The EU Emissions Trading System (“EU ETS”) requires large emitters of greenhouse gases to purchase yearly certificates that allow them to produce these emissions. The purchase of these certificates represents a significant financial burden for the affected companies – even more so after prices for certificates have skyrocketed over the past months to reach over €60 per metric ton of carbon dioxide equivalent emissions.

In order to provide a level playing field with producers outside of the EU unburdened by such a “cap and trade” or similar system to tax or regulate greenhouse gas emissions, the European Commission has presented a proposal for a CBAM which is aimed at imposing an equivalent cost of emissions for goods imported into the EU. In addition, the CBAM is intended to serve as an incentive to reduce the emission of greenhouse gases in the countries of production outside of the EU. Further, it addresses “carbon leakage,” which would occur if EU producers were to transfer production outside the EU to avoid EU ETS certificate costs, or if production facilities subject to the EU’s strict emissions regime were to be displaced by lower-cost imports from countries that do not have comparable carbon emissions restrictions.

Main elements of the European Commission’s CBAM proposal

Scope

At present, the CBAM will most likely only cover a handful of sectors, including cement, fertilizers, iron and steel, aluminum and electricity. The goods covered by the scope of the CBAM are identified on the basis of their customs code in Annex I to the CBAM Proposal (“CBAM goods”). The list of sectors could be reviewed over time. All imports into the EU except those from Iceland, Liechtenstein, Norway and Switzerland will be subject to CBAM obligations.

The CBAM Proposal provides the possibility to exempt third countries from the CBAM requirements if, for example, the country is included in the scope of the EU ETS or if an agreement was made to link its own emissions trading system to the EU ETS.

How it will work: authorized declarants and CBAM certificates

EU importers must apply for authorisation to the relevant Member State authorities to become “authorized declarants”. This status would allow them to import CBAM goods into the EU. "Authorized declarants" will then have to purchase and surrender on an annual basis CBAM certificates that reflect the amount of so-called “embedded emissions” in the CBAM goods imported into the EU. Non-authorized declarants will not be able to import CBAM goods.

"Authorized declarants" must submit to the national authorities of the Member State on a yearly basis a CBAM declaration that specifies the amount of embedded emissions in the CBAM goods and the number of CBAM certificates surrendered. To do so, they would rely on the information provided by the non-EU producers on embedded emissions for the reporting through the CBAM declarations. Accredited verifiers can be used to verify emissions of operators in third countries that voluntarily register under the CBAM. The European Commission also proposes “default” calculation methods for embedded emissions of goods subject to the CBAM where actual emissions cannot be determined. The calculations shall include direct emissions, i.e. those emissions resulting from the production process itself, most notably from the combustion of (fossil) fuels, as well as indirect emissions which take into account the emissions in earlier stages of the production and related to the use of electricity.

The price of the CBAM certificates will be linked to the price of EU ETS certificates and shall reflect the closing prices of all auctions of EU ETS allowances during each calendar week.

Failure to comply with the obligations set forth under the CBAM will lead to severe fines for EU importers. Penalties under the CBAM proposal are the same as the potential penalties for EU operators who fail to surrender sufficient certificates under the EU ETS (€100 for each metric ton of carbon dioxide equivalent emitted without EU ETS certificate). Payment of a penalty does not release the “authorized declarant” from its obligation to surrender the outstanding amount of CBAM certificates. Member States may also impose additional administrative and criminal sanctions in accordance with their national legislation for failure to comply with the CBAM.

Adjustment mechanisms for number of CBAM certificates to be surrendered

The amount of CBAM certificates to be surrendered shall be adjusted to reflect:

• The carbon price paid for embedded emissions in the country of origin of the CBAM  goods. The declarant must demonstrate the overlap between the CBAM and carbon price already paid through clear records of documentation, including proof of actual payment and certification by an independent body.
• The extent to which EU ETS certificates are allocated for free due to carbon leakage rules under the EU ETS. These sectors (which are all of the sectors initially covered by the CBAM, except electricity) will be able to benefit from automatic reductions of their obligations under the CBAM.

These adjustments are designed to enhance the compatibility of the CBAM Proposal with the EU obligations under the World Trade Organization (“WTO”), in particular with the principle of non-discrimination when comparing EU produced goods with like CBAM goods.

