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Radical changes proposed to the EU Carbon Border Adjustment mechanism

© Supplied by Photographer: KrisztCarbon Border Adjustment mechanism
Photographer: Krisztian Bocsi/Bloomberg

On July 14, 2021 the EU unveiled its much anticipated ‘Fit for 55’ package of proposals to align the trading block with its 2030 emission reduction targets.

A key component of the package is the introduction of a Carbon Border Adjustment Mechanism (CBAM) which will apply a levy on certain goods imported into the EU by reference to the embedded carbon emissions within the goods. One of the key design principles it to create a level playing field by imposing an equivalent carbon price on imported goods through a new levy: currently, if a manufacturer is in the EU it is subject to carbon pricing via the EU Emissions Trading Scheme, but if they are outside the EU they are free of carbon pricing pressures.

© Supplied by (Photo: Richard Frew
Derek Leith, EY’s UK Tax Sustainability Leader.

As a consequence, the threat of ‘carbon leakage’ (the displacement of carbon intense industries from the EU to other jurisdictions) ought to be eliminated through the CBAM. At present, carbon leakage is addressed by installations within the EU ETS being awarded free allowances to ensure they remain competitive with their non EU peers. With the introduction of the CBAM, free allowances are no longer necessary and were initially proposed to be phased out over a 10 year period from 2026 to 2035.

CBAM is an ambitious policy and the first such carbon border mechanism to be deployed at scale. Therefore, it came as a surprise this week to discover reports that the EU lawmaker leading the negotiations on the implementation of CBAM has determined that the initial proposals are not radical enough.

Proposals reportedly include: that the scope of CBAM be expanded to include hydrogen, organic chemicals and polymers (alongside the original aluminium, cement, iron, steel, fertilisers and electricity); that the levy apply to embedded indirect emissions as well as direct emissions; that the transitional period, where there is a reporting obligation but no actual levy applied, be shortened from three to two years; and that the levy apply from 1 January 2025 rather than 1 January 2026. In addition, he proposes that the phasing out of the ETS free allowances is greatly accelerated such as to eliminate them entirely by 2028, rather than 2036.

The EU cement industry has been the first to react to the proposed changes claiming they will be a ‘fatal blow’ to the competitiveness of the EU’s producers.

We will have to wait and see how these amendments play out within the EU, and what the exact design of the final provisions will be. However, it is clear that the EU is determined to maintain momentum on its emission reduction goals. At the beginning of 2021 the EU carbon price was at an all time high of 33 euros and commentators were predicting a price of 100 euros by the end of the decade. In reality, the price reaching 90 Euros in December 2021, albeit driven by the extremely tight gas market which caused a switch to coal-fired power generation and a surge in demand for carbon permits.

The newly introduced UK ETS has been in operation for a year. It is a copy of Phase IV of the EU ETS and its first fundamental review is due in 2023. However, given the EU Fit for 55 reforms – which extend the EU ETS to include the maritime sector – propose a new ETS for transport and buildings, as well as these radical proposals for CBAM, the UK ETS is in danger of being left behind. One rational move could see the future of the UK ETS formally linked to the EU ETS, and if that is to be the case we can expect signs of significant domestic reforms during 2023.

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