Understanding the EU’s carbon border adjustment mechanism

The European Union (EU) last month put into effect its Carbon Border Adjustment Mechanism (CBAM), kicking off a two-year transitional phase that would require EU-based importers of goods covered by the mechanism to report embedded carbon emissions of imports. Starting from 2026, CBAM certificates would effectively price carbon embedded throughout the production process of the imported goods and charge a levy on them at European borders based on their emissions footprint.

Many European companies in carbon-intensive industries, like others around the world, are naturally inclined to relocate their carbon-intensive production to countries with less stringent climate rules, a phenomenon termed carbon leakage.  

To address these challenges and to make the EU ETS more robust, the EU put its CBAM measures in place to effectively globalize its climate policy.  

How will it work?  

The mechanism will initially apply to six carbon-intensive industries that are also considered to be at a higher risk of carbon leakage – cement, iron and steel, aluminum, fertilizers, electricity, and hydrogen. Importers in these industries will enter a trial period starting October 2023 during which they will only have to report greenhouse gas emissions (GHG) embedded in their imports (direct and indirect emissions), without making any financial payments or adjustments. From 1 January 2026, importers will need to declare each year the quantity of goods imported into the EU in the preceding year and their embedded GHG, and then surrender the corresponding number of CBAM certificates. The price of these certificates will be calculated based on the weekly average auction price of EU ETS allowances expressed in euro (EUR) per metric ton of carbon dioxide emitted.

Is CBAM WTO-compliant? 

National Treatment Principle  

Article III: 4 of the General Agreement on Tariffs and Trade (GATT) states that, based on the national treatment principle, the WTO allows for border adjustments, and that WTO members must not accord discriminatory treatment between imports and “like” domestic products (except for the imposition of tariffs, which is a border measure). Therefore, under the CBAM (which is being applied as a border measure and not an internal tax), imports shall be treated no less favorably than like products in the EU. Even if it means that imported “dirtier” steel with higher embedded emissions and “cleaner” EU-manufactured steel are considered like products, the EU could use recent WTO rulings on technical barriers to trade that suggest that processes and production methods (PPMs) can be taken into account as a basis to differentiate between goods otherwise considered alike.  

While there appears to be legal basis for discrimination between EU imports and EU products – since CBAM certificates will be priced according to the weekly average auction price of EU ETS allowances, thus justifying a level charge per metric ton of carbon for both categories –the EU’s trading partners could counter-argue that the CBAM represents de facto discrimination. They could say that reporting requirements under the CBAM from 2023 onward will put imports on an unequal footing, as the legal due diligence requirements for foreign entities under CBAM are more stringent than the reporting requirements under the EU’s ETS.

General exceptions 

GATT Article XX exempts measures from being considered WTO violations based on various domestic policy goals, including the protection of public morals. If all else fails, to make CBAM WTO-compliant, the EU may rely on this provision and argue that the CBAM regulations qualify for general exceptions (on the grounds of preservation of exhaustive resources or human health) per GATT Article XX. However, to qualify for Article XX, the EU must show that the CBAM is the only option that would allow it to protect health concerns and that it is the least trade-restrictive measure reasonably available. Most importantly, Article XX states that the CBAM regulation cannot be a disguised restriction on international trade. To rely on this provision, WTO rules require the EU to prove a “close and genuine” relationship between the border adjustment on imports and conservation goals. The fact that revenue generated from the CBAM will go to the EU budget may attract scrutiny. There have been suggestions to use the revenue generated to assist developing countries in meeting these countries’ clean energy goals.  

Impact on trade flows and economy 

Impact on Europe 

European trade flows – both imports and exports – will be affected by CBAM provisions. For exports, the subsequent elimination of free allowances will have a bearing on the export competitiveness of European downstream sectors. For imports, the extent of the impact will really depend on how carbon-intensive the EU’s trade partners are and whether they have meaningful measures in place to drive decarbonization in their industries, and how quickly they are able to do so.   

European consumers will face higher prices as imports become more expensive. As the allocation of free allowances to domestic sectors is gradually reduced, the phasing-in of CBAM will drive up costs for EU producers.  

Reporting obligations related to CBAM will also push up costs, to be eventually borne by consumers. Some of the immediate and direct impacts that EU companies may feel include higher import prices of goods from industries covered under the CBAM (e.g., steel) and increased prices of secondary goods that include components of such goods (e.g., vehicle manufacturers buying parts from another EU manufacturer that contain imported higher-priced steel or aluminum).  

Impact on trading partners 

The CBAM could have a significant impact on the competitiveness of countries that export these goods to the EU, particularly emerging and developing economies. The extent to which a country is affected by the CBAM depends on the EU ETS price, the severity of the CBAM’s impact, and on exporting countries’ exposure, i.e., the volume of their affected exports to the EU. However, exposure alone does not say much about possible economic risks. A more significant risk measure is vulnerability. Vulnerability measures economic dependency, export diversification, and export concentration, besides exposure alone.  

