By Paul A. Davies, Michael D. Green, and James Bee
The CBAM would seek to mitigate carbon leakage through the imposition of a levy on carbon-intensive imports into the EU, while free allowances under EU ETS would be phased out.
On 13 December 2022, negotiators from the European Parliament and European Council reached a provisional and conditional agreement on the terms of the EU’s carbon border adjustment mechanism (CBAM).
The CBAM was initially proposed by the European Commission in July 2021 as part of its “Fit for 55” package of policies. The measure seeks to address and mitigate the risk of “carbon leakage” from the EU, which refers to the risk that the EU’s greenhouse gas reduction efforts will be offset by increasing emissions outside of its border through the relocation of production to non-EU countries with less ambitious emissions reduction policies.
The CBAM would impose a levy on in-scope goods that are imported into the EU. Importers of such goods would be required to pay an amount equal to the cost of the emissions allowances under the EU Emissions Trading System (ETS) that would have been necessary to pay to produce that good in the EU.
Status of the Provisional Deal
While the CBAM agreement remains provisional, further discussions continue in relation to the proposed update of the EU ETS. The update considers the phasing out of free allowances and also requires, in the words of the European Council, “further work on exports”.
The EU ETS negotiations play a vital role, since the CBAM and the EU ETS are inextricably linked in their contributions to EU emissions policy. Under the EU ETS, entities in high-emitting sectors are provided with “free allowances” for a certain amount of emissions, so as to mitigate replacing the carbon leakage that would be caused by EU entities that are required to surrender allowances under the EU ETS by non-EU entities manufacturing the same products that are not subject to such costs.
The update to the EU ETS would phase out these free allowances over time in certain sectors, and replace them with the CBAM (which would impart an additional cost on products entering the EU, as opposed to reducing costs on domestic EU products by providing free allowances). The phasing in of the CBAM and the phasing out of free allowances are envisaged to work in parallel (e.g., as free allowances drop by a certain percentage each year, the CBAM will be phased in by the same percentage), to ensure a smooth transition for entities in relevant sectors. As a result, the exact timing of the implementation of costs under the CBAM remains subject to the timing of the phasing out of free allowances under the revised EU ETS.
Unlike the provision of free allowances under the EU ETS, the CBAM would not provide assistance for EU entities looking to export their products to third countries. EU negotiators continue to discuss an approach to rectifying this potential issue.
Terms of the Provisional Deal
The provisional agreement confirms that the CBAM will initially cover a number of specific products in some of the most carbon-intensive sectors:
- iron and steel;
- electricity and hydrogen as well as some precursors; and
- a limited number of downstream products including screws, bolts, and similar iron and steel items.
The Commission will also assess whether to extend the scope to other goods at risk of carbon leakage, including organic chemicals and polymers, with the goal to include all goods covered by the EU ETS by 2030.
Under the provisional agreement, the CBAM would begin to operate from October 2023 and apply initially to reporting obligations only. The full CBAM would then be phased in, matching the timeline of the phase-out of free emissions under the EU ETS.
As noted above, the deal depends on a final agreement on the revised EU ETS, and all eyes will turn to ongoing discussions in that regard. Once such an agreement exists, the European Parliament and the European Council will look to formally adopt the CBAM, at which point it can formally enter into force 20 days after its publication in the EU’s Official Journal.
Latham & Watkins will continue to monitor updates in relation to the CBAM, the EU ETS, and other European and global regulatory updates in relation to the climate.
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