What is the Carbon Border Adjustment Mechanism?

In recent weeks, we have frequently been hearing in the news about the concerns of the international community to take actions aimed at reducing greenhouse gas emissions (GHGs) and the "carbon footprint" of industrial products. This is one of the topics at the 16th G20 meeting in Rome, Italy (October 30 and 31, 2021) and the 26th. summit conference of the UN world leaders (over 100 countries) on climate change (COP 26) taking place in Glasgow, Scotland from October 31 to November 12, 2021.

Additionally, a current news story in our country is the potential proposed energy reform, which promotes the generation of electricity through fossil fuels.

The intention of this article is to review the initiatives launched mainly by the European Union (EU) and the United States (USA) to try to discourage the production of goods that generate what is called "carbon leakage", through the mechanism discussed here.

CBAM stands for "Carbon Border Adjustment Mechanism", also known as "Carbon Border Adjustment Tax" in the USA and as "MAFC" in the Spanish version, that is, "Mecanismo de Ajuste en Frontera por Carbono".

Background

Why does the European Commission (EC) propose a mechanism for carbon adjustment at the border?

On July 14, 2021, the European Commission published the document (of 291 pages) titled "Proposal for a REGULATION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL establishing a carbon border adjustment mechanism", as part of the European Green Deal that seeks to reduce carbon emissions by 55% based on 1990 emissions, by 2030 and to make Europe a carbon-neutral continent by 2050.

It establishes that the CBAM is a climate measure that seeks to prevent the risk of carbon leakage and contribute to the growing European ambition to mitigate environmental effects, while complying with World Trade Organization (WTO) regulations.

Climate change is a global problem that requires global solutions. While the EC increases its climate ambitions, there are countries outside the region where less strict environmental regulations prevail, which could increase the risk of carbon leakage, as companies established in Europe, whose production is carbon-intensive, could relocate their operation outside the region in order to take advantage of these more lax regulations, or that European products could be replaced by more carbon-intensive imports. This would shift emissions outside of Europe and therefore seriously undermine the EU's and the rest of the world's climate change efforts.

The CBAM will match the price (of emissions) of carbon between domestic products and imported ones and will ensure that the EU's climate objectives are not undermined by the relocation of production to countries with less ambitious environmental policies.

What does the CBAM consist of?

The CBAM complies with WTO rules and will operate as follows: CE importers will acquire carbon certificates corresponding to the carbon price that would have been paid if the corresponding goods had been produced under the CE's carbon pricing rules. In turn, once a non-European producer can demonstrate that they have already paid a price for the carbon used in that third country in the production of the imported goods, the corresponding cost can be fully deducted by the European importer. The CBAM will help reduce the risk of carbon leakage by encouraging producers in non-European countries to make their production processes "greener".

The revenues from the CBAM will contribute to the EC's budget, as established in the Interinstitutional Agreement of December 2020 on budget and own resources.

Which countries are launching this initiative?

In addition to the initiative of the countries that make up the EU, carbon border adjustment mechanisms are already operating in some regions of the world; for example, in California where an adjustment is applied to certain electricity imports. Canada and Japan are planning similar initiatives. Additionally, the International Monetary Fund (IMF) and the Organization for Economic Cooperation and Development (OECD) have recently carried out work to study how these measures could help international efforts to reduce greenhouse gas emissions.

In the statement issued after the board meeting of their meeting on July 9-10, 2021, the ministers of the G20 also mentioned the need for greater international cooperation for the use of carbon pricing mechanisms.

Coincidentally, in the United States, on July 19, 2021, Senator Chris Coons (D-Del.) and Representative Scott Peters (D-Calif.) unveiled new legislation (“The FAIR Transition and Competition Act of 2021”) to establish a border carbon adjustment (BCA) on imports of polluting goods in order to offset the costs that US companies will incur to comply with laws and regulations limiting greenhouse gas emissions, also arguing that this measure will protect jobs in the US and reduce global emissions. The imposition of a fee on imported pollution will address carbon leakages that undermine urgent climate actions. It comments that this import fee will be based on the domestic environmental cost incurred (by the local industry) and will initially cover goods that are both intensive in (generation of) carbon as well as those exposed to intense commercial competition, including aluminum, cement, steel, iron, natural gas, oil, and carbon.

Which countries will be most affected?

