The EU CBAM: New Times, New Rules

The Times They Are A-Changin'. With the transitional period of the EU Carbon Border Adjustment Mechanism (CBAM) officially commencing on October 1st, could we be witnessing the beginning of the end for free-riding in international climate policy? Perhaps; time will tell. What does seem certain is that these new times will come with new rules and implications for businesses.?

1. The established role of carbon accounting: For EU businesses importing in-scope CBAM goods (aluminium, fertilisers, hydrogen, electricity, iron & steel, and cement), greenhouse gas emissions data will become an integral part of their procurement and supply chain decisions. All enterprises, from large to small and midsize (SMEs), will need to become familiar with the language, data, and methods of carbon accounting. In meetings and discussions, someone in the room should be prepared to address questions related to the carbon footprint of their purchased goods. Businesses must understand the emissions released at different stages of a product's lifecycle in order to identify cost-effective abatement opportunities in their supply chain. Note, however, that the scope of CBAM (i.e., its system boundaries) is narrower than a typical product's total carbon footprint. This is a deliberate choice made to align the scope of CBAM with that of the EU Emissions Trading System (ETS). Hence, businesses that have already embarked on the journey of gauging their products' carbon footprints using standards like the GHG Protocol or ISO 14067 may be better positioned to address their new CBAM obligations.
2. Data exchanges for supply chain emissions: From the perspective of EU businesses, the EU CBAM focuses on a subset of their Scope 3 emissions. Companies under CBAM's scope (i.e., those importing in-scope CBAM goods from third countries) will need to report embedded emissions using data provided by the operators of the facilities where the CBAM goods are produced. In some cases, they might have to rely on data provided by intermediaries, such as commodity traders, to obtain this data. These traders, in turn, might gather it either from other intermediaries or directly from the operators. Data exchanges might also take place between third-country installations before the goods reach EU borders. This might be the case for installations that buy precursor materials from other suppliers. For example, non-integrated cement plants that purchase finished clinker from other facilities. Regardless of the data's path, it ultimately must reach the EU reporting declarant, who bears the responsibility for reporting and disclosure. In 2024, the Commission will grant EU businesses greater flexibility in reporting emissions data for their purchased CBAM goods, recognising the challenges suppliers will face with setting up monitoring, reporting and verification (MRV) systems in time. This leniency will allow third-country installations to monitor and report their emissions based on the rules of alternative systems that apply in their respective locations, provided they cover equivalent emissions and ensure similar accuracy. This provision will be in place until the end of 2024. Simultaneously, EU reporting declarants can use alternative estimation methods for disclosing emissions until 31 July 2024. From 2025 onwards, the EU method will become the standard practice, which means that third-country installations will have to monitor their emissions following the EU CBAM monitoring rules and EU businesses should report their emissions based on that data.
3. Assigning CBAM reporting responsibilities: EU businesses should promptly determine which department will handle the new EU CBAM obligations and designate who within those departments will undertake the data collection tasks. These obligations could fall under various departments, such as sustainability teams, procurement, legal, and supply chain. This transversal nature makes assigning CBAM-related responsibilities more complex, highlighting the importance of enhanced inter-departmental cooperation and coordination.
4. Delegating CBAM obligations: EU businesses (importers) can delegate their CBAM obligations to customs representatives. The option for an indirect customs representative to choose whether to assume these responsibilities primarily depends on their client's location. If the importer isn't established in an EU Member State, the indirect customs representative becomes the default party to handle CBAM obligations. Conversely, if the importer is based within the EU, the indirect customs representative will only take on CBAM reporting duties if they explicitly consent to do so. So, what are the advantages and drawbacks for indirect customs representatives in taking on CBAM duties? On the upside, CBAM could introduce new revenue streams and business opportunities. On the downside, non-compliance with CBAM reporting could result in accumulated liabilities. Additionally, given that carbon accounting and carbon pricing are outside their traditional fields of expertise, many representatives might be hesitant to assume these new responsibilities. It's worth noting that where importers act through direct representatives, they remain responsible to comply with the CBAM disclosure obligations.
5. Greater data granularity: From the perspective of third-country operators, emissions will have to be monitored at the facility level, adhering to specific monitoring, reporting and verification (MRV) rules. These rules draw from the MRV standards of the EU ETS. However, a notable difference from the EU ETS is that emissions will not be reported per installation but per CBAM good. This requires attributing an installation's emissions to the portion of produced goods that fall under the EU CBAM. This idea is encapsulated in the term 'embedded emissions', which have been defined in parallel to the emissions causing CO2 costs in the EU ETS. The specific embedded emissions from the supplier, being a normalised measure of emissions, enable EU reporting declarants to calculate their share of emissions relative to the amount of CBAM goods they purchase. The above underscores the increasing value of asset-level information. As previously noted, data exchanges between various actors across the supply chain will be paramount. To reduce the administrative burden on suppliers, the EU Commission has created an 'emissions data communication' template. This will enable operators to present CBAM data in a consistent manner. Additionally, the Commission will set up a CBAM registry for third-country operators to submit their CBAM data so they don't have to distribute it to each of their clients individually.
