Carbon Border Adjustment Mechanism: Implications for Australia

Here are some of my thoughts on the Carbon Border Adjustment Mechanism (CBAM) that I shared on The Drum on the 15th of July '21. The ABC iview link to the episode can be found in the comments section below.

What is the Carbon Border Adjustment Mechanism (CBAM)?

Climate change due to greenhouse emissions is a global problem. The Paris agreement requires countries to set Nationally Determined Contributions (NDCs). Countries can set their own NDCs, and therefore the only way for unilateral measures to have global impact is through carbon border adjustments. Otherwise, emission reduction in one territory could be displaced by emissions elsewhere where carbon ambition is lower (‘carbon leakage’). The EU, the US, Canada, Japan, South Korea and the UK are ramping up climate commitments ahead of the COP26 Climate Summit, including through domestic carbon prices. To enable their carbon pricing to operate effectively across the global economy, they are contemplating carbon border adjustment mechanisms (CBAMs). Once implemented, CBAMs will tax the carbon content of imports from countries with unpriced carbon, such as Australia.

I describe the CBAM as needing three attributes – ‘there’, ‘fair’ and ‘share’. As outlined below, border adjustment for carbon is a necessary feature in decarbonisation to net zero. So, it needs to be there. Any such mechanism that impacts industries, livelihoods, communities and trade has to inherently be fair, otherwise it will not be accepted. Finally, the scheme will only be successful if the benefits accrued and the EU looks to share the revenue in order to accelerate climate goals.

There: Logically, a mechanism such as CBAM is inevitable as the world rapidly tries to decarbonise to net zero. The reason is simple. Unless all or even most economies of the world commit to a similar trajectory to net zero, there are two risks. The first is that those who commit to net zero fastest will wear a higher cost, particularly when trading with economies who are free riding from a carbon point of view. These economies need to protect their industries and jobs. The second is that there may be carbon leakage, that is, businesses shifting emission intensive operations to jurisdictions that don’t have a carbon cost (or one that is lower or negligible) or importers choosing to import from similar jurisdictions avoiding the carbon payments. This means that climate objectives remain unmet. Ultimately, mechanisms such as CBAM will work to set a global price for carbon.

The European Union is proposing to be the first mover on CBAM. This is likely to be, after Kyoto and Paris and alongside COP26, one of the most significant steps in global climate diplomacy. It is also happening at a time when world trade (and the WTO) is experiencing significant headwinds, and at a time when the EU itself is on survival mode following Brexit. Therefore, it is imperative that the CBAM is developed in a constructive manner that does not alienate trade partners, nor take away from the foundation of collective ambition founded by the Paris Agreement on climate change, but is phased in with CBAM policy success and climate diplomacy as the outcomes rather than a short-term mechanism that erodes business in other trade economies.

The EU has committed to very significant emission cuts — 55% on 1990 levels by 2030, and zero net emissions by 2050. The set of policies forthcoming is therefore called ‘fit for 55’. On this trajectory, Europe is set to become the first carbon neutral continent per the EU Green Deal (including just transition, using income from the ETS and CBAM to help business and workforce transition) and the EU ETS (plus several other focus areas such as biodiversity and sustainable transport to name a few). Therefore, it is unsurprising that the EU is looking at a CBAM. EU ETS covers Entire EU, plus Norway, Iceland and Liechtenstein. It covers c. 11,000 installations (in specified heavy industries), and 600 aircraft operations flying to/from EEA. The ETS mechanism is very similar to the carbon pricing mechanism implemented in Australia during the Gillard era. 

The European Commission (EC) adopted on July 14 a package of proposals under the EU Green deal including a Carbon Border Adjustment Mechanism (CBAM). The CBAM will initially apply to imports into the EU of iron and steel, aluminium, cement, fertilizers and electricity. During a transition period from 2023 to 2025, importers will have to report the emissions embodied in the goods brought to the EU without paying any duties.

Definitive measures will come into force in 2026, and importers will then have to declare annually the quantity of goods and the amount of embedded emissions in the total goods they imported into the EU in the preceding year, and surrender the corresponding amount of CBAM certificates. CBAM will apply to direct emissions but, by the end of the transition period, the EU will evaluate whether an extension of the measures is needed, possibly including indirect emissions. Finally, the phased approach will also allow the EU to fully phase out by 2035 the system of free allowances to domestic producers.

