On March 15, 2022, the European Council reached an agreement on the Carbon Border Adjustment Mechanism (CBAM) regulation. The mechanism stipulates that the EU will levy taxes on cement, aluminum, fertilizer, iron and steel, and other products imported from countries and regions with relatively loose carbon emission restrictions. It aims to achieve the climate target stated in the European Green Deal adopted by the EU on January 5, 2020, that is, to reduce greenhouse gas (GHG) emissions by 55% by 2030 compared to 1990 levels and to achieve carbon neutrality by 2050.

According to the Council of the European Union, the CBAM will be operating in parallel with the EU’s carbon emission trading system (EU ETS) as it gradually replaces the existing EU ETS, as the latter currently offers free GHG emission allowances to participants. The EU initially tried to replace the existing free allowances of EU ETS with CBAM, but it was strongly opposed by the region’s energy-intensive industries. They believed that the cancellation of free carbon emission allowances would impact the international competitiveness of enterprises in the EU and exacerbate the risk of carbon leakage. Therefore, the EU finally decided not to reduce the free allowances until 2026. From 2026, the free allowances will be reduced by 10% year by year until 2035. This means that CBAM will coexist with EU ETS Free Allowances before 2036. Compared to the initial proposal by the Commission, the most recent agreement on CBAM will opt for greater centralization of governance. At the same time, it also exempts goods with a value under EUR150 from CBAM obligations.

According to the agreement, 2023-2025 will be the transitional period of the mechanism, during which no fees will be charged, relevant imported goods only need to fulfill the obligation of emission reporting, and importers who fail to declare in time will be punished. By 2026, CBAM will be officially implemented. At that time, EU importers of all relevant commodities will need to buy CBAM certificates. The certificate price is also linked to the carbon cost of EU carbon emissions trading. According to Reuters, in February 2022, the trading price of EU carbon emission was close to EUR100 per metric ton.

Background of CBAM

The EU has always played a leading role in the global fight against climate change. After the EU announced its carbon neutrality target, China, Japan, and other major economies also announced their respective carbon neutrality ambitions. By the end of 2020, 137 economies around the world have announced their carbon neutrality timelines. In terms of emission reduction policy tools, the EU is the first economy in the world to establish a carbon emission trading system. The EU ETS covers industries, aviation, power, and other sectors, accounting for 40% of their total carbon emissions every year. The EU has designed two protection measures to avoid carbon transfer and carbon leakage. One is to allocate free carbon emission allowances to the industrial sector, and the other is to compensate the indirect costs to large power users. However, as the carbon emission trading system enters the fourth stage, the total amount of carbon emission allowances has been greatly reduced, and the availability of free allowances has begun to shrink. With the promotion of strict emission reduction targets, the price of carbon allowances has risen rapidly, arousing concerns that European enterprises may lose their trade competitiveness.

To address these concerns, the EU proposed the CBAM mechanism as part of the European Green Deal. In March 2020, the European Commission submitted the CBAM impact assessment report and completed the public consultation procedure in October. The CBAM design scheme was announced in the legislative proposal of “fit for 55” on July 14, 2021, thus officially starting the legislative process. The legislative process involved the European Commission, the European Council, and the European Parliament. The European Parliament passed a resolution on the establishment of CBAM in March last year. The Council recently reached an agreement on relevant rules. By the end of December 2022, the legislative process will be completed. The transitional period will begin in 2023. It is expected that more products will be involved in this system in 2023.

Disputes over CBAM

The introduction of the EU CBAM has aroused great controversy around the world. The European Commission believes that the purpose of CBAM is to encourage manufacturers exporting goods to the EU to improve their production processes and implement energy conservation and emission reduction. In the legislative proposal, the European Commission pointed out that CBAM is only applicable to industries with a high risk of carbon leakage in the initial stage, which serves to limit the amount of embodied carbon in imported goods and the carbon cost paid by producers, encourage green production, and contribute to the investment in further emission reduction in the EU.

However, since CBAM entered the legislative process, Brazil, India, South Africa, and other emerging markets have criticized the mechanism. These countries accused the EU of implementing trade protectionism under the pretext of climate action. Last August, India and Russia warned the EU that if it continued to promote the implementation of CBAM, they would file a lawsuit with the World Trade Organization (WTO). For countries with large export volume to the EU, the implementation of CBAM will raise export costs, reduce export volume and weaken their trade competitiveness. Developing countries believe that this violates the principle of non-discrimination in WTO rules. According to the International Monetary Fund (IMF), even if countries around the world fully implement their nationally determined contributions (NDCs) in the Paris Agreement, the price of carbon emission would still reach about USD75 per ton by 2030. In this context, if developing countries do not fundamentally improve emission reduction technologies, they will have to face high carbon costs.

Impact of CBAM on China

Currently, the impact of CBAM on China is mainly reflected in two aspects:

Impact on the carbon price. China’s national ETS was announced in 2017 and officially launched in January 2021. In July 2021, trading commenced on the platform operated by the Shanghai Environment and Energy Exchange. Trading initially covers only the power sector, which accounts for 40% of the country’s annual carbon emissions. In 2020, the average carbon price in China’s national ETS remained between USD3.28 to USD12.62, significantly lower than that of the EU ETS. After the implementation of CBAM, even if China’s exports to Europe paid the carbon cost at home, EU importers still need to buy CBAM certificates due to the unequal carbon price. The price of the CBAM certificate is the average price of EU ETS, so the EU can dominate global carbon prices and influence other countries’ carbon prices. As a result, China will face a challenge in independent pricing for its emission trading market.

Potential impact on China’s commodity exports. According to Comtrade, products covered under CBAM in 2020 accounted for only 1.19% of China’s exports to the EU. Therefore, it has little impact on China’s export to the EU in the short term. But in the long run, because the EU continues to make efforts in the low-carbon field and design new rules to enhance the competitiveness of its own industries, it may weaken major manufacturing powers’ advantages in terms of technology and production cost. Once a new carbon tax is formulated and levied on China’s advantageous industries, combined with other bills on trade such as countervailing and supply chains, a policy package to restrict China’s industries may be formed.

In general, CBAM is bound to change the flow and structure of international trade, leading to significant changes in global trade patterns. From this perspective, China’s 2030 “carbon peak” and 2060 “carbon neutrality” goals (dual-carbon goals) not only have the significance of ecological and environmental protection but also strategic significance for the economy and trade. Under the dual-carbon goals, as China’s industries continue to optimize production processes and reduce energy consumption and emissions, China has the potential to significantly improve its relative cost advantage and market competitiveness despite the challenges of the EU’s CBAM.

Reference：

https://www.consilium.europa.eu/en/press/press-releases/2022/03/15/carbon-border-adjustment-mechanism-cbam-council-agrees-its-negotiating-mandate/

https://www.reedsmith.com/en/perspectives/2021/12/five-key-things-about-the-eus-carbon-border-adjustment-mechanism

https://www.reuters.com/business/energy/europes-carbon-price-nears-100-euro-milestone-2022-02-04/

https://www.ey.com/en_ch/tax/green-taxes/carbon-border-adjustment-mechanism

https://chinadialogue.net/en/climate/understanding-cbam-eu-carbon-levy/