Accelerating climate goals with regulation

• The EU's CBAM is intended to shut the door on carbon leakage as carbon pricing increases.
• It will create a more level playing field for EU companies in carbon-intensive industries but will also create complexities for importers and their foreign suppliers.
• The EU CBAM could inspire similar regulatory mechanisms in other markets or other new models for reducing carbon leakage.
• These mechanisms would make the management of greenhouse gasses (GHG) a top priority for businesses across the globe.

Proponents of carbon credit schemes have long been concerned about a phenomenon known in those circles as 'carbon leakage'. Now there are efforts underway to do something about it.

The theory goes like this: As Europe and other markets ratchet up the cost of carbon emissions, products from markets with no, or lower, carbon-pricing schemes become more competitive. This then creates an incentive for companies to shift high-carbon production activities to locations where carbon costs are lower, or for customers to switch sourcing to such markets.

“The EU is arguably further along with its system of policies and targets on carbon reduction than most other markets, which is great,” Carl van der Horst, Director of European Affairs at Tata Steel in the Netherlands told me recently. “But it also means costs for European companies are much higher than for their foreign competitors and that is something the EU and its Member States need to sort out if they want to encourage companies to make the transition to Net Zero.”

Indeed, the EU has one of the world's most robust carbon emission cap-and-trade systems with the EU Emissions Trading System (or ETS). Which is why EU leaders and regulators are particularly concerned about the prospect of carbon leakage. Not only would it severely undermine their efforts to reduce global carbon emissions. It would also make EU businesses much less competitive than their foreign competitors.

Currently, carbon leakage is more of a theory than a reality, for two reasons. The first is that carbon prices under the ETS have historically been fairly low (versus what economists believe they must be in order to achieve the Paris Agreement goals). But as those prices rise, the incentive to avoid them also increases.

The second reason is that, in an effort to reduce the potential for carbon leakage when the scheme was first introduced in 2005, the EU already hands out free allowances, based on benchmarks, to industries at high risk of leakage (cement, iron and steel, for example).

The scheme has been hugely successful. The EU's ETS has been credited with helping reduce the region's carbon emissions by some 31 percent versus 1990 levels.

However, the EU now wants to move faster and more aggressively on its plans to combat climate change - the EU Green Deal plans to make the continent climate-neutral by 2050, with a milestone target of 55 percent emissions reductions by 2030, when compared to 1990 levels (the so-called `Fit for 55' package). To achieve these ambitious goals, the EU wants to, amongst other efforts, further reduce the number of free allowances and raise carbon prices at auction. And that makes the prospect of carbon leakage much more realistic.

The EU's new Carbon Border Adjustment Mechanism is designed to shut the door on carbon leakage. Simply put, it aims to impose an emissions-based levy on imports of certain products in order to level the playing field for EU producers in carbon-intensive industries. The levy would be equivalent to the price of an ETS certificate at auction (with credit for any carbon taxes or carbon pricing paid in the country of origin).

EU importers of these products would need to verify the embedded carbon content of their imports and then purchase and surrender CBAM certificates corresponding to the declared emissions. That means working with foreign producers to ensure they have the right data and that it is officially verified.

Currently, the CBAM proposal covers iron and steel, aluminum, cement, chemical fertilizers and electricity. While the European Parliament is pushing for the scope to be extended to polymers, organic chemicals, hydrogen and ammonia, this has not yet been accepted or included in the European Commission's proposals. CBAM is expected to come into force from 2023 with a three-year transition period covering 2023 to 2025 (during which only reporting obligations apply).

The EU's climate policies are pushing the transition to carbon-neutral manufacturing up the agenda for business leaders. Tata Steel, for example, runs one of the largest steel mills in Europe out of the Netherlands. With the planned reduction of the free allowances and certainty around a level competitive playing field, the company sees the necessity of speeding up its decarbonization plan.

“We're working to replace one of our two coal blast furnaces by 2030 and the other within the following decade. Our ultimate goal is to be carbon neutral well before 2050,” noted Carl van der Horst. “The entire industry is moving in the same direction.” Tata Steel's plans are to shift to hydrogen-fed Direct Reduction Plants, using natural gas as a transitionary fuel until green hydrogen becomes sufficiently available at an acceptable cost.

While the CBAM, if effective, would be a clear addition to the EU's tool chest for reducing carbon emissions, it is not without complexity or controversy. “An important issue that needs to be resolved is the disadvantage when competing against foreign providers outside of the EU,” added Carl van der Horst. “The EU steel industry exports around 20 percent of its volume outside the EU and the lack of a solution will severely hamper its competitiveness.”

There are also some at the World Trade Organization (WTO) - particularly emerging markets with high exports of carbon-intensive products into the EU - who would argue that the CBAM discriminates against foreign competition.

Much of the complexity comes down to the management system for GHG monitoring, reporting and verification (MRV), which is a cornerstone of the EU ETS and CBAM. “For companies exporting into the EU, ensuring emissions and reductions are measurable, traceable and without double counting is key,” noted Richard Lin, Partner and Head of Compliance Carbon Market at KPMG in China focused on GHG Emissions and Reduction. “Whilst most businesses in the EU already have certain level of GHG management system in place, many companies outside of the EU have not taken any actions or plans towards the minimum MRV set-up. There will be some challenges as companies prepare.”

Whether or not the CBAM is enough to bolster the ETS and help the EU achieve its 'Fit-for-55' goal remains to be seen. It is possible that its biggest impact will be to encourage other countries to increase decarbonization measures.

“You can always debate if these measures are ambitious enough. What is clear is that we need to dramatically shift our course by 2030 and once we have done that, it will be easier to build on that foundation,” argued Tata Steel's Carl van der Horst.

What the CBAM does demonstrate, however, is that governments can work at a regional level to encourage real action on reducing carbon emissions outside of their jurisdictions. The opportunities to apply similar thinking to other key areas of the ESG agenda are intriguing and could be significant.