The EU Carbon Border Adjustment Mechanism proposal and considerations for U.S. businesses

The EU Carbon Border Adjustment Mechanism proposal and considerations for U.S. businesses

By Hogan Lovells

September 28th, 2021

The EU CBAM proposal signals a transformation of the European carbon pricing regulations. U.S. businesses with significant European operations, or with operations in emissions-intensive, trade-exposed industry sectors, should understand the CBAM proposal’s various provisions, their potential impact, and the risks associated with these regulatory changes. In particular, U.S. businesses should be aware of and plan for the CBAM proposal’s potential trade effects, legal vulnerabilities, and administrative challenges. Hogan Lovells continues to closely monitor climate and climate border measure developments in Europe, the United States, and other markets, and is well positioned to help clients navigate these rapidly unfolding developments and their impacts on environmental regulation and international trade.

In this article, we provide a brief overview of the EU’s July 2021 proposal to implement a Carbon Border Adjustment Mechanism (CBAM) on its Emissions Trading System (EU ETS), before raising important considerations for U.S. businesses who aim to comply with (or challenge) its various provisions.

Background on the CBAM proposal
Since its implementation in 2005, the EU ETS has required “covered entities” (i.e., certain producers of greenhouse gases) to purchase certificates that allow them to emit greenhouse gases. Until now, the EU granted free allowances to emissions-intensive, trade-exposed industries to mitigate against competitiveness and political risks of the EU ETS.1

On July 14, 2021, the European Commission (Commission) presented its first official proposal to implement border adjustments on the EU ETS, as part of efforts to reduce its greenhouse gas emissions by 55 percent compared to 1990 levels by 2030. The proposal would (by 2036) phase out free allowances for producers in emissions-intensive, trade-exposed industries, and levy import tariffs—equivalent to the weekly average EU ETS price—on certain products based on their embedded emissions. In doing so, the Commission seeks to address concerns over carbon leakage while continuing to protect EU industries from adverse competitive (and related employment and political) effects.2 The proposal is part of the EU Green Deal and is a major priority for Commission President von der Leyen and the EU institutions as a whole.

Important aspects of the proposal include:

Scope. In terms of products, the CBAM proposal would cover cement, fertilizers, iron and steel, aluminum, and electricity (Covered Products). But, while the proposal appears not to apply to indirect emissions or to downstream products, the CBAM’s exact product scope will remain uncertain until the Commission sets precise “system boundaries.”3 Regarding countries of origin, all imports other than those from the 27 EU Member States, plus Iceland, Liechtenstein, Norway, and Switzerland—as well as those countries granted exemptions from CBAM import duties because they have adopted comparable carbon pricing regimes—will be subject to CBAM duties.

CBAM certification. The CBAM will be mainly administered by the competent authorities of individual Member States, who are responsible for setting up a national registry of authorized importers and information on CBAM certificates. Only those importers authorized by the competent authorities would be allowed to import goods into the EU that fall within the scope of the CBAM. These authorized importers would purchase (at a price that reflects the weekly average price of carbon credits auctions under the EU ETS) certificates for the embedded emissions in the Covered Products from the competent authorities of the Member States. At the border, customs authorities will ensure that the declarant of the good is registered and report the quantity, country of origin and the declarant of the goods.

Embedded emissions calculations. Importers provide the underlying data used to determine the embedded emissions of Covered Products on an annual basis. These data would be subjected to verification procedures. Default values will be used when importers cannot determine embedded emissions. The calculations would account for both direct emissions (i.e., emissions resulting from the production process itself) and indirect emissions (i.e., emissions in earlier stages of the production and related to the use of electricity).

Implementation. At present, the CBAM is expected to enter into force on January 1, 2026, assuming it is approved by the European Parliament and Member States. Between 2023 and 2026, however, importers would have to report the actual embedded emissions in Covered Products—detailing direct and indirect emissions, as well as any carbon price paid abroad—but would not have to buy CBAM certificates. The phasing in of the CBAM would coincide with the gradual phasing out of the existing system of free allowances to certain European industries under the EU ETS.

Import duty modification. The CBAM would modify import tariffs on Covered Products based on carbon prices paid abroad. As mentioned above, importers will report information to the competent authorities of the Member States on any such fees incurred abroad. If the declarant can show sufficient and certified proof that the embedded emissions were already subject to a carbon price, the authorities will reduce the number of certificates that must be purchased for those imports to account for the carbon price paid in the country of origin. The CBAM proposal suggests that the Commission might extend the number of countries exempted from the CBAM requirements—including instances where countries agree to link their emissions trading systems (or equivalent carbon pricing measures) to the EU ETS.

A more detailed description of the CBAM proposal’s provisions can be found in a previous Hogan Lovells news alert. Note that the CBAM proposal will be subject to review and modification by the European Parliament and the Council of the European Union (with input from civil society, trade organizations, and other stakeholders), and is therefore subject to change—particularly in terms of scope and implementation.