Institutional framework

Member States shall set up a national registry of authorized declarants and relevant information with regard to the declarants’ CBAM certificates. Member States will be responsible for the enforcement of the CBAM.

In addition, the European Commission will act as a central administrator responsible for maintaining an independent transaction log recording the purchase and sale of CBAM certificates, holding and surrendering them, and for carrying out risk-based controls on transactions recorded in national registries.

A previous draft of the CBAM Proposal provided for the establishment of a designated CBAM Authority. The administration of the CBAM is likely to be pretty burdensome, given the complexities of tracing and verifying each producer’s carbon content. Time will tell whether a CBAM authority would help facilitating the implementation and enforcement of the CBAM.

Procedures at the border upon importation

Custom authorities must verify that EU importers of CBAM goods are registered in the CBAM register of the relevant Member State. Customs authorities must also regularly report to the competent authority of the Member State on the quantity of CBAM goods imported, country of origin, the date of declaration and customs procedure used.

Legislative process and entry into force

The CBAM Proposal is subject to the ordinary legislative procedure which involves the European Parliament (mainly the Committee on the Environment, Public Health and Food Safety) and the Council of the EU. This legislative process is likely to take at least one year. While a controversial interinstitutional process involving heavy lobbying by stakeholders is expected, the CBAM Proposal may become a reality faster than one may expect, as any EU Green Deal-related policy currently enjoys highest priority of the EU.

The proposed date for entry into force of the CBAM is 1 January 2026, but the registration and reporting obligation is expected  to be applicable as from 1 January 2023 in order to reduce the risk of disruptive impacts on trade.

The European Commission’s proposed legal instrument for the CBAM is a regulation. Once adopted, the  regulation becomes immediately enforceable as law in all Member States.

The CBAM as an inspiration for others?

The extent to which the CBAM Proposal prompts the adoption of similar measures in other countries remains to be seen. In the United States, there have been several legislative proposals in the 117th Congress, and the Biden administration recently signaled that it is exploring such a policy. A carbon import fee amendment by Senator Coons (D-DE) was incorporated in the Senate Democrats Budget Reconciliation Bill, which was approved by Senate and is awaiting action by the House of Representatives. The Coons proposal would impose a carbon tax on imports, but would not involve a comparable tax on domestic carbon emissions. It is thus of dubious WTO-legality and carries a high risk of trade conflict. While many House and Senate Democrats support strong action on climate change, the U.S. Congress is deeply divided and enactment of a carbon tax or other climate measures appears remote at this time. In Canada, on 5 August 2021, the government launched consultations on a carbon border adjustment. In its press release, Canada announced it would continue important conversations with its international partners, such as the United States and the EU, on ensuring a common understanding for international border carbon adjustments.

Given the WTO’s dysfunctional state and the limits of the UNFCCC/Paris Accord process, an international agreement on border carbon adjustments appears unlikely in the foreseeable future. While governments like the EU appear willing to act unilaterally to restrict competition from carbon-intensive imports, such steps carry a high risk of trade conflict. Despite recent initiatives, the EU’s CBAM is expected to be subject to heavy scrutiny from the EU’s trading partners and a WTO dispute on the legality of the CBAM does not seem unlikely.

Next steps

While there is still a high degree of uncertainty about the final outcome of the negotiations at EU level, the general framework of the CBAM is unlikely to change drastically. Companies are well-advised to follow the developments closely, and to start thinking about the necessary adjustments now. As was also the case after the introduction of the EU ETS in 2005, the CBAM is likely to lead to contractual disputes along supply chains.

Concerned operators both in the EU and outside the EU should start preparing to comply with the administrative procedure to import CBAM goods into the EU, including identifying potential business partners as authorized declarant. Navigating the entire process with great attention to detail will be necessary to avoid disruptions in trade flows as well as severe penalties.

Hogan Lovells has well-established environment and trade practices and significant experience in advising on the EU ETS. We would be happy to provide any assistance in preparing your company for the CBAM roll-out.

Authored by Lourdes Catrain, Stephanie Seeuws, Stefan Schroeder,  Finn Poll-Wolbeck, Warren H. Maruyama, and Gregory M. Hawkins.