This is a guest post from trade lawyer Bixuan Wu of the Hiways law firm:
On July 14, the European Commission unveiled its ambitious “Fit for 55” package, which includes the long-awaited legislative proposal on Carbon Border Adjustment Mechanism (CBAM).
The CBAM is the first climate measure that has potential to profoundly change the rules of world trade. In China, its details didn’t draw as much attention as in Europe. Since May, I wrote three articles on Chinese media analyzing the CBAM’s possible design choices. Now with the release of the official text, CBAM observers can finally not use leaked drafts as best information available.
- Prudence is the EU’s paramount choice
I-1. CBAM will co-exist with free emissions allowances for a long while
The question of whether free allocation of allowances should continue when the CBAM is in place has always been the center of controversy.
The Proposal says Yes. Article 1 sets the tone that the CBAM will “progressively become an alternative to” free allowances. So, taking how long is “progressively”? The answer is not in the Proposal. Rather, we should look at the EU ETS proposal published the same day, which says that during the CBAM’s transitional period, i.e., from 2023 to 2025, CBAM covered sectors will still receive 100% of their share of free allowances. In 2026, the percentage will drop to 90%, and thereafter be reduced by 10% each year and thereby be 0% in 2035. In other words, it takes 12 years to phase out free allowances.
This must be a tough decision for the Commission. The CBAM and free allowances are both measures to prevent carbon leakage. Keeping free allowances could potentially be inconsistent with WTO rules because it may lead to double protection and thus make the CBAM more vulnerable to criticism from EU’s trading partners. On the other hand, ending free allowances will certainly provoke more resistance from inside, from EU industries.
The Commission tried to appease both sides by keeping free allowances and meanwhile avoiding double protection. The solution is to deduct from imports’ “carbon levy payable” an amount equal to free allowances received by EU like products.
I-2. CBAM covers direct emissions only
During the transitional period (2023-2025), the CBAM applies only to direct emissions released from the production processes of imported goods, not to emissions embedded in electricity, and not to emissions embedded in inputs purchased. Will indirect emissions still be excluded after the transitional period? No guarantee. The Proposal says that before the end of the transitional period, the Commission will consider if CBAM is to be extended to indirect emissions.
The exclusion of indirect emissions is a big surprise. Recall that the European Parliament’s CBAM Resolution published in March stated that the CBAM should cover both direct and indirect emissions. The drafts leaked recently also indicated the same. With no doubt, letting indirect emission go will significantly lower the “taxable” emissions of imports. This looks like a big concession by the EU to its trading partners. Well, not necessarily. It has to be read in context with the transitional provisions below.
I-3. No monetary obligation during the transitional period
During the transitional period (2023-2025), importers will have no monetary obligation under the CBAM. In other words, no tax. However, they must report, on a quarterly basis and for each type of goods imported: 1. total quantity; 2. total direct emissions embedded; 3. total indirect emissions embedded, and 4. carbon price due in the exporting country corresponding to the total direct emissions, if any. There will be a penalty for failing to report.
Sounds like a mandatory drill. For importers, except for no carbon tax expenses, they still have to calculate both direct and indirect emissions for imported goods. Thus, excluding indirect emissions during the transitional period is meaningless. When it comes to money, it has no burden relief effect because there is no tax burden in the first place. When it comes to time and effort, it provides no relief either, because importers have to calculate indirect emission anyway. Maybe it will finally benefit importers after the transitional period? Well, the Proposal leaves room for the Commission to extend the CBAM to indirect emissions, which I think is probable.
Summary: “No tax” during the transitional period is a tangible benefit. It helps alleviate the vigilance of EU’s trading partners towards the CBAM. The prolonged phase-out of free allowances will ease the anxiety of the EU industries. Excluding indirect emissions is symbolic but still is a placebo. Overall, the European Commission did not underestimate the resistance that the CBAM may face and thus picked a prudent route. However, as time passes, particularly after the COP26, strategic adaptation is not ruled out.
- Product scope and countries exempted
Takeaway 1: CBAM covers cement, electricity, fertilisers, iron, steel and aluminium
According to Annex I of the Proposal, CBAM will apply to imports of cement, electricity, fertilisers, iron, steel and aluminium. This is a shrunken list. Recall that back in March, the European Parliament considered the CBAM “should cover all imports of products and commodities covered by the EU ETS” and ‘should cover the power sector and energy-intensive industrial sectors like cement, steel, aluminium, oil refinery, paper, glass, chemicals and fertilisers”. The current scope is much smaller than that of the EU ETS and skipped some sectors deemed at high risk of carbon leakage.