Potential challenges for U.S. businesses
The CBAM’s impact on industries and supply chains will be global. U.S. businesses should begin assessing their potential exposure to a new requirement to purchase CBAM certificates. And they should carefully consider the possible impact on their costs and competitiveness from 2026, planning for the contingency that CBAM may be expanded to cover indirect emissions and additional products.

U.S. businesses should also brace for significant legal uncertainty. The CBAM is likely to face external legal challenges to its compatibility with World Trade Organization (WTO) rules. And the proposed phase-out of free allowances risks legal challenge from domestic industry in vulnerable emissions-intensive, trade-exposed sectors, as well as from labor groups and trade unions across the EU, since it could put European exports at a significant competitive disadvantage.4

Finally, as was the case when the EU ETS was first implemented in 2005, contractual disputes along supply chains will most certainly result from the CBAM. But certain design elements of the CBAM proposal pose additional risks, from suboptimized supply chains to increased exposure to potential duty circumvention by competitors.

The potential challenges to U.S. businesses from these three factors—potential adverse trade effects, legal challenges, and contractual and supply chain issues—are discussed in greater detail below.

Potential adverse trade effects
For most U.S. businesses, the most obvious impact of the CBAM will be increased tariffs on goods exported to the EU. With the EU ETS price recently exceeding € 60 per metric ton of CO2-equivalent emissions, this is not an insignificant cost.5

Prices of EU-origin goods will be affected in one of two ways. For Covered Products—products currently exempted from purchasing EU ETS certificates under the system of free allowances—prices will increase. Free allowances will be phased out and will not be replaced with an export border adjustment under the current CBAM proposal. For products not currently granted free allowances under the EU ETS, pricing dynamics should remain fundamentally the same as these downstream goods continue to be sold outside the EU with an unadjusted carbon price. But if the EU ETS price continues to rise, the lack of an export border adjustment will become more significant and may affect the competitiveness of these EU industries in export markets.

In view of these challenges, we recommend U.S. businesses that produce covered products in countries that lack comparable climate regimes (e.g., U.S., China, India, Japan, Brazil, etc.), and thus are likely to be covered by CBAM, begin immediately analyzing their potential exposure to the requirement to purchase CBAM certificates. Companies should plan specifically for the possible impact on their competitiveness from 2026, but also their ability to implement the necessary reporting requirements in the interim. And these plans should include contingencies in case CBAM is eventually expanded to cover a greater share of so-called “indirect emissions” or expanded to cover a broader set of products.

Likelihood of legal challenge
The CBAM proposal is likely to be challenged by other WTO members for its incompatibility with WTO rules. Generally, the WTO rules related to border adjustment rest on the distinction between two types of taxes: indirect taxes (i.e., taxes on products) can be border adjusted, whereas direct taxes (i.e., taxes on producers or facilities) cannot.6 While the WTO rules are designed to accommodate the border adjustment of taxes, they are not designed to permit the border adjustment of regulatory requirements like the EU ETS.7 Unless the WTO Appellate Body overrules related precedents and determines that the regulatory effects of the EU ETS are “equivalent” to a tax—potentially opening the door to similar arguments regarding other regulatory measures (e.g., healthcare, consumer safety, and environmental costs)—General Agreement on Tariffs and Trade (GATT) and WTO precedents indicate that the EU ETS would not be a tax, and therefore the CBAM would not be a legal border tax adjustment. And, assuming the CBAM is not a legal border tax adjustment, it would be vulnerable to challenges on other grounds—such as violations of National Treatment, Most Favoured Nation, and the prohibition on quantitative restrictions. As a result, the EU likely would have to defend the CBAM under GATT Article XX’s exceptions for public health measures (Paragraph (b)) or for conservation of exhaustible natural resources (Paragraph (g)). While the WTO has loosened the requirements for Article XX(g)’s exception for conservation of exhaustible natural resources over the last decade (see, e.g., US–Shrimp), such a dispute would raise difficult legal issues.8 It would also pose major institutional challenges for the WTO, since would likely divide its membership between those with similar carbon pricing regimes (e.g., EU, Nordics, Canada) and the vast majority that do not.

The CBAM proposal may also be challenged by EU industry, particularly in emissions-intensive, trade-exposed sectors that rely heavily on the existing system of free allowances under the EU ETS. Reports suggest that many EU industry groups only support the CBAM proposal if it were to operate alongside some system of free allowances—a clear violation of WTO rules. But the policy’s lack of export rebates poses legitimate challenges to EU industry. Without export border tax adjustments, EU companies could be subjected to a significant cost disadvantage in export markets.9

The high risk of legal challenges from both inside and outside the EU creates significant uncertainty. U.S. businesses, and particularly those in emissions-intensive, trade-exposed industry sectors, or those heavily reliant on carbon-intensive inputs, should be aware of the basic legal concerns surrounding the CBAM proposal as currently drafted and how U.S. businesses might be affected by possible amendments to the proposal.

Administrative challenges
Increased import duties represent only some of the increased costs associated with the CBAM proposal. U.S. businesses should be prepared for increased transactional and administrative costs, as well as potential capital expenditures involved in the rerouting of supply chains.

