Energy Transition – An evolving journey

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The European Union (EU) and a growing number of countries around the world are working on taxing at their borders the greenhouse gas (GHG) emissions embedded into imported products. This is seen, especially in Europe, as the only way to adopt an ambitious agenda for reducing GHG emissions and creating a level playing field where domestic and third-country producers pay the same level of emission rights or tax for the same product.

With its Carbon Border Adjustment Mechanism (CBAM) proposal, the EU takes the lead in setting up such a field, but other environmentally impactful countries, including the United States, are discussing their own measures. In this article, we take stock of the CBAM, and similar initiatives in the United States, Canada, the United Kingdom, South Korea, and China, and we explore what they mean for global businesses and the energy sector.

The EU is expected to introduce the CBAM in 2023, which means that payment of CBAM certificates upon importation would already be required in 2026. Calculating how much is to be paid at the EU border will require knowledge of how much carbon is embedded in the imported product. Alternatively, the importing company can demonstrate that it has already paid emission rights elsewhere. The EU will indeed recognize certain foreign emissions reduction schemes as equivalent to the EU’s own Emissions Trading System (ETS). Such “equivalence recognition” is mainly determined through bilateral discussions between the EU and the third country concerned. This bilateral engagement with the EU is likely to create an incentive for third countries to develop their own emissions reduction measures, which may lead to multilateral harmonization among like-minded countries. However, we are likely to see in the interim period a patchwork of different carbon pricing systems in different jurisdictions before countries agree to create a global or plurilateral carbon pricing system. The CBAM and similar schemes are also likely to apply to a rapidly growing list of products that will extend beyond the current products and commodities in scope. This is an area to watch, urgently.

European Union

The European Commission tabled a proposal implementing the CBAM on July 14, 2021. This proposal is now with the EU’s two co-legislators: the European Parliament and the European Council. The Council already approved the Commission’s draft proposal, with minor changes, in March 2022. The Parliament is expected to adopt its own version, in June 2022. The text will then be finalized by the Parliament and the Council, in the presence of the Commission (a process known as a “trilogue”). The legislative process is expected to be completed by the end of the year.

The proposed CBAM aims to guarantee that carbon emissions embedded in imported goods are equally taxed in comparison with domestic productions, the latter being currently subject to the EU Emissions Trading System (ETS). This means that EU importers must pay for the carbon embedded into CBAM-targeted goods that are placed on the EU market by purchasing CBAM certificates upon importation.

The CBAM is expected to enter into force as early as 2023 in a transitional form, and it is likely to fully apply from 2026. During the transitional period (2023-2025), EU importers will have to comply with reporting requirements, but will not need to purchase CBAM certificates yet. Once the CBAM is fully in place from 2026 onward, importers will be required to purchase CBAM certificates in order to import CBAM goods into the EU.

The key features of the CBAM, once it is fully in place from 2026, are as follows:

  • Targeted sectors: Five emissions-intensive, trade-exposed industries under EU ETS are targeted in the current proposal. In the first phase, the CBAM will impose a carbon price on imports of cement, fertilizers, iron and steel, aluminum, and electricity. However, the EU’s ultimate objective is a broad product coverage of the CBAM, possibly including energy and other products.
  • Authorized declarants: CBAM goods must be cleared through customs by declarants who are authorized to do so.
  • CBAM declaration: EU importers must submit a CBAM declaration for the preceding year on the number of imported goods and their total (verified) embedded emissions. Embedded emissions in imported goods will be calculated on the basis of direct emissions of GHG per ton of goods produced in the production installations.
  • CBAM certificates: EU importers must purchase CBAM certificates corresponding to the embedded emissions in the imported goods. The embedded emissions are either based on the default value or on the actual proven emissions, if lower.
  • Carbon prices already paid in the country of origin: CBAM certificates can be reduced to account for carbon prices already paid in the country of origin, but this needs to be certified by an independent person.
  • Geographical exemptions: Countries that adopt the EU ETS (Iceland, Norway, and Liechtenstein) or are linked with the EU ETS (Switzerland) are exempted from the CBAM.

The EU will further elaborate a mechanism for other third countries to be exempted in the future.

While the CBAM may not initially cover energy products, it is expected to expand its targeted sectors quickly. For instance, before 2026, the Commission will consider broadening the CBAM to sectors identified as having the highest risk of carbon leakage in Decision (EU) 2019/708, which includes hard coal, crude petroleum, iron ores, non-ferrous metal ores, and others. It is therefore important for companies to pay close attention to the further development of the CBAM, even after its implementation.

United States

The United States is considering the implementation of its own mechanism to tax carbon emissions at the border, although it trails the EU in the development of such a program due to a lack of consensus in Congress.

In July 2021, similar versions of legislation creating the Fair, Affordable, Innovative and Resilient Transition and Competition Act (FTCA) were introduced in the House of Representatives and the Senate. The legislation seeks to impose a cost on the GHG emissions associated with imported goods “to account for the marginal increased costs incurred by U.S. businesses to comply with laws and regulations limiting greenhouse gas emissions.” The bills require the Treasury Department to determine (1) the costs that U.S. companies in the covered sectors incur to comply with U.S. environmental policies, and (2) the quantity of greenhouse gas emissions associated with the production of each covered good.

As drafted, the FTCA would, among other things:

  • Impose a “border carbon adjustment” fee on imports of carbon-intensive goods into the United States, including but not limited to steel, aluminum, cement, and fossil fuels.
  • Apply to regulated products made with “covered fuel,” defined as natural gas, petroleum, coal, or any other product derived from natural gas, petroleum, or coal that is used or may be used so as to emit GHGs into the atmosphere.

Unlike its EU counterpart, the FTCA is not accompanied by an equivalent domestic tax or price on carbon emissions per se – but it would impose a residual cost to offset the carbon emission costs incurred by compliant U.S. businesses.

The FTCA faces some hurdles. First, it has not advanced far (in terms of the congressional committee review process) after almost nine months. For example, the House version of the FTCA was introduced by a Democrat and was only co-sponsored by one other Democrat. Since being introduced, it has been referred to several different committees but has failed to pass out of any committee, let alone come up for a vote on the floor of the House, after which it would need to be approved in the Senate, where bipartisan approval will likely be needed and will be harder to achieve. Second, it is likely that ongoing conflict in Ukraine will further raise energy prices, which makes it less likely that the FTCA will pass in the near term. Finally, any U.S. carbon border adjustment will be scrutinized closely by U.S. trading partners, both in terms of its impact on trade flows and its consistency with World Trade Organization rules.

Key takeaways
  • Under the EU’s CBAM, importers will be required to pay for carbon-intensive imports into the EU
  • The EU is expected to introduce its CBAM in 2023, and other countries are currently discussing the introduction of their own measures
  • The EU’s measures will likely set the pace, with possibly conflicting rules adopted elsewhere
  • Calculating carbon contents of imports and payments will require significant preparation work from exporting and importing companies
  • Covered goods do not include energy goods yet