The European Commission is currently discussing a draft of a proposal for a Carbon Border Adjustment Mechanism (“CBAM”) Regulation that it is expected to present on July 14, 2021.  A CBAM was already announced in the European Commission’s Communication for a Green Deal  and is intended to protect the EU’s domestic industry that is at risk of carbon leakage—to create a level playing field—and to serve as a policy tool to encourage third countries to reduce their greenhouse gas (“GHG”) emissions.

The CBAM draft proposal is subject to intense negotiations among the different Directorates-General of the European Commission, and it is likely that it will be amended several times before the Commission finally presents it on July 14.  Nevertheless, the draft already suggests that the CBAM proposal will require importers of covered goods into the EU to purchase and surrender a number of CBAM certificates that reflect the goods’ embedded emissions.  In line with the European Parliament’s resolution, the CBAM would be linked to the EU Emissions Trading System (“EU ETS”) as the price of the CBAM certificates would reflect the average price of the ETS allowances.

The CBAM proposal is likely to have the following elements:

  1. Geographical Scope: The CBAM is expected to apply to a limited category of goods that are imported from all third non-EU countries except those of the EEA. The European Commission would be empowered to adopt delegated acts excluding particular countries from the CBAM if they are fully integrated into the EU ETS or they conclude an agreement with the EU linking the third country’s emissions cap-and-trade system to the EU ETS.
  1. Product Scope: Initially, the CBAM is expected to cover only imported goods of certain sectors that in the EU are among those determined to be at high risk of carbon leakage: cement, certain fertilizers, iron and steel, and aluminum. In addition, the CBAM would cover electricity. The Commission would have the power to increase or reduce the sectors covered.  For example, it could later include paper, glass, and chemicals, as the European Parliament requested in its resolution.
  1. CBAM Authorized Declarants: Only persons authorized as declarants by a CBAM Authority to be created by the European Commission would be able to import goods falling within the scope of the CBAM into the EU. These authorized declarants would be liable for any failure to comply with the CBAM Regulation’s obligations.  The CBAM Authority would maintain a partially public registry of all authorized declarants and the CBAM certificates they hold.
  1. CBAM Declarations and Certificates: Every year, by May 31, authorized declarants would be required to submit to the CBAM Authority a CBAM declaration reflecting the emissions embedded in the covered goods they imported during the previous calendar year and the number of CBAM certificates corresponding to the total embedded emissions in the imported goods that the declarant is surrendering.

One CBAM certificate will correspond to one tonne of CO2 or its equivalent GHG emissions embedded in goods imported by an authorized declarant.  The general principle is that the number of CBAM certificates must be equal to the total embedded emissions of the imported goods.  The embedded emissions declared must be verified by an independent verifier accredited by the CBAM Authority.

  1. Product Carbon Footprint Methodology: The CBAM declarations must contain the total quantity of covered goods imported during the calendar year expressed in megawatt hours for electricity and in metric tons for other goods, multiplied by the embedded emissions. The embedded emissions include direct and indirect (electricity) emissions released during the production of a goods.  They would also include the emissions of input products within the system boundaries that the Commission would define.

Neither the methodology nor other elements of the CBAM seem to take into account the different levels of development of countries across the globe, particularly in the developing world.  Depending on how this issue is ultimately addressed, the CBAM may raise questions of compliance with WTO law.

  1. Emission Reduction Efforts in Third Countries: The draft CBAM proposal tries to take into account the emission reduction efforts of third countries where the imported goods are manufactured. Authorized declarants may claim a reduction in the number of CBAM certificates that they must surrender corresponding to the carbon price paid in the goods’ country of origin.  This carbon price would be the amount paid in the third county in the form of a tax or emissions allowances under a GHG emissions trading system, which would have to be proved and certified.  The EU may conclude agreements with third countries in order to take into account their carbon pricing mechanisms.

The draft proposal does not seem to allow for taking into account measures other than taxes or cap-and trade systems to reduce emissions in third counties.

  1. Continuation of Free Allowances for EU Sectors at Risk of Carbon Leakage and Adjustments to the CBAM Declaration: The draft CBAM proposal foresees that during an initial period to be specified, EU installations at risk of carbon leakage would continue to receive free allowances under the EU ETS. During that period, the CBAM certificates that authorized declarants must surrender would be reduced to reflect the extent to which free allowances continue to be allocated to the EU domestic industry. This adjustment would be necessary to ensure the CBAM’s compliance with WTO law.
  1. Price of CBAM Certificates: The price of the CBAM certificates would reflect the price of the EU ETS allowances. The CBAM Authority would be empowered to sell CBAM certificates to authorized declarants at a price reflecting the average weekly closing price of all auctions of the EU ETS allowances.  Arguably, authorized declarants would be able to purchase the CBAM certificates any time before the surrendering date, but the CBAM authority would only be required to repurchase the declarant’s excess certificates to a maximum of 10% of all the certificates purchased by the declarant during the prior year.  All other certificates in excess of 10% would be canceled each year at the end of the reporting year.  The wording of the draft proposal seems to suggest that authorized declarants would not be able to sell their CBAM certificates to other authorized declarants or third parties.
  1. Penalties: Authorized declarants that fail to surrender by May 31 of each year a number of CBAM certificates corresponding to the embedded emissions in their imported goods or that submit false information would be liable to a penalty equivalent to three times the prior year’s average price of CBAM certificates that the declarant failed to surrender.
  1. Transitional Period: The draft CBAM proposal also foresees an initial transitional period of three years. During this period, customs authorities of the Member States would have to ensure that declarants of covered imported goods and electricity pay a CBAM price.  This CBAM price would reflect the average weekly price of the EU ETS allowance, multiplied by the embedded emissions of the imported goods, which would be calculated on the basis of the default values that reflect the average (rather than the worst 10%) emissions of the EU-based production of similar goods, unless the third country can demonstrate that the average emission intensity of a product in the third country is lower.
  1. Not a Tax: The European Commission seems determined to ensure that the CBAM is not a tax under EU law, in order to facilitate the European Parliament’s and Council’s adoption of the CBAM Regulation through the ordinary legislative procedure without the need for unanimity among the Member States.  The CBAM Regulation would be based on Article 192(1) of the Treaty on the Functioning of the European Union (e., the clause to adopt EU environmental legislation), which also raises a question about the extent to which Member States could create their own CBAMs to cover additional industrial sectors. 
  1. Ordinary Legislative Procedure: As indicated above, once the Commission presents its proposed CBAM Regulation, the proposal would have to go through the ordinary legislative procedure in the Parliament and Council.  This process is likely to take at least one year (and on overage it would take over 18 months) and will provide Member States and Members of the European Parliament with the opportunities to introduce significant changes.  This procedure will also provide industry, trade associations, and third countries with opportunities to influence the wording of the CBAM Regulation that the EU finally adopts.

In addition to the details of the CBAM Regulation yet to be concluded by the EU, it also remains to be seen how the EU’s pending efforts to adopt the CBAM will affect other international carbon pricing and climate mitigation efforts.  However, the timing of the EU’s movement on the CBAM is significant in the context of the G7 Communiqué from the Cornwall meeting, which “acknowledge[s] the risk of carbon leakage” and “recognise[s] the potential of high integrity carbon markets and carbon pricing to foster cost-efficient reductions in emissions levels, drive innovation and enable a transformation to net zero.”  These actions provide important fodder for the prospect of a more significant international agreement on carbon pricing as momentum continues to build toward the Glasgow COP 26 in November.