Major changes from the leaked draft of June: the iron and steel scope expands significantly. In the leak, the scope involves only CN code chapter 72 “Iron and Steel”. Within that chapter, only carbon steel is covered. Now that stainless steel and special steels are added to the list. Moreover, the scope is expended to cover some downstream products, namely tubes and pipe fittings as well as some other products under chapter 73 “Articles of Iron or Steel”. As explained by the Commission, this is to prevent circumvention.
Country exemption: According to Article 2, the EU will exempt countries that either participate in the EU ETS or have linked their carbon market to the EU ETS. In addition, the carbon price charged in those countries must be bona fide paid. Annex II exempts Iceland, Liechtenstein, Norway (all participate in the EU ETS) and Switzerland (due to linking), as well as 5 EU overseas territories. The Proposal does not give special treatment to Least Developed Countries and Small Island Developing States notwithstanding such special treatment has been stressed by the European Parliament earlier in its Resolution. The Proposal merely states that the EU should support less developed countries with technical assistance.
III. The “Taxing” Process
Takeaway 2: Only authorized importers can import CBAM goods
Only importers authorized by national CBAM authorities can import goods covered by the CBAM. Each authorized importer will be assigned a unique account number in a national CBAM registry and database. It is the authorized importer who declares the carbon content embedded in imports and pays the “carbon levy”.
Takeaway 3: Carbon price of imports mirrors that of the EU ETS
For each tonne of embedded emissions of imported goods, the authorized importer must purchase one CBAM certificate issued in electronic format.
For each week (week 1), the European Commission will calculate the average price of all EU ETS allowances sold, and then publish the price on the first working day of the next week (week 2). That price will be the price of CBAM certificates to be sold from the second working day (of week 2) to the first working day of the following week (week 3). Put simply, the CBAM price mirrors the average EU carbon price of the previous week, with the exception of the first working day of each week. On that day, the CBAM price mirrors the average EU carbon price of the week before last.
Takeaway 4: Carbon levy collected yearly, not at the time of importation
At the time of importation, the importer is not required to pay the “carbon levy”. Rather, it is collected on a yearly basis.
By the end of May, an authorized importer shall report to the CBAM authority the following information with respect to goods imported last year: 1. total quantity; 2. total emissions embedded; and 3. total number of CBAM certificates to be surrendered, which equals to the total emissions reduced by carbon price paid in the exporting country and free allowances allocated to EU like products.
By the end of May, an authorized importer must submit CBAM certificates in a number corresponding to the declared emissions which is verified by an accredited verifier.
Takeaway 5: Bookkeeping, inventory threshold, re-purchase and cancellation of CBAM certificates
CBAM certificates cannot be traded between importers. This is a major difference with the EU ETS allowances.
Bookkeeping: Each CBAM certificate has a unique ID number. For each certificate sold, its ID number, price and date of sale are recorded in the purchasing importer’s account.
Inventory threshold: The Proposal sets a quarterly inventory threshold for importers. At the end of each quarter, an importer must maintain on its account enough CBAM certificates to cover at least 80% of estimated emissions of goods imported during the quarter. The estimation is based on default carbon intensity values. This is to prevent importers from withholding purchases until the surrender deadline approaches or a time when the CBAM certificate price is relatively low.
Re-purchase and cancellation: Once an importer fulfilled its obligation to submit certificates, it may request the CBAM authority to re-purchase the remaining CBAM certificates on its account at the original price paid at the time of purchase. The re-purchase is capped to one third of the total CBAM certificates bought last year. By the end of June, any CBAM certificates that were bought during the year before last and remained on the importer’s account will be cancelled.
The combination of the above measures is to prevent arbitrage and to ensure the carbon price charged to imports reflects the price fluctuation of the EU ETS. The 80% inventory threshold means importers have to buy most CBAM certificates at a time close to the importation. The cancellation measure is to discourage stockpiling. In a given year, after paying CBAM, if there is a surplus of certificates in excess of the entitled re-purchase cap, the excess has one year “shelf life” left and can only be used to pay CBAM in the following year.
