Regulation | ~ 4 min read

CBAM: adjusting for carbon leakage

Some companies may seek to dodge stringent emissions rules by shifting operations to cheaper, less-regulated locations. The new Carbon Border Adjustment Mechanism aims to prevent this.

The European Union’s Carbon Border Adjustment Mechanism (EU CBAM) came into force in October 2023. The regulation addresses “carbon leakage,” where companies might seek to offset the rising costs of emissions by switching their production to locations with less stringent environmental policies. It works by applying a carbon price to imports into the European Union to cancel out any competitive advantage that firms may gain.

Two-phase transition

The regulation aims to both lower emissions and ensure firms that pursue greener production processes are not at a competitive disadvantage. In the first phase, which continues into 2025, importers are required to simply declare the emissions of the production processes of imported goods. Initially, this applies to six sectors – steel, concrete, aluminium, electricity, hydrogen and fertiliser production – representing around 50% of EU carbon emissions. This phase is expected to have limited impact.

The second phase begins in 2026 and will have a bigger impact. It requires importers to buy EU carbon certificates to remedy the price advantage that products manufactured in locations with less stringent climate policies might have. Companies will be required to transition from declarations to payments. The EU considers CBAM neither a tax nor a tariff and states that it complies fully with World Trade Organization requirements.

Others view it differently. CBAM risks friction with China and the US, as well as other countries with high export volumes to Europe like Canada, South Africa, Brazil and Turkey.1 Most impact assessments mask the potential impact on smaller economies because they focus on measuring trade value or CO2 volumes which will be less significant compared to larger importers but could still have an impact.2

Consideration of local carbon pricing systems in these calculations will present an additional challenge. Finally, by putting the burden of transition on other countries, the EU may be counter to the principle of “common but differentiated responsibilities” at the core of the United Nations Framework Convention on Climate Change.

Greener imports

The EU wants to promote greener products, rather than discourage imports. CBAM will be accompanied by a progressive phasing-out of free emissions trading allowances in the EU carbon market, originally put in place to avoid carbon leakage. The success of CBAM will likely depend on the EU convincing its partners that it is not a protectionist tool.

While the introduction of CBAM is a step in the right direction, the jury is still out on whether it can be successfully implemented to move the needle on reducing carbon emissions.

1 S&P Global, February 2023, Developing economies hit hardest by EU’s carbon border tax
2 Magacho, G., Espagne, É. & Godin, A. (2022), Impacts of CBAM on EU trade partners: consequences for developing countries

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