Some developing countries export large quantities of these goods to the EU. Zimbabwe, for example, is a major exporter of iron and steel to the EU, and Ukraine sells large quantities of fertilizer to the bloc.¹ In absolute terms, Russia, China, Turkey, and Ukraine are the main EU trade partners in CBAM products, and hence the most exposed countries. In relative terms, the degree of exposure of economies that export CBAM products to Europe varies substantially, with many developing economies having more than 2% of their exports and 1% of their production impacted by this measure.² Promoting the substitution of highly polluting technologies with green technologies, while arguably easier in economically advanced Europe, is not as feasible in developing and emerging economies. Many jobs and fiscal revenues are at risk if the CBAM is implemented without considering the specific contexts of the EU’s trading partners. 

Expectedly, CBAM has triggered a backlash from several of the EU’s trading partners including the United States, China, India, Brazil, and South Africa. It is viewed in China as a new tariff barrier. “If Europe imposes taxes based on the [carbon] price differences on relevant products from China, it may have a very large impact on China’s related industries and enterprises,” Zhou Chengjun, director of the Financial Research Institute of the People’s Bank of China, said at an academic forum in Beijing in July³. Others have also expressed concerns that the new rules will further complicate trade and raise export costs for non-EU manufacturers.  

The EU’s trading partners might choose to retaliate and impose barriers on EU imports in response. Some like China and India could further challenge this policy at the WTO. China has already asked the EU to justify its incoming carbon border tax at the WTO. India plans to file a complaint to the WTO over the EU's proposal to levy imports of high-carbon goods like steel, iron ore, and cement from India, top government and industry sources say⁴. India has set up its own carbon trading system and brought in a series of measures and norms to push high-emission industries towards decarbonization to “mitigate the impact” of the CBAM⁵.

The CBAM is in its initial phase and may grow to include Scope 2 emissions and additional targeted industries and covered commodities. This means downstream products that undergo complex manufacturing processes and finished products (e.g., white goods).⁶ Businesses must start adapting to the changes already underway. Among the most urgent compliance requirements is the adherence to reporting obligations from 1 January 2023. Businesses must report the embedded emissions in the imported goods every quarter (during that quarter of the calendar year), detailing the direct and indirect emissions and any carbon price effectively paid in the country of origin. Some other key considerations⁷ for businesses are:  

1. Review the global supply chain to determine the potential impact of the CBAM. 
2. Check if their product is on the list (Annex I of the CBAM). 
3. Register for the CBAM in collaboration with customs.  
4. Calculate direct and indirect emissions for their products, and determine if actual emissions can be calculated, or whether they should rely on default values. 
5. Set up systems for CBAM administration, quarterly reports, yearly declarations, and the verification of embedded emissions. 
6. Calculate and be ready to absorb the financial impact. 
7. Keep an eye on carbon pricing developments in other countries (since carbon prices paid outside of the EU can be adjusted).  
8. Actively work to improve business and contact suppliers to reduce carbon emissions and create a sustainable supply chain. Evaluate if a complete supply chain overhaul is needed or if there is a need for some new partnerships.  
9. Monitor future CBAM developments closely.  

CBAM requires businesses to re-evaluate their strategies. It goes beyond mere adherence to regulations, spurring companies to re-examine their supply chain strategies and overall business processes to incorporate technologies that are more efficient in reducing greenhouse gases.

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[1] How developing countries can measure exposure to the EU’s carbon border adjustment mechanism, World Bank: https://blogs.worldbank.org/trade/how-developing-countries-can-measure-exposure-eus-carbon-border-adjustment-mechanism.
[2] Impacts of the CBAM on EU trade partners: consequences for developing countries, Taylor & Francis: https://www.tandfonline.com/doi/abs/10.1080/14693062.2023.2200758.
[3] EU’s trade-focused climate policy seen as ‘new tariff barrier’ in China economic circles, SCMP: https://www.scmp.com/economy/china-economy/article/3227326/eus-trade-focused-climate-policy-seen-new-tariff-barrier-china-economic-circles.
[4] India plans to challenge EU carbon tax at WTO, Reuters: https://www.reuters.com/world/india/india-plans-challenge-eu-carbon-tax-wto-sources-2023-05-16.
[5] India prepares own carbon trading system and decarbonisation measures to counter EU’s CBAM, Business Line: https://www.thehindubusinessline.com/economy/india-prepares-own-carbon-trading-system-and-decarbonisation-measures-to-counter-eus-cbam/article67212862.ece.
[6] Impact of the EU's Carbon Border Adjustment Mechanism, KPMG: https://kpmg.com/xx/en/home/insights/2022/08/carbon-border-adjustment-mechanism-impacts.html.
[7] Ibid.

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