The EU Agreement on a Carbon Border Adjustment Mechanism

On December 13, 2022, the Council of the European Union ("the Council") and European Parliament came to a provisional agreement on the final text of a Carbon Border Adjustment Mechanism ("CBAM") regulation. The compromise text was released to the public in January 2023.

The CBAM regulation would require importers of certain energy-intensive goods to pay a levy in respect of their imports that corresponds to the price of emissions allowances under the EU Emissions Trading System ("EU ETS"). Reporting obligations under the CBAM will apply starting from October 1, 2023, while the obligation for importers to pay a levy will kick in as of 2026. 

The final text of the CBAM regulation will require formal adoption by both the European Parliament and the Council, and will then be published in the Official Journal of the European Union. Therefore, these agreements will not be final until early-to-mid 2023.

Purpose of CBAM

The CBAM regulation would require importers of certain carbon-intensive goods to pay a levy on their imports corresponding to the charge imposed on comparable domestic industries under the EU ETS, thus extending the carbon price paid by EU firms to foreign producers of the same goods.¹  The overarching rationale of the regulation is to address the risk of "carbon leakage", which would occur if the greenhouse gas ("GHG") emissions reductions achieved within the EU under the EU ETS were to be offset by covered operators shifting their operations to jurisdictions outside the scope of the EU ETS and/or by EU firms increasing their imports from such jurisdictions.²

CBAM Entry into Force

The European Parliament and the Council agreed that the CBAM regulation would enter into force on October 1, 2023.³  There will be a three-year transition period, during which only reporting obligations will apply.⁴ After the transition period, the CBAM will be gradually phased-in, at the same pace that EU ETS free allowances in sectors covered by the CBAM are phased-out.⁵ In the interim, the CBAM will only apply to the proportion of emissions not benefitting from free allowances under the EU ETS.⁶  This is intended to ensure that producers of goods covered by the EU ETS are not treated more favourably than foreign producers of the same goods which are covered by the CBAM.⁷ The EU ETS compromise agreement indicates the below timeline for the phasing out of free allowances: 

Thus, while obligations under the CBAM for importers to pay a charge in respect of their imports will enter into force on January 1, 2026, this obligation will only become fully operational in 2034, the year in which EU ETS free allowances are fully phased out.⁹

Scope of CBAM

Products

According to the compromise text, the CBAM would apply to the following goods when imported into the EU:

• Iron and steel; 
• Cement; 
• Fertilizers; 
• Aluminium; 
• Electricity; and
• Hydrogen.¹⁰

The Commission will adopt implementing acts to further define the scope of the CBAM, including regarding the system boundaries of production processes and the relevant precursor materials, emission factors and default values.¹¹

Before the end of the transition period, the Commission will have to report on various issues to assess whether to extend the scope of the CBAM.¹²  At least one year before the end of the transition period, the Commission will be required to prepare a report to evaluate the proposed scope to determine if it should include products further down the value chain from those currently listed in Annex 1.¹³

^Countries 

CBAM would apply to covered products imported from all countries outside the EU, unless the country (i) already participates in the EU ETS – such as Iceland, Liechtenstein and Norway, which are part of the European Economic Area ("EEA") – or (ii) fully links its own emission trading system to the EU ETS and adopts the same carbon price as paid under the EU ETS – such as Switzerland.¹⁴

Calculation of Emissions

According to the current draft, the embedded emissions of goods are calculated by dividing the attributed emissions by the quantity of goods produced at the installation in the reporting period.¹⁵

In this context, the term "embedded emissions" encompasses both direct and indirect emissions. Direct emissions are defined as "emissions from the production processes of goods […]", ¹⁶ while indirect emissions refer to emissions relating to "the production of electricity consumed in the production processes of goods".¹⁷

Indirect emissions will not be calculated in respect of CBAM certificates for goods listed in Annex 1A, currently:

• Iron and steel; 
• Aluminium; and
• Hydrogen.¹⁸

However, for other products included in the scope of the regulation, indirect emissions would be included. The Commission will report on the scope, as mentioned above, and this may change depending on the recommendations of that report. 

