known as the Carbon Border Adjustment Mechanism (CBAM) seeks to address the problem of ‘carbon leakage’. This is whereby firms located in the EU might lose market share to more carbon intensive products exported into the EU by firms located elsewhere in the world.

This might prompt a carbon intensive firm (or even a whole industry) based in the EU to move its operations to a jurisdiction where power generation is more carbon intensive and / or where there is less onerous environmental regulations (see The battle for Europe's industrial sovereignty).

Carbon leakage hasn’t really been an issue so far, but as carbon prices increase the more likely it is that it will be factored into corporate decision making. The CBAM should put EU firms obligated under the EU ETS on a level playing field with firms outside the EU. In turn, the CBAM removes uncertainty over the competitive position of EU based companies, thereby increasing the incentive to invest in climate mitigation.

The implication of this is that there would no longer be any need to protect industries vulnerable to ‘carbon leakage’ with free allowances. Indeed, as the CBAM is introduced, free allowances will be gradually withdrawn (see Europe's steel industry yet to feel the full force of the carbon market).

Originally expected to cover imports of iron and steel, cement, fertiliser, aluminium and electricity, the CBAM will now also extend to cover imports of hydrogen, indirect emissions (those caused by the production of the energy used in the manufacturing process) under certain conditions, certain precursors, as well as some processed products including screws and bolts and similar articles made from iron or steel.

A transition period will begin on 1st October 2023 in which only reporting obligations apply. Originally expected to begin in full in 2026, a final decision on when the CBAM will start is expected to take place later in December, but there is likely to be an implementation period of at least three years before carbon intensive imports into the EU first face a charge.

A decision on whether to add other processed products as well as organic compounds and plastics will be made before the end of the transition period. Nevertheless, the plan is that all sectors covered by the EU ETS will also be subject to the CBAM by 2030.

Businesses that export products covered by the CBAM into the EU will need to purchase CBAM certificates based on the volume of goods brought in and the independently-verified emissions content of those goods. The price of CBAM certificates will closely mirror the prices of an allowance in the EU ETS (see Hedging the CBAM).

Raising their game

The only way to avoid buying a CBAM certificate is if the country of origin has the same climate ambition as the EU. It follows that the CBAM should act as an accelerant for global climate ambition and the adoption of carbon markets as an instrument for decarbonisation.