CBAM – The last hope

The EU’s strategy to initiate a global carbon tax movement

The latest climate models suggest that a worldwide carbon tax is essential to limit global warming to under 2°C, a limit strictly outlined in the Paris Agreement and defined by the scientific community as the threshold before irreversible and catastrophic weather events would start. A carbon price, according to the Intergovernmental Panel on Climate Change (IPCC), would bring a reduction in greenhouse gas emissions by encouraging innovative green alternatives, while providing the necessary funding.

The European Union, the global leader in climate-related policy, has a legal obligation to achieve net-zero emissions by 2050, as outlined in the Climate Law mandated back in 2021. To reach this ambitious target, the EU has implemented stricter rules in its already existing Emissions Trading System (ETS) such as an increased yearly emissions cap and systems to stabilize certificate prices. Generally, the EU ETS covers Europe’s electricity production and manufacturing sector, about 40% of the continent’s total emission production, and as for now, stands as the most advanced carbon pricing initiative in the world.

The EU ETS requires over 10,000 companies to receive a set number of emission certificates, directly proportionate to their carbon footprint, mainly for free, and to pay for the exceeding ones in the market from companies that have certificates to spare. Currently, the EU cannot make those initial certificates payable due to the risk of companies outsourcing the production to third countries because of unattractive local economic conditions. This current outlay of the system also encouraged some local factories to decrease their local production while importing more carbon intensive products from abroad in order to save on certificates, which would later be sold in the ETS market to generate additional revenue.

The EU has been solely moving towards being the global leader in green policy and carbon pricing frameworks since the signing of the Kyoto Protocol back in 2005. The rest of the countries only advanced in a poor and rather fragmented way, up until CBAM was officially mandated in mid-2023.

Carbon leaking into the EU market – A major challenge for an effective CO2 tax

The European economy has been facing a major hurdle in advancing its most effective green policy – a carbon tax. This problem is known as carbon leakage. This issue arises when EU-based companies choose to import manufacturing goods from abroad, which are on average more carbon intensive, rather than producing or sourcing them locally. Not only this phenomenon increases global emissions as greener EU goods are substituted for more carbon intensive ones, but it also undermines the effectiveness of Europe’s green policy, as its own market chooses to shift production outside of the EU’s regulatory scope.

In order to kickstart a policy that effectively taxes the total consumption of greenhouse gasses and not only its production, the EU recognized that it must regulate not just its local factories but also its imports. This realization led to the development of the Carbon Border Adjustment Mechanism (CBAM): the last missing piece of the puzzle of the EU green policy and the first move towards global greenhouse gas taxation.

The consequences of CBAM

Initially, during the transitional period, CBAM forces international factories exporting to the EU to disclose their greenhouse gas emissions. This serves as a starting point to ensure that a CO2 price is fairly assigned to both local production and imports. This mechanism works jointly with the Emissions Trading System (ETS) as its price per ton of CO2 is used also for CBAM. This creates the base of a comprehensive regulatory framework that could potentially become the worldwide’s first well functioning carbon tax and also set the price for other initiatives in other countries.

The CBAM’s impact extends beyond regional policy: it is a potential driving force for global climate action, encouraging the decarbonization of industrial processes and promoting the adoption of national carbon taxes worldwide. This is because international carbon taxes can be deducted from the price of the EU ETS (more on this later).

The CBAM is anchored in three key objectives that align with the broader goals of the EU’s climate policy:

• Maintain Competitiveness: It aims to level the carbon costs for both EU-produced and imported goods. This approach is crucial to ensure that European companies remain competitive, especially compared to firms in countries with less rigorous environmental regulations.
• Fulfill Environmental Goals: The CBAM, along with other EU initiatives, plays a crucial role in helping the EU reach its primary climate goals, including the big target of having no net emissions by 2050.
• Generate Global Benefits: By imposing a cost on carbon-intensive production, the CBAM indirectly promotes cleaner industrial practices beyond the EU borders, encouraging countries outside the EU to adopt more sustainable production methods. More on exporter’s market fracturing, in a blog post to be published soon.