Products will be divided into "simple" and "complex" goods for the purpose of calculating emissions.¹⁹ "Simple goods" are defined as goods produced in a production process requiring exclusively input materials and fuels having zero embedded emissions and "complex goods" encompass all other goods.  For complex goods, the calculation of emissions will need to take into account the embedded emissions of the input materials (precursors) consumed in the production process.  The Commission's implementing acts will elaborate on how goods listed in Annex 1 will be broken down into these categories.²²

The Commission's implementing acts will provide additional detail on the calculation method for both direct and indirect emissions.²³ For indirect emissions, Annex III also lays out the requirement that the Commission's implementing acts will include the calculation of default values.²⁴ It will be possible for an importer to include the actual embedded emissions from the production of electricity, rather than the default values prescribed by the Commission. This will be subject to the CBAM declarant, demonstrating that there is direct link to the electricity generation source or there is a power purchasing agreement for the same amount of electricity as is claimed.²⁵

Reporting obligations during transition period

During the transition period, from 1 October 2023 until 31 December 2025, importers will have to submit a CBAM report containing information on the goods within scope of the CBAM. The deadline for the report will be one month after the end of each quarter. The first report is thus due in January 2024. CBAM reports need to include: (i) the quantity of each type of good expressed in megawatt-hours or tonnes; (ii) total embedded emissions subject to clarification in the Commission's implementing acts and (iii) any carbon price due in the country of origin for the embedded emissions in the imported goods, taking into account rebates and other forms of compensation.²⁶

Sales and Price of CBAM Certificates

As of January 1, 2026, the CBAM will require importers of the covered goods and products to purchase and surrender "CBAM certificates" for the products' embedded emissions, at a price equivalent to that set for EU ETS allowances.²⁷  The text proposes that the Commission take the average of the closing prices of the EU ETS allowances on the common auction platform on a weekly basis to determine the price of CBAM certificates.²⁸  The Commission will ensure that all certificates have a "unique identification number" assigned to them and that they are registered to the account of the CBAM declarant after purchase.²⁹

CBAM Declarations and Verifications

An importer that is required to surrender CBAM certificates will need to apply to become an authorised CBAM declarant.  CBAM declarants will be required to set up a CBAM account with the EU Member State of importation and, each year, surrender to that Member State the number of CBAM certificates corresponding to the level of carbon emissions embedded in the products that they have imported, as verified by accredited bodies.³¹ CBAM declarations will need to be made annually by the end of May to the CBAM registry, in respect of the preceding calendar year.³² Declarations must include:

• The quantity of each type of good expressed in megawatt-hours or tonnes;
• The total embedded emissions in those goods that have been calculated and verified under the regulation;
• The total number of CBAM certificates to be surrendered – corresponding to the quantity of emissions mentioned above minus any carbon price paid in the origin country; and 
• A copy of the verification report issued by an accredited verifier.³³

Bodies shall be accredited for the purpose of making verifications under CBAM, in accordance with the procedure set out under Commission Implementing Regulation (EU) 2018/2067,³⁴ which applies to the trading of GHG emissions in the Union. 

Carbon prices paid in other countries

Where a carbon price has been paid in the country of origin in respect of GHG emissions embedded in the goods, the CBAM declarant could be able to claim a reduction in the number of CBAM certificates to be surrendered equal to the carbon price already paid in the third country. This only applies to the extent that the carbon price is not rebated or compensated, and independent certification will be required.³⁵  The Commission is expected to adopt a set of rules for determining how this reduction will be applied.³⁶

Enforcement 

The compromise text sets out the penalties and enforcement mechanisms in cases of non-compliance, with competent Member State authorities empowered to apply penalties in several situations. 

