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EU ETS and CBAM: how can businesses navigate the complex landscape of carbon pricing?

Climate action is one of the main priorities of the European Union. In 2019, the unveiling of the European Green Deal, an ambitious growth plan to reshape EU industries towards more sustainable production, set a roadmap to achieve carbon neutrality for the whole continent by 2050, and included several regulations and policies to achieve the target.

Among these, a crucial tool is the EU Emission Trading System (ETS), which creates one of the largest carbon markets in the world. The EU ETS has been in place since 2005, but subsequent reforms – including the Green Deal – have extended the sectors covered by carbon pricing. The system works following a ‘cap and trade’ logic: every year, it establishes a ‘cap’ – the maximum amount of emissions possible by sector – and allowances ‘to pollute’ are distributed among producers. These allowances can also be traded among producers: hence, ‘greener’ firms can sell their allowances to other producers and make profit. On the other hand, polluting firms can buy more allowances, which generates an additional cost. The system creates a series of economic incentives that rewards sustainable firms and pushes polluting firms to decarbonise their production processes.

However, the EU ETS also poses some risks. The most important one concerns the scenario where, instead of cutting emissions, the production of carbon-intensive goods is shifted to extra-EU countries where climate regulation is less stringent. This effect is called ‘carbon leakage’: in brief, European importers might find it more convenient to choose cheaper carbon-intensive goods produced abroad, rather than EU-produced goods – which, owing to better environmental standards, might be more expensive. As such, the overall emissions of the supply chain, instead of being abated, are simply moved from the EU to extra-EU countries, resulting in a loss of profit for European producers.

To face the risk of carbon leakage, the European Commission has proposed a Carbon Border Adjustment Mechanism (CBAM), which would complement the EU ETS system. In short, the CBAM consists of a ‘carbon tax’ on imported goods, paid by the importer, that would price the emissions used along the production process of goods imported to the EU. As such, the CBAM will ensure the carbon price of imports is equivalent to the carbon price of domestic production, and that the EU’s climate objectives are not undermined.

The EU CBAM is now in its transitional phase, lasting from 2023 to 2026. Its current design only covers six sectors: aluminium, cement, electricity, fertilisers, iron and steel, and hydrogen. During the transitional period, importers only have the obligation to report the embedded emissions in the imported products and familiarise themselves with the new obligations. Starting from 2026, the CBAM will then be entirely phased in, and EU importers will have to buy CBAM certificates, declare the embedded emissions in imported goods, and later surrender to authorities the amount of CBAM certificates covering those emissions.

If your business is affected by the Green New Deal, ETS, CBAM or other European legislation, get in touch to find out how European Diplomats can help.


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