ETS and CBAM: two instruments to deliver on the European Green Deal
The European Green Deal presented by the European Commission in 2019 sets the very ambitious target of making Europe the first climate-neutral continent by 2050. The revision of the EU Emissions Trading System (ETS) and the introduction of a Carbon Border Adjustment Mechanism (CBAM) as proposed by the European Commission in July 2021 share the same objective: reducing the EU’s greenhouse gases (GHG) emissions while ensuring that those environmental efforts do not undermine the competitiveness of EU companies.
In 2005, the EU introduced a cap-and-trade system to limit the overall GHG emissions within the EU. Today, the ETS is the biggest carbon market in the world. The EU now wants to impose stricter rules for GHG emitters both within and outside the EU Single Market, in line with its climate target for 2030.
To that effect, the European Commission presented, in July 2021, two proposals for a revision of the EU ETS and for the introduction of a Carbon Border Adjustment Mechanism (CBAM). The proposals form part of the “Fit for 55” package which aims to reduce by 2030 the EU’s GHG emissions by 55 per cent compared to 1990 levels.
The revision of the current ETS
The EU ETS currently sets an annual cap on the amount of GHG that companies in specific carbon-intensive sectors may emit in the EU. Under the EU ETS, an annual cap is set on the number of emission allowances by power plants, industry factories and the aviation sector. Within that cap, EU companies are required to buy emission allowances corresponding to their CO2 emissions; unused allowances can be sold or used the following year. The cap is gradually reduced over time to ensure emission reductions. In addition, a number of sectors considered to be at risk of “carbon leakage” receive allowances for free to support their competitiveness. Carbon leakage occurs when companies transfer their production of carbon-intensive goods to third countries with no, or less stringent rules on the pricing of such goods.
The July 2021 ETS revision proposal sets to further reduce the total cap on emissions (which will subsequently increase the price of emission allowances) and to phase out free allowances granted under the current EU ETS.
The introduction of a CBAM to complement the new ETS
In order to maintain the competitiveness of the EU, the CBAM would progressively replace the system of free allowances that currently exists under the EU ETS. The CBAM would operate as a pricing mechanism on certain goods with a high carbon footprint, such as iron and cement, that are imported in the EU from third countries. In practice, importers would be required to purchase CBAM certificates in amounts that correspond to the embedded emissions of their imports and that reflect the ETS price.
This would ensure an equivalent price on carbon for imported products and for EU products, and thus a level playing field between domestic producers (which are already subject to the EU ETS) and third country exporters, which will become subject to the CBAM when importing goods.
According to the Commission proposal, the CBAM would start to apply in 2023 with a “phase in” period of three years during which only reporting obligations would be imposed on importers. As of January 2026, importers would need to buy CBAM certificates for their imported products. The CBAM would be gradually implemented over ten years. The European Parliament proposes January 2027 as a starting date for the application of the CBAM. This means that the amount of required CBAM certificates would be adjusted to mirror any free allowances still allocated under the EU ETS – via a proportional discount.
The calibration of this transitional ten-year period during which free allowances will be phased out will be one of the key elements to ensure that the CBAM does not discriminate against third country exporters, in compliance with the principle of national treatment under World Trade Organisation (WTO) rules.
Compliance of CBAM with WTO rules
The CBAM will be the first carbon adjustment mechanism to be implemented worldwide and its compliance with the WTO framework has come under intense scrutiny. A briefing on the legal issues related to carbon border adjustment mechanism published by the Directorate-General for external policies in April 2020 explains the main WTO issues raised by the introduction of such a mechanism in the EUIt has been carefully designed by the Commission to ensure a level playing field between EU and third country producers.
In addition to the coordinated phasing out of free allowances described above, the price of the CBAM certificates will reflect the price of carbon in the EU ETS so that EU and third country producers are subject to the same price. To achieve this, CBAM certificates will be sold at a price equal to the average of the closing prices of all auctions of EU ETS allowances during the relevant calendar week.
Furthermore, third country exporters will be able to claim a reduction in the number of CBAM certificates to be surrendered corresponding to the carbon price already paid for those emissions in the country of production. This measure also encourages third countries to adopt carbon pricing measures.
Potential WTO challenge?
The chances that the CBAM is challenged before the WTO are slim since the WTO Dispute Settlement Understanding process is currently blocked by the refusal of the United States to nominate new members for the WTO Appellate Body. Even if the CBAM was challenged under the WTO framework, the EU has put a lot of efforts to make the mechanism compliant with the WTO rules. In fact, the difficulties related to the CBAM are more likely to stem from the complexity to put in place such a mechanism and for companies and national authorities to implement it.
The EU has made the reduction of the GHG emissions a priority for the coming years. The war in Ukraine has recently further delineated the need to accelerate the green transition to make the EU less dependent on fossil fuels. The trilogue negotiations between the European Parliament, the Council and the European Commission on the two proposals to revise the ETS and establish a CBAM are ongoing and an agreement could be reached by the end of this year. As the interest for carbon pricing mechanisms is increasing worldwide, the EU may thus well pave the way for the implementation of CBAM at global level.