Where a CBAM declarant has not surrendered the necessary certificates by May 31, in respect of the preceding year,  the declarant will have to pay a penalty of EUR 100 for each tonne of carbon dioxide equivalent for which it has not surrendered CBAM certificates, to be increased in line with consumer prices.³⁸

If covered goods are imported by a person who is not an authorised CBAM declarant, then the penalty will be three to five times higher, depending on the "duration, gravity, scope, intentional nature and repetition" of the non-compliance, as well as the level of cooperation seen in the investigation.³⁹ In non-compliance cases, it will be necessary to purchase and surrender the required number of CBAM certificates in addition to paying the penalties stipulated under the regulation. 

The draft includes provisions to prevent circumvention, defined as a "change in the pattern of trade in goods, which stems from a practice, process or work, for which there is insufficient due cause or economic justification other than avoiding, wholly or partially, any of the obligations laid down in the [r]egulation". ⁴⁰

Next Steps

The final text of the CBAM regulation requires formal adoption by both the Parliament and the Council and will then be published in the Official Journal of the European Union. Therefore, these agreements are not yet final and will not be final until early-to-mid 2023.

_{1 Chapter II of Draft Regulation of the European Parliament and of the Council establishing a carbon border adjustment mechanism (CBAM) – Compromise Text.
2 See, e.g., Recital 8.
3 Article 36.
4 Article 32.
5 Article 31(1).
6 Article 31(1).
7 See Recital 11.
8 Percentage of free allocation retained. The reduction of free allowances is to be calculated as provided for in Article 10a(1a) Proposal for a Directive of the European Parliament and of the Council amending Directive 2003/87/EC establishing a system for greenhouse gas emission allowance trading – Compromise text.
9 Please see our client alert: European Parliament and Council Reach Agreement on Carbon Border Adjustment Mechanism and EU Emissions Trading System; Council of the EU. 'Fit for 55': Council and Parliament reach provisional deal on EU emissions trading system and the Social Climate Fund. 18 December 2022.
10 Certain downstream products are also covered such as screws and bolts made from iron and steel, see for the detailed list of materials included: Annex I. Products made from the covered goods under the inward processing procedure pursuant to EU customs rules are also subject to CBAM, see Article 2(1). Consignments under a certain de minimis value will not be covered, see Article 2a.
11 Article 7(6).
12 These include: (i) other goods at risk of carbon leakage (i.e.organic chemicals and polymers), (ii) embedded indirect emission for the sectors mentioned in Annex 1A, which do not currently have indirect emission included in the CBAM calculations, (iii) embedded emissions relating to the transport of goods and transportation services, and (iv) other precursor materials for the goods listed in Annex 1.  See Article 30(2)(a).
13 Article 30(2a).
14 Article 2(3) and (5). A separate exemption mechanism is foreseen for the importation of electricity, Article 2(8) and Annex II.B.
15 Where the inputs for a good present embedded emissions and are considered complex goods themselves, the formula used will also include additional calculations to incorporate the emissions that resulted from the production of those inputs. Specific rules apply to the calculation of embedded emissions of imported electricity.
16 This includes "emissions from the production of heating and cooling consumed during the production processes, regardless of the location of the production of the heating and cooling". Article 3(15).
17 Annex III(2).
18 Article 7(1).
19 Annex III.
20 Annex III (1)(a).
21 Annex III.3, and subject to implementing acts.
22 Article 7(6).
23 Article 7(6).
24 Annex III(4.3).
25 Annex III(5a).
26 Article 35.
27 Articles 20-22.
28 Article 21.
29 Article 20.
30 Articles 5 and 17.
31 Articles 6 – 8.
32 Article 6.
33 Article 6.
34 Article 18.
35 Article 9(1) and (2).
36 Article 9(4). 
37 Article 26(1).
38 Article 26; Article 16(3) and (4) of Directive 2003/87/EC.
39 Article 26(2).
40 Article 27.}

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