Share: Revenues from the CBAM for the EU have been estimated to be between 5B – 14B Euro per annum, which could aid in implementing aspects of the Green Deal including just transition.

Why now?

Globally, 2020 was the warmest year on record, matching 2016, with a mean temperature above 1.2 degrees Celsius above pre-industrial levels. We are therefore four-fifth of the way to the 1.5 deg C safe level to which the world is committed to try and limit global warming. The average global concentration of carbon dioxide for 2020 was higher than any point in the past 800,000 years. 

There is significant movements this year is the Conference of Parties (COP26) meeting in November, delayed by a year due to Covid. The UK government, which is co-hosting the summit with Italy, has laid out four objectives:

-         For every country to commit to hit net zero by 2050

-         Ensure the protection of the most vulnerable peoples in a warming world

-         Deliver a $100B a year climate finance pledge from richer nations

-         Increased collaboration across business, civil society and nations.

Concerningly, early this year, only 74 countries representing 30% of global emissions had submitted a climate plan. Worse still, current pledges would only cut 0.5% of emissions by 2030 compared to 2010 levels, a significant gap from the 45% emissions cuts needed to achieve 1.5 deg by 2030. The Schroder’s Summary Climate Progress Dashboard is also quite concerning from the points of view of ambition and action (see above, source: Schroders).

What requirements does an EU Carbon Border Adjustment Mechanism (CBAM) need to have?

An EU CBAM has to meet climate objectives, meet EU Law and articles, ideally be Paris-aligned (and UNFCCC aligned) and most importantly, be WTO compliant (so that it is not used in a protectionist trade instrument that discriminates against foreign imports or particular foreign countries). Agreement needs also be met between the EU Council, EU Parliament and the EU Commission.

In order to comply with the new CBAM regulation, importers of the covered goods would need to obtain authorisation from a newly created CBAM authority, and purchase CBAM certificates. The price of these certificates would be tied to the weekly price of ETS permits sold to domestic producers. Companies have two methods for calculating emissions. The default method of accepting the emission profile for the worst 10% carbon performers in the EU for that sector, or alternatively calculating actual emissions.

What are some of the weaknesses of the proposed EU CBAM?

Administrative costs: The CBAM approach based on importers’ authorisation, on third-party verification of emissions and on the purchase and surrender of certificates would introduce a large amount of additional administrative costs for importers. 

Impact on Developing and Least Developed Nations: Several countries that are developing or leased developed are significant exporters to the EU, including Cameroon, Mozambique and Ukraine. There is an important argument to support these economies to transition rather than impact their current business models. Exports by developing countries across the targeted carbon-intensive sectors would be reduced by 1.4% if the CBAM is implemented with a price of $44 per tonne of embedded CO2 emissions, and by 2.4% if it’s implemented with an $88 per tonne price, a recent UNCTAD report shows. The significance of the impact notwithstanding, with a CBAM based on a carbon price of $44 per tonne, the income of developed countries would rise by $2.5 billion, while that of developing nations would fall by $5.9 billion, according UNCTAD’s analysis. However, developed countries would experience a higher welfare loss of $51 billion from the initial introduction of a carbon price of $44 per tonne, driven by losses in the EU, while developing countries would gain $1 billion in the absence of the CBAM. Potential employment effects would be small for most economies, the report shows.

Greening Asia and Africa: The main Paris mechanism, which has lagged, is climate support finance to least developed and developing countries. Given the big game over the next three decades aside from decarbonisation is shifting production capacity to South and SE Asia and Africa. Greening this build out is key to net zero by 2050, which may be aided by CBAM revenue.

Protectionism: If the free allowances provided under the EU ETS are not phased out, removed or taken into account in setting CBAM prices, this will result in trade disputes and potential legal action by exporters, threatening an orderly decarbonisation transition, and in the near-term potential impacts on expected climate outcomes at COP26. However, the phased approach outlined suggests a complete phase out of free allocations by 2035.