The analysis published by “Rabobank Research” on July 16, 2021 (by Alexandra Dumitru, Barbara Kölbi and Maartje Wijffelaars) comments that, based on their exports Russia, Turkey, Ukraine, India and China are among the countries that will be most affected by the CBAM. Within the EU Bulgaria and Greece will see an impact on their imports of products under the CBAM, although in total imports represent a small part of their GDP.

The publication “US lawmakers push carbon border tariff similar to EU’s CBAM” from Euractiv.com, July 22, 2021, has stoked fears among emerging countries, including China, who expressed their concern that this measure will create new trade barriers.

As a reference, this same publication indicates that the week of July 15, 2021, the carbon price in China's ETS (Emissions Trading Scheme) scheme, set a carbon price of 51.23 yuan - around 7 euros, the same day of its launch. In comparison, the carbon price in the EU on the same date was 50 euros/ton. According to Simone Tagliapietra of Brugel economic (a Brussels think tank), a coordinated CBAM measure between the EU and USA will increase pressure on China, the world's most polluting country, to start reducing its greenhouse gases.

What industrial sectors are contemplated within this initiative?

The carbon border adjustment mechanism (CBAM) will be implemented gradually. Initially, it will apply to a limited number of goods with a high risk of carbon leakage, such as:

cement
iron and steel
aluminum
fertilizers
imported electricity (or indirect emissions which are the carbon emissions of the electricity used to produce the good)

And according to a report by Allianz Research, the ones that may follow are:

basic chemicals
industrial gases
paper

In the US initiative (BCA) discussed above, The FAIR Transition and Competition Act of 2021, it is stated that this import fee will initially cover goods that are both intensive in carbon generation as well as those exposed to intense international commercial competition, including:

aluminum
cement
steel
iron
natural gas
oil and
carbon.

As you can see, there is a great coincidence in the criteria and in the products subject to this mechanism, both in the EU and in the USA.

The Allianz Research publication of October 14, 2020 titled "European Climate Policy Goes Global" shows the location of carbon leakages by sector in the risk space (see Figure 1). The size of the bubbles is proportional to emissions and the color indicates whether direct or indirect emissions dominate the sector. The vertical axis measures the relative exposure to costs related to the carbon price (emission intensity in Kg of CO2/euro) and the horizontal axis estimates the ability to pass these additional costs onto customers. The risk increases if we move up or to the right of the diagram. The border for the primary risk assessment is indicated by (above) the red line. As seen in the diagram published by Allianz Research, sectors with more than 50% direct emissions (blue bubbles) dominate the diagram.

Diagram of location and size of sectors at risk of leakage

When will the CBAM come into effect?

In order to give certainty and stability to companies and other countries, it will be from the year 2023 when a system will begin to be applied in which importers will have to report the implicit emissions (those generated during their production) in these products with the objective of facilitating their smooth deployment and facilitating dialogue with third countries and importers, and it will be from the year 2026 when importers will begin to pay the carbon tax or adjustment.

In the meantime, dialogue with third countries will continue in multilateral forums and in bilateral relations. As the CBAM aims to stimulate and encourage cleaner production processes, the EU is ready to work with low- and middle-income countries in order to achieve the decarbonization of their industries. The EU will provide technical assistance to developing countries.

What actions have some steel-producing companies already taken to reduce carbon leakage?

In specialized publications and in presentations to investors, actions such as the following are already being discussed, and the trend is surely irreversible:

From 2025, the German vehicle manufacturer BMW will use steel produced with up to 95% reduction of CO2 emissions, in which no coal is used, through an agreement with the Swedish company “H2 Green Steel”, which uses hydrogen and renewable energies for the production of steel. Data obtained as of October 22, 2021.
The auto parts manufacturer Gestamp will offer its customers steel with “X Carb green steel” certificates as a result of an agreement with ArcelorMittal (AM) based on AM's decarbonization initiatives, being the first tier1 to offer them, in its effort to reduce CO2 emissions from its activities and in its supply chain. Data obtained as of October 22, 2021.
ThyssenKrupp Steel announces the production of certified steel with a low level of CO2, with a reduction of up to 70%. Data obtained as of October 7, 2021.
At their last conference with investors, on November 4, 2021, Heikki Malinen (President and CEO) and Pia Aaltonen-Forsell (CFO) of the Finnish stainless steel producer Outokumpu, reported the reduction of their levels of CO2 emissions and their comparison with the European average and those of China and Indonesia.

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