Europe

The Choreography of Carbon Pricing

The EU’s CBAM has met the approval of the Council, but progress will require balance and timing. 

2022 is proving to be a year of action for EU climate policy, with a number of new regulations coming into force or reaching the final stages of discussion. Efforts to extend carbon pricing are seen as central to the ultimate goals of reducing CO2 emissions and limiting global warming. 

On 15 March, the EU Council reached an agreement on the general approach of the Carbon Border Adjustment Mechanism (CBAM) regulation. 

CBAM was first introduced as part of the ‘Fit for 55’ (Ff55) regulatory package in July 2021, which aims to reduce the EU’s emissions by 55% by 2030. CBAM will ensure importers of certain carbon-intensive goods into the EU are required to pay for their pollution, by purchasing carbon certificates for each tonne of embedded CO2 emissions. The price paid by importers will be based on weekly prices on the EU’s Emissions Trading System (ETS), meaning their pollution costs are similar to those of European firms. 

The agreement was heralded as “a victory for European climate policy” by Bruno Le Maire, French Minister for Economic Affairs, Finance and Recovery. 

Many investors will have been happy about the agreement, too.  

As a step towards more universal carbon pricing, CBAM holds out the hope that investors will be able to identify the carbon risks in their portfolios more easily if the cost being paid to emit carbon is more transparent for a wider range of firms.  

In principle, CBAM is designed to prevent ‘carbon leakage’, where companies can offset their emissions by importing carbon-intensive products that have been manufactured in non-EU countries not subject to emissions-related costs.  

Phased in gradually over a seven-year period starting in 2023, CBAM will initially cover aluminium, iron, steel, electricity, cement and some fertilisers 

“CBAM is necessary to ensure the EU’s efforts to combat climate change are effective and don’t result in […] the European industry being outcompeted by cheaper, carbon-intensive imports from other countries,” Paul Stockley, Head of Oil and Gas at law firm Fieldfisher, tells ESG Investor. 

It will also be a source of capital. The Commission has estimated that, while CBAM is not expected to raise revenue during the transition and information-gathering phase from 2023-25, it will ultimately generate at least €1 billion a year between 2026-30. 

“A subsequent success of CBAM will be an increase in the price of carbon-intensive products such as cement, iron and steel, and fertilisers. This will feed through the supply chain and have a dual benefit of encouraging emission reduction activity in these industries and switching away from carbon-intensive products,” says Guy Turner, Founder and CEO of specialist data, analysis and advisory firm Trove Research. 

In the March agreement, key steps were taken, such as opting  to centralise CBAM’s governance structure. This means that companies intending to import goods that fall within the regulation’s scope will have to apply to a new registry of CBAM declarants, rather than applying to relevant authorities in the region the exporting company is established. 

However, the Council’s agreement also highlighted “the scale and complexity of the challenges still to be addressed”, Stockley warns. 

Most notably, the extent of CBAM’s alignment with the EU ETS and the phasing-out of the latter’s free carbon allowances needs be discussed, as well as the impact of more recent energy security concerns, exacerbated by Russia’s invasion of Ukraine. 

The Council said it wishes to make “sufficient progress” on these challenges before starting negotiations with the EU Parliament. But it’s not clear what will constitute sufficient progress, Stockley points out, adding that “realistically the Council is facing huge challenges to reach agreements in these areas”.  

As with all climate policy, putting theory into practice is easier said than done.  

Making way for change 

First introduced in 2005, the EU ETS sets a cap on the amount of CO2 emissions that can be released by companies in certain sectors through a limited number of free allowances that are distributed to prevent carbon leakage. If needed by high emitters, additional allowances must be purchased on the ETS trading market.  

The market has had to maintain a tricky balance between incentivising firms to innovate away from carbon-intensive processes, through rising costs for emissions, and punishing them so severely that they move production offshore.  

“Free allocation is currently the main instrument to protect against carbon leakage. Industrial companies embrace it, climate champions oppose it,” says Anders Nordeng, Senior Analyst of Carbon Research at research and data provider Refinitiv. 

While the system has so far been effective in addressing carbon leakage, CBAM will more directly target the embedded emissions from imports, mirroring the price set by the ETS.  

“CBAM will apply only to the proportion of emissions that does not benefit from free allowances under the EU ETS, thus ensuring that importers are treated in an even-handed way compared to EU producers,” the Commission noted in the CBAM Q&A document 

But a question mark remains over the timeline for phasing out ETS free allowances, thus meaning CBAM will apply to an increasing proportion of emissions. It is likely to be a “sticking point” for EU policymakers, says Dierk Brandenburg, Head of Credit and ESG Research at European ratings agency Scope Ratings.  