Addressing these weaknesses will make the CBAM fairer, and given the phase-in approach proposed, there's now time to work through these areas with critical stakeholders to progress global climate diplomacy.

Which countries exempt from an EU CBAM, and which ones are likely impacted?

Some countries are exempted from the CBAM altogether. Switzerland has already linked its ETS to the EU’s, and the European Economic Area (EEA) countries Iceland, Liechtenstein and Norway participate in the EU’s ETS. More countries could be added to this list if they either fully integrate within the EU’s ETS, or link their own ETS to the EU’s. 

The intention is that the EU CBAM will coverage of sectors over time, and that a ‘climate club’ will also form expanding the number of countries enforcing a CBAM. Likely countries are the G7, comprising of Canada, France, Germany, Italy, Japan, the UK and the US. China may also join given the recent announcement that China’s long-awaited national carbon trading market, set to be the world’s largest, will be launched very soon and include more than 2,000 power companies in its initial stage. Together, these firms account for about four billion tonnes of carbon dioxide (CO2) emissions annually. The world’s largest producer of greenhouse gases, China accounts for 27 per cent of the world’s emissions.

Countries most impacted are shown above (Source: UNCTAD based on UN COMTRADE).

What is the impact on Australia?

Australia’s two-way services trade with the European Union (EU) was valued at $20 billion in 2016 and accounted for almost 8 per cent of Australia’s total services trade. However, much of this was related to tourism and services.

The Australian Government is opposed to the tax burden imposed by the CBAM. Trade Minister Dan Tehan recently announced that the Government will push back against the CBAM via the WTO. Instead, it will argue for a plan to eliminate tariffs on certain environmentally friendly products and services.

Australia is a relatively small exporter to the EU. In terms of specific impacts on Australian Industries, modelling by Victoria University suggests that Coal (about 6% of Australian exports to the EU) would have a 50% price increase, Aluminium and Alumina (around 10% to 20% of exports going to the EU) may see a 3.5 to 4% price impact and Iron and Steel (about 12% of exports going to the EU) may see around 9% price impact. The long-run projected loss in gross domestic product is 0.05%, which is equivalent to a fall in weekly income of less than $1 per person or about one weeks’ worth of normal growth. Overall, it is projected to cut Australian coal production by 3.8% relative to where it would have been with the loss of about 3,000 jobs. However, if in addition to the EU, the UK, the US and others such as Canada, Japan and South Korea go ahead with CBAMs or join the ‘climate club’, the impact on Australia will be greater. But it will be a magnitude more significant if the CBA becomes a supply chain issue that could ultimately affect Australian commodity producers that export to companies in jurisdictions not covered by a CBAM, that in turn export goods to these countries.

What is the impact on Australian Business?

That said, businesses in Australia have been busy on two fronts. Understanding climate risk using the Taskforce for Climate Related Financial Disclosures Framework and starting to map a path to limit impacts of decarbonisation. They have also been trying to get a handle on global movements and stay current on the climate front by setting ambitious net zero goals. These measures, alongside Australian sub national (or State) Governments all setting net zero targets have meant that Australian business is not starting from such a low base, and in my view will become competitive even within the context of an EU CBAM by using mechanisms such as the Emission Reduction Fund and the Modern Manufacturing Fund to innovate and reduce carbo intensity.

Nationally though, Australia stands almost alone among high-income advanced economies in increasing emissions from fossil fuel combustion since 2005 and falls well short of its international peers in the commitments it has made under the Paris Agreement to reduce emissions. It is also now one of the very few high-income countries without some form of a carbon price. This, according to Prof. Bob Carr suggests that Australia has ‘dialled out’ from future climate diplomacy and negotiations, costing vital opportunities for the Australian economy from the green transition.

The CBAM may become a global precedent for carbon tariffs. Despite indicating some initial resistance to the proposed CBAM, the US has indicated a long-term plan to follow the EU in enacting carbon border tariffs. Commentators have suggested the UK will also likely follow this path. Ambitious environmental targets set by Australia's key trading partners Japan, China and South Korea last year may also indicate a growing appetite globally for the implementation of carbon tariff regimes.