Trading in a New Climate: how EU CBAM will reshape the global trading system
Published 7 September 2023
Tim Figures, Associate Director, EU & Global Trade and Investment
Boston Consulting Group
Ahead of the COP 26 climate summit in Glasgow in 2021, most of the world’s economies set themselves net zero targets – the date by which their economies would become carbon neutral. But on returning from Scotland, those governments were faced with a challenge – how to turn a target date (of 2050 in most cases) into reality.
Their response has been to ramp up the use of demand and supply side regulatory levers in order to mobilise the massive private sector investment required to decarbonise. In the EU, the Fit for 55 programme incorporates over 14 separate but interconnected policy initiatives impacting all sectors of the economy, from industry to agriculture and transport. Most of these involved tightening standards or raising costs on EU companies – such as by increasing the price industry pays to emit carbon under the EU Emissions Trading System (ETS).
But the EU isn’t an autarky – consuming only what it produces. It is inextricably part of the global trading system, importing over €3 trillion of goods a year – many of which are carbon-intensive and whose producers aren’t subject to the bloc’s strict new domestic rules. Without regulatory intervention, the economic response to this situation would be clear – cheaper but more carbon-intensive imported goods would substitute for domestic ones. This phenomenon – often termed ‘carbon leakage’ - would produce negative economic impact and job losses in the EU without addressing global carbon emissions: a lose-lose situation unacceptable to Brussels.
The EU’s solution – the introduction of the world’s first Carbon Border Adjustment Mechanism – will have profound consequences for world trade. By pricing the carbon embedded in imports of certain goods at the same price as domestic emissions, the bloc hopes to incentivise the decarbonisation of global supply chains while also protecting its local producers from being undercut. Carbon-intensive sectors such as steel, aluminium and fertilisers will be first hit by the levy, with other industries and products set to follow later in the decade. And although it is first and foremost a climate-related measure, CBAM will be administered at the border by importers and customs authorities, just like a traditional tariff.
Those impacted can be broadly broken down into four groups: non-EU producers, EU importers, EU end-users and overseas governments. Each will be faced with a set of compliance and strategic issues to consider as CBAM starts to take effect from October 2023.
Non-EU producers will in many cases have to address emissions calculation and carbon pricing concepts for the first time. In the short term, they will need to determine which impacted products they export to the EU and establish the embedded carbon emissions of each, using the European Commission’s approved methodology. This information will then need to be passed on to their importers to ensure that their goods continue to flow smoothly across the EU’s borders. In the medium term, once these compliance obligations have been addressed, non-EU producers face a range of strategic questions – including whether and how to decarbonise their own products and processes to maintain competitiveness in the EU market.
EU importers are legally responsible for declaring embedded emissions and paying the CBAM levy. But they can only do this if they receive accurate and timely information from non-EU producers about the goods they trade. The transport and logistics industry – which has never before had to engage in this way with climate-related regulation enforced at the border - faces significant challenges to ensure it can comply with the new rules on behalf of its customers.
EU end-users are the purchasers of CBAM products, which often represent key inputs into a wide range of sectors from construction and automotive to packaging and agriculture. On the assumption that CBAM costs are passed on to them by importers, these end-users will see the price of their carbon-intensive imports rise relative to EU or low-carbon alternatives. This will particularly be the case from 2030 when around 50% of the free ETS allowances EU producers currently receive will have been phased out. End-users will need to reconsider their procurement strategies, placing additional emphasis on carbon footprint alongside price, to ensure that they manage the consequences appropriately.
But it isn’t just companies who will be affected – governments will need to consider the impact on their economies and export strategies. As a consequence of CBAM, countries will need to think about their own ‘carbon competitiveness’ – in other words, whether are they at risk of being shut out of global value chains due to the carbon intensity of their exports. Initial analysis of the impact of the CBAM suggests that countries such as Turkey, South Africa, Brazil, India and China could face significant challenges given they currently export significant quantities of products such as steel and fertilisers to the EU.
The EU may be the first bloc to introduce a CBAM but it is unlikely to be the last. Other developed economies face similar carbon leakage challenges as they progress towards their 2050 net zero targets. By the end of the decade, we might see as many as 5-6 similar schemes globally, with countries such as the US, Canada, UK and potentially China and South Korea also following suit. While this would expand the effectiveness of CBAM as an industrial decarbonisation measure, it could also bring with it new administrative trade barriers, particularly if these various global schemes are not coordinated. Multinationals run the risk of being faced with a multiplicity of different systems, bringing additional complexity and compliance risks to their supply chains.
Bilateral or multilateral agreements between countries with CBAMs could help to ensure these barriers are minimised. Perhaps by building on developing concepts such as climate clubs, we might see a new generation of Free Trade Agreements (FTAs) focussing on trade in carbon. Countries with similar domestic carbon rules (and carbon pricing) might agree that goods traded between them would be exempted from their respective CBAM regimes (while maintaining the levy on third-country imports). The European Union envisages negotiating these types of agreements, but as things stand none have been concluded1. As the EU and US are finding in their current negotiations on the treatment of the transatlantic steel trade, this process brings with it many of the challenges associated with traditional FTAs – including assessing the equivalence of different regulatory regimes and development of measures to avoid circumvention.
It is still early days. The EU CBAM starts with a light-touch transitional phase, running until the end of 2025, allowing all those impacted some time to get to grips with the new rules. But it’s when we look beyond these short-term implementation challenges to the strategic impact on global trade that things start to get interesting. Will we see a world of increasingly decarbonised supply chains, as companies get the message that access to EU markets depends on taking climate action? Or will we see a more decoupled world, with a group of high-ambition climate club members trading low-carbon products between each other, while raising barriers to market access for non-members? Either way, there is no doubt that the linkage between climate action and the global trading system is here to stay – and companies and governments worldwide will need to consider their response.
- The EU has exempted Switzerland from the CBAM as its’ carbon pricing scheme is linked to the EU ETS but this is not strictly speaking a state to state ‘equivalence’ agreement.