“For the European Parliament, the process is complicated by the fact that the question [of when to phase out free allowances] is split across two files: the CBAM proposal (new legislation) and the review of the ETS directive (existing legislation),” agrees Nordeng. 

Phasing out free allowances too quickly may raise concerns for investors, Brandenburg adds, noting that “it will increase the cost for these industries at a time where their investment needs for climate-friendly technologies are high”.  

The original proposal suggested that free allowances granted through the ETS in sectors also covered by CBAM should be gradually phased out from 2026. 

Adding to the complexity is the fact the current parameters of the EU ETS are also subject to review, with further progress on CBAM dependent on the finalisation of any changes to the ETS. 

Under Ff55, the new proposal for a revised ETS targets a 61% emissions reduction across in-scope sectors by 2030 compared to 2005 levels. To achieve this, the number of free allowances for all sectors will have to decline over time, meaning companies either purchase more credits, or – as is preferred – transition to low-carbon alternatives. The ETS will also be extended to cover emissions from maritime transport. A separate ETS for buildings and road transport will target a 43% emissions reduction across both sectors by 2030 compared to 2005 levels.  

A vote on the ETS reforms will take place in June, which will hopefully inform the EU Council’s continued CBAM deliberations, experts say.  

CBAM’s certificate system is slated to become live from 1 January, 2026, but, to comply with the planned transitional period beginning January 2023 – in which importers will need to report on their imported goods and related emissions on a quarterly basis (with some costs) – the EU must finalise the regulation by the end of this year.  

This week, the European Securities and Markets Authority (ESMA) also published its final analysis of the existing EU carbon market. While it did not uncover any “major deficiencies in the functioning of the EU carbon market”, ESMA did recommend that the Commission opens a separate in-depth investigation into the benefits and drawbacks to position limits for carbon trading. Reporting rules should also be amended to provide greater transparency, the report added. 

Navigating a crisis 

Russia’s invasion of Ukraine has catapulted concerns about the EU’s energy security to the top of policymakers’ agendas. This may have an impact on both CBAM and the EU ETS.  

“It is hard to see how the EU can implement any of its carbon pricing policies without first addressing the security of its energy supply,” acknowledges Brandenburg. 

The ESMA report referred to the “major impact” the war in Ukraine has had on the carbon market, and the subsequent increased price volatility. In early February, prices for EU allowances reached highs of €97 per tonne of CO2 (/tCO2e), but plummeted back down to below €70 by the beginning of March. 

Increased volatility has prompted some EU policymakers to call on member states to agree to lower the threshold at which regulators are allowed to intervene in the ETS under Article 29a of the ETS directive. Regulators would then be able to put a price cap on the ETS at times price volatility. 

A number of European energy exchanges warned against it, noting that the ETS is finally enabling decarbonisation at the scale required to reach climate targets. 

“CBAM should moderate calls for a cap on EU ETS prices, as it protects the European economy from imports of cheaper products made in high carbon-intensive environments,” Trove Research’s Turner notes. 

But the geopolitical situation could also limit CBAM’s effectiveness as a contributor to the EU budget, according to research by resourcetrade.earth, the resource trade database of international affairs think tank Chatham House. 

Beyond supplying 40% of the EU’s gas supply, Russia is also a major trading partner in carbon-intensive goods. Nearly 17% of imports that will be covered by CBAM come from Russia, the research noted. Ukraine supplies 5.5%, it added.  

This may cause disruption, but impact on the functioning of CBAM could be limited, given that the aim is to impose a carbon price on any in-scope products, regardless of origin, with a view to encouraging companies to identify low-carbon solutions that will cut carbon costs altogether.  

As such, it is likely to work in concert with investor efforts to reallocate capital to bolster the EU’s renewable energy transition, recently accelerated by the recently published REPowerEU agenda, aimed at rapidly reducing member states’ reliance on Russia. 

This does not offset the possibility that current events will cause delays. “The energy crisis and the conflict in Ukraine have both made the progress of CBAM more challenging and there is certainly temptation to postpone, if not water down, some measures,” says Fieldfisher’s Stockley. 

Further, concerns around energy security – which are likely to be longer-lasting – are expected to inform policymakers’ future discussions of CBAM.  

To therefore limit the potential for disruption from future geopolitical tensions, the ETS and CBAM will “need to be matched as closely as possible during the phase-in period”, Brandenburg urges. 

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