Understanding the importance of the strict emission measurement rules of CBAM

The main objective of the transitional period of CBAM is to ensure that factories worldwide track CO2 emissions like EU manufacturers currently do within the EU ETS. This means that not only the emission boundaries (scope 1, 2 & 3) but also the measurement rules must align with the strict and 15-years long emission measurement standards factories in the EU are used to dealing with. For instance, this means that the transport of goods and employees, mining and several other emission drivers are not included in the scope of CBAM, which is mainly focused on capturing the emissions derived from the processes happening below a factory’s roof.

Secondly, it is worth mentioning that emission measurement tools that take rigorously accurate estimates are not compliant with CBAM, as the regulation foresees a traditional way of surveying. This means that, in order to comply with CBAM, efforts should not be made towards finding a tool that best uses AI or any other machine-learning-based system mapped with scientific datasets. In contrast, the focus should lay on finding a way to efficiently manage surveying and to ensure they are always up to date and directly feeding into CBAM reporting. Real factory data is needed to have maximal transparency in the market. An estimate-based approach would probably distort the risk perception between market players by assigning, for instance, to a coal-based producer and a green manufacturer of the same good, located in the same country, the same average emission intensity.

Starting from the CBAM report due on October 31st, 2024, in fact, first real international factory emissions need to flow into the importers’ CBAM reports. Until the end of the year, they can still be calculated according to “any international approach”, in other words, according to no strictly binding rules. However, from the first report due by April 30th, 2025, CBAM emissions will need to be calculated according to the EU method, which includes either the monitoring-based or the calculation-based approach. Briefly, the monitoring-based approach foresees sensors and IT systems to be put into factories in order to measure real-time CO2 emissions, while the calculation-based approach envisages calculating emissions based on the amount of fuels, electricity and other factors consumed during the production of certain goods.

The initial spark for a global cascade in national CO2 pricing systems

The main objective of the transitional period of CBAM is to ensure that factories worldwide track CO2 emissions like EU manufacturers currently do within the EU ETS. This means that not only the emission boundaries (scope 1, 2 & 3) but also the measurement rules must align with the strict and 15-years long emission measurement standards factories in the EU are used to dealing with. For instance, this means that the transport of goods and employees, mining and several other emission drivers are not included in the scope of CBAM, which is mainly focused on capturing the emissions derived from the processes happening below a factory’s roof.

Secondly, it is worth mentioning that emission measurement tools that take rigorously accurate estimates are not compliant with CBAM, as the regulation foresees a traditional way of surveying. This means that, in order to comply with CBAM, efforts should not be made towards finding a tool that best uses AI or any other machine-learning-based system mapped with scientific datasets. In contrast, the focus should lay on finding a way to efficiently manage surveying and to ensure they are always up to date and directly feeding into CBAM reporting. Real factory data is needed to have maximal transparency in the market. An estimate-based approach would probably distort the risk perception between market players by assigning, for instance, to a coal-based producer and a green manufacturer of the same good, located in the same country, the same average emission intensity.

Starting from the CBAM report due on October 31st, 2024, in fact, first real international factory emissions need to flow into the importers’ CBAM reports. Until the end of the year, they can still be calculated according to “any international approach”, in other words, according to no strictly binding rules. However, from the first report due by April 30th, 2025, CBAM emissions will need to be calculated according to the EU method, which includes either the monitoring-based or the calculation-based approach. Briefly, the monitoring-based approach foresees sensors and IT systems to be put into factories in order to measure real-time CO2 emissions, while the calculation-based approach envisages calculating emissions based on the amount of fuels, electricity and other factors consumed during the production of certain goods.

Conclusion

According to the CBAM regulation, by 2026, no steel, aluminum, cement, fertilizer or hydrogen-based product should be imported without an attached and compliantly calculated carbon footprint, and more information about the exact factory where it had been produced. This data will come together with the emission data which is already measured locally in the EU ETS, in order to allow a fair taxation between the EU’s local production and its imports. This will set the start of the world’s first carbon tax and thereby increase our chances to stay below 2°C of global warming.

Many countries like the UK, Japan, Canada, Australia, India and even China have already pledged or are at least discussing the possibility of implementing a carbon border pricing system on their own.  According to our internal analysis, as the world slowly shifts towards implementing a carbon price on the most polluting sectors, green industrial commodities will become cheaper than their carbon-intensive alternatives by 2029 (22.5% of CBAM & ETS carbon footprint taxation), making a fast decarbonisation of the supply chain not only a first mover advantage, but also the only long-term strategy available.