EU Carbon Border Adjustment Mechanism (CBAM)

The Council of the EU Agreed this week on a general approach to the European Commission’s proposal on the Carbon Border Adjustment Mechanism (CBAM). The mechanism is a key aspect of the wider EU agreement Fit for 55 which aims to reduce net greenhouse gas (GHG) emissions in the EU by 55% by 2030. This is also a fundamental aspect of the Commission’s new own resource proposal to fund EU budget initiatives. However, Russia’s war in Ukraine could destabilize these financing plans.

In 2005, the EU introduced a national carbon pricing mechanism called the Emissions Trading Scheme (ETS). This cap and trade mechanism sets a cap on the amount of emissions allowed to be released into the air by companies. The carbon market price is then set by “cleaner” companies trading allowances with more carbon-intensive companies.

The CBAM is designed to complement the ETS by setting a carbon price on certain imports into the EU from third countries such as Russia or the US that do not tax carbon at an EU-approved level . The objective is to maintain the competitiveness of European producers in relation to foreign producers and to avoid “carbon leak”.

A border adjustment requires two elements. One is a levy on imports, and the other is a credit mechanism for exports. So far, CBAM design has mostly focused on the former. In theory, the CBAM would increase the cost of importing products into the EU from countries that do not levy a carbon tax while offering a rebate or credit for carbon taxes paid by EU exporters on goods they sell outside the union.

So far, the European Commission has mainly focused on a border tariff.

The EU hopes this border tariff will inspire other countries without a carbon tax to implement their own. Once third countries link their national carbon pricing systems to those of the EU, third country exporters will no longer face CBAM payments.

The price of the border tariff would be calculated based on the average weekly ETS auction price. By doing so, the price foreign producers would pay for carbon emissions would be equal to the price European producers pay without the administrative burden of daily calculations.

From a budgetary point of view, the Commission has propose that 75% of CBAM revenues go to the EU budget as new own resource, while 25% goes to Member States. Curator Johannes Hahn noted that CBAM revenues, together with new own resources from Pillar 1 of the OECD Agreement and the ETS reform, will provide a “steady flow of revenues to repay the NextGenerationEU COVID-19 recovery plan” adopted in 2020.

The Commission estimates CBAM’s revenue to be around €1 billion per year from 2026 to 2030. During the transition and information gathering phase from 2023 to 2025, CBAM is not expected to increase its revenue. However, Russia’s war in Ukraine could impact the stability of CBAM as a new own resource for the EU budget.

On the one hand, Russia is a major trading partner of the EU for carbon-intensive goods. The GHG emissions embodied in EU final demand from Russia represent 14% of all GHG emissions imported by the EU, or 138.6 million tonnes of GHG emissions. Slightly more than half of them come from the electricity sector (31%) and metals (21%).

Almost 17% of imports covered by the current CBAM proposal would come from Russia, most of all countries. In terms of share of EU imports, Russia is the leading exporter of iron and steel (14.6%) and fertilizers (33.1%) and the second of aluminum (17.6%) .

In addition, Ukraine is fifth in terms of the share of EU imports of products covered by CBAM (5.5%). Switzerland and Norway export more CBAM-covered products to the EU than Ukraine, but these countries have agreements with the EU not to apply CBAM to their exporters.

It is difficult to calculate the exact amount of potential CBAM revenue that will be affected, but it is safe to say that trade disruptions between Russia and the EU would have a negative impact on the EU budget. Moreover, a post-war Ukraine in need of reparations may not trade with the EU at the same levels as before.

Exporters to the EU will not be required to start paying until 2026, but if the war in Ukraine or its aftermath limits trade relations in the years to come, the Commission’s estimate of €1 billion per year will need to be revised.

Second, there is a correlation between a persistent increase in gas prices and an increase in the EU carbon price. Indeed, as gas prices rise, power producers are encouraged to use more polluting coal-fired power and, therefore, increase the demand for carbon permits.

Now that the Nord Stream 2 gas pipeline between Russia and Germany has been suspended and further EU sanctions against Russian oil and gas seem likely, the price of gas in the EU is almost certainly going to be constantly higher. high in the short and medium term. Even though the EU has just announced REPowerEU the agenda allows for a faster end to dependence on Russian energy, it is unclear what the transition will have on prices. It is, however, difficult to imagine how prices would decline in the medium term during such a disruptive and costly transition.

While rising carbon prices may lead to increased CBAM revenues over time, this is not guaranteed. The war and its aftermath create volatile market dynamics. Furthermore, since the majority of CBAM’s revenue depends on a handful of countries, including Russia, any loss of revenue from Russian imports would place a greater burden on exporters in other countries if the EU were to increase the same level of income. It could also change how these countries trade with the EU and how much revenue the EU can expect to collect.

Given the uncertainty surrounding the war in Ukraine, future trade relations with Russia, and the overall revenue structure of CBAM, the EU should carefully reassess any plans to spend CBAM revenue in the future. The mismanagement of a relatively small €1 billion a year may not endanger the soundness of the EU budget in the long term. However, as the EU seeks to increase its role in budgetary affairs through new own resources, it would be wise to show that it is able to adjust its policy cautiously when difficulties arise.

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