6. The strategic role of carbon pricing: Carbon pricing will increasingly influence business strategy. When making procurement decisions, the presence of a carbon pricing system in a third country - and its potential to offset some CBAM liability - will be a crucial consideration. Notably, third countries with existing carbon pricing systems might have a strategic edge over other countries that trade with the EU since their industries are already incentivized to decarbonize. The specifics of these carbon pricing systems will be just as vital, as changes to their scope or measures allowing exporting companies to decrease their carbon pricing obligations at home will affect the CBAM liability of the EU importer and, subsequently, its overall carbon costs. Once the transitional period ends, EU businesses will be required to buy CBAM certificates to cover emissions embedded in imported products. In doing so, they will be able to take advantage of the price changes of the EU ETS. Finally, with the gradual implementation of the EU CBAM and the phasing out of free allocation, their indirect exposure to carbon pricing is expected to change.
7. The educational challenge ahead: While many companies are familiar with the concept of carbon accounting, carbon pricing remains a newer and perhaps less understood domain. Indeed, the majority of businesses are already aware of what greenhouse gas emissions are, whether because these arise from their own production processes or because they've heard it from their own suppliers, competent authorities, or other stakeholders like carbon accounting service providers. This is less likely to be the case for carbon pricing. Many companies under CBAM's scope may never have been confronted to carbon pricing concepts and language as the EU ETS mainly covered large upstream operations. As a result, companies at mid- and downstream stages of the supply chain may not understand carbon pricing's operational dynamics or its business implications. Yet, by introducing new obligations to that part of the supply chain, the EU CBAM brings carbon pricing to a much wider set of actors. To fully grasp its implications, it is fundamental to understand the following: even if many of the companies under CBAM's scope were not directly covered by the EU ETS, they have probably been affected by it too. In all likelihood, they have felt the indirect effects of the EU carbon market via their supply chain emissions (e.g., through electricity prices). However, such costs often remained unnoticed as they were embedded in the prices of their procured goods. The EU CBAM, on the contrary, creates a visible carbon price in the supply chain, prompting businesses to confront a pressing question: what exactly is carbon pricing?
8. A new international trend: From a policy perspective, the EU CBAM has the potential to pave the way for other jurisdictions to propose similar mechanisms. This trend is already evident in jurisdictions such as Australia and the UK, both of which are considering implementing their own carbon border adjustment mechanisms. Furthermore, the EU CBAM could encourage the introduction of new carbon pricing regimes in jurisdictions where none existed before and could expand the reach of current ones. Recent examples illustrate this trend. In Vietnam, the Ministry of Finance has proposed collecting an emissions fee from large industrial facilities that generate large volumes of industrial emissions and dust. Meanwhile, both Brazil and India are examining carbon pricing-related initiatives. Additionally, the Chinese Government is mulling over accelerating the expansion of its national carbon market to include in-scope CBAM sectors, such as cement, aluminium, and iron and steel. These examples highlight that carbon pricing is on the rise, with more nations likely to join the 'Climate Club' in the near future.
9. Implications for the financial sector: Financial institutions should keep a close eye on what is happening in the carbon pricing ecosystem. From a climate risk management perspective, the EU CBAM introduces a new transition risk that could become material. 1) Probability of materialisation: The EU CBAM regulation is already set in law, having been published in the Official Journal of the European Union (OJEU). EU entities, including both large corporations and SMEs, that import cement, aluminium, iron & steel, fertilizers, hydrogen, or electricity from third countries will be subject to CBAM obligations. 2) Time-horizon: as indicated above, the EU CBAM is not a distant policy but an imminent reality. The transitional period will commence on October 1, 2023, and the definitive period is scheduled for January 1, 2026. 3) Magnitude of impact: Beyond the administrative costs, the EU CBAM also comes with potential penalties during the transitional phase. Companies that fail to meet reporting requirements could face penalties up to €50 per tonne of unreported emissions. When the definitive phase kicks in, these penalties could double. Importantly, starting from 2026, the financial obligations will be phased in. EU businesses will be required to pay for the embedded emissions of their purchased CBAM goods. As the EU CBAM continues to phase in, the free allocation of emission permits under the EU ETS, a subsidy to energy-intensive and trade-exposed industries currently worth around €20 billion a year, will be gradually phased out. This shift can have significant financial repercussions for both EU ETS regulated and non-regulated entities. Companies that don't adapt and adopt decarbonisation strategies in time will be hit the hardest. As Mr. Dylan once wrote in his iconic song, 'Then you better start swimmin' or you'll sink like a stone' because the times, they are indeed changing.