The CBAM proposal may also significantly increase the risk of contractual disputes with EU customers for U.S. businesses. For example, following CBAM’s implementation, contract terms with EU customers will likely include obligations or assumptions regarding the imports’ embedded emissions. U.S. companies will be required to prove (subject to verification) the actual specific emissions intensity of their production. Even minor changes in determinations by the competent authorities could cause significant price effects, likely resulting in contractual disputes.

U.S. businesses selling into the EU may face an increased risk of circumvention by both domestic and foreign competitors.10 Without a carbon price in their own country, businesses would be incentivized to “shuffle” emissions—only exporting their production with the lowest embedded emissions to the EU while avoiding incentives to reduce the emissions intensity of their overall production. The risk of circumvention is particularly high if the CBAM proposal moves forward with a tariff modification provision for foreign carbon prices. For example, producers/distributors from countries with high emission intensities of major inputs or without a recognized carbon price under CBAM would be incentivized to transship through other countries with either lower embedded emissions (for inputs like electricity) or with recognized carbon pricing policies (to secure the reduction or elimination of the import tariff).

Finally, U.S. businesses should assess the extent to which their supply chains will be affected by the increased duties on imports into the EU and the elimination of free allowances on EU domestic production and exports for their local EU operations. This will lead to short-term costs but may ultimately reduce production and operating costs once the CBAM proposal enters into force.

Other considerations
First, U.S. businesses should anticipate action on the proposal in the near future and be aware of the proposed implementation timeline. The CBAM proposal is subject to the “ordinary legislative procedure,” during which the European Parliament and the Council of the EU will review and modify the proposal. However, while the CBAM proposal is not without controversy, the EU has indicated that it will give any EU Green Deal-related policy the highest priority. Currently, the proposed date for entry into force of the CBAM is January 1, 2026. And, as noted above, importers will be subject to reporting requirements related to actual embedded emissions in Covered Products and any carbon prices paid abroad effective January 1, 2023.

Second, while U.S. proposals are generally less advanced relative to the EU’s CBAM proposal, carbon pricing proposals in the United States are slowly growing in number and becoming a more significant legislative priority for both parties. The Biden administration recently signaled that it is exploring such a policy. There have been several legislative proposals in the 117th Congress. And, perhaps most notably, a carbon import fee amendment introduced by Senator Chris Coons (D-DE) and Representative Scott Peters (D-CA) (Coons–Peters bill) was incorporated in the Senate Democrats Budget Reconciliation bill, which was approved by the Senate and is awaiting action by the House of Representatives.

Important considerations with current U.S. proposals include:

Trade effects. The trade effects of these proposals will vary based on certain fundamental design choices of the carbon tax itself as well as the border tax adjustment mechanism. A carbon tax with border adjustments on both imports and exports promises to be trade-neutral. Certain legislative proposals have called for an import-only approach, however. Without export border tax adjustments, U.S. exports could be subjected to double taxation (i.e., both a U.S. carbon tax and an importing country’s carbon tax), significantly undermining the competitive position of U.S. goods.

WTO compatibility. Relative to the EU ETS, carbon taxes—the carbon pricing proposals currently favored by Congress—hold significant advantages in terms of WTO compatibility. A more detailed analysis of this distinction can be found here.11 As discussed previously, the relevant WTO rules are designed to accommodate adjustment of indirect taxes (i.e., taxes on products) on both imports and exports, including a properly designed carbon tax. That said, this is true only to the extent that it corresponds to an internal tax imposed on like domestic products (such as a carbon tax). Therefore, proposals including the Coons–Peters bill that would provide a border adjustment without a comparable domestic carbon tax raise serious questions under WTO rules, and would almost certainly create trade conflict.

Administrability. While a border tax adjustment system would be easier to administer than border adjustments to the EU ETS, it would still be administratively complex because carbon intensity would vary according to the producer’s technology and country of origin. This is particularly difficult for border adjustments on imports, which would require importers to submit (and federal agencies to verify) detailed information on the energy intensity of their production. This will make importing inputs or certain finished goods significantly more costly. Although border adjustments on exports would be comparatively easier to administer, with U.S. companies themselves submitting the data—data similar to that currently reported to the EPA by emissions-intensive producers—anticircumvention and other related verification procedures would be required. The system will likely require a large bureaucracy.

U.S. businesses, and particularly those with operations in emissions-intensive, trade-exposed industry sectors, should understand the breadth of these policy proposals and the impact that certain design choices would have on their business. But it should also be noted that while the Biden Administration and many House and Senate Democrats support strong action on climate change, the politics in this area remain complex and U.S. Congress is deeply divided, such that enactment of a carbon tax or other climate measures remains unlikely in the immediate future.

Finally, businesses should be aware of developments in other markets. For example, the Government of Canada suggested in its 2021 Budget that it would begin consultations for a carbon border adjustment in the coming weeks. In its press release, Canada announced that 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. Rapid development in this policy area seems likely to intensify in the months and years ahead, but the situation remains fraught with potential for trade conflict.