- Calculation rules
Takeaway 6: Actual emission data preferred
Embedded emissions of imported goods is the “tax base” of the carbon levy. The basic equation is:
Embedded emissions (tonne CO2) = quantity of goods (tonne or MWh) * carbon intensity (tonne CO2/tonne or tonne CO2/MWh);
In principle, embedded emissions in goods other than electricity shall be determined based on actual data. When actual data is not available, default values will be used.
For electricity, emissions will be determined based on default values. This is irrelevant to China though.
Takeaway 7: Default value use exporting country average, if unavailable, use EU’s worst performance
According to Annex III, default values shall be set at the average emission intensity of each exporting country and for each type of goods, increased by a mark-up which is to be determined in implementing acts. The Proposal contains no clues on the what and why of the mark-up.
When reliable data of average emission intensity is not available for a type of goods of a particular country, the default values will be the average emission intensity of the 10% worst performing EU producers of the like product. This is the flip side of the benchmark for free allocation of allowances in the EU ETS, i.e., 10% best performing EU producers.
Takeaway 8: Emissions reduced by free allocation and carbon price paid in exporting country
Given that EU producers will continue to receive free allocation of allowance, charging a carbon price on the full amount of emissions embedded in imports will lead to double protection. Thus, an adjustment that reflects the free allocation should be made on the “carbon levy payable” of imported goods. This is a “tax base” adjustment.
To be fair, if a foreign producer has paid carbon cost in its country, that part should be deducted from the CBAM. Otherwise, the carbon content of imports will be charged twice. That will be against the principle of non-discrimination under WTO rules. Accordingly, Article 9 stipulates a deduction for the carbon price paid in the exporting country.
Takeaway 9: Foreign producers may register the emission intensity of their products
According to Article 10, a foreign producer may register in a central database managed by the European Commission (compared to importers who register at the Member State level). The registration is valid for five years. Registered foreign producers may disclose their verified actual emission intensity to importers. This is important because if importers use that disclosed information to declare emissions, the latter need not to be verified again.
Takeaway 10: Emission intensity calculation methods
For “simple goods” and “complex goods”, Annex III each provides for a method to calculate emissions. My understanding is that the former corresponds to products resulting from one step production process, and the latter corresponds to products resulting from multi step production process. The emission intensity of simple goods is direct emissions attributed to the production process divided by the quantity of goods produced. The emission intensity of complex goods is the sum of direct emissions of all steps in the production process divided by the quantity of goods produced. For complex goods, while emissions from the production of inputs is counted, it is limited to those emissions released within the system boundaries of the process. In other words, the emissions embedded in purchased inputs is not to be considered because they are released outside the system boundaries.
- Administration and enforcement
Takeaway 11: Implementation mostly at Member State level
Compared to the leaked draft of June which proposed a central CBAM authority, the Proposal confers most implementation and enforcement tasks to authorities in Member States, such as authorization of importers, acceptance and review of declarations and the sale, re-purchase, cancellation and bookkeeping of CBAM certificates. On the other hand, the Commission acts as central administrator to maintain an independent transaction log and oversees irregularities.
Takeaway 13: Measures against tax evasions
Importer’s bond: Newly established importers will be required to post a bond so as to ensure the fulfilment of its CBAM obligations.
Emissions verification: Emissions reported by importers or foreign producers must be verified on-site by an accredited verifier.
Declaration review: After declaration, imports must keep the data used for emissions calculation for four years not including the year of declaration. During the bookkeeping period CBAM authorities may review the data and carry out on-site audit.
Penalty: For each tonne of unpaid emissions, the importer must surrender one CBAM certificate and pay a fine of EUR 100.
Anti-circumvention measure: Circumvention is a change in the pattern of trade without sufficient economic justification other than avoiding CBAM obligations, including replacing CBAM goods with slightly modified products. If over a two-month period import volume of a CBAM goods significantly decreases, and at the same time import volume of slightly modified products significantly increases, the Commission may add the slightly modified products to the CBAM.
- Concluding remarks
The CBAM Proposal is less aggressive than expected. There will no payment obligations during the transitional period. This allows more time for preparation for exporting producers. But they still have to calculate and report emissions of exports to the EU. This is a warm-up drill in itself. The CBAM is very likely to encounter challenges in the WTO. Proponents and opponents alike both can find a basis in the existing WTO rules as they were not drafted to address climate change problems and policies. Two questions are worth asking. Will the next decade be WTO’s decade? Will the next decade be carbon neutrality’s decade? These two questions shed lights on from where come the rules of the game of the future.
