On July 14, 2021, the European Commission released its draft proposal for a Carbon Border Adjustment Mechanism (CBAM).
The CBAM forms part of a package of regulatory proposals and revisions aiming to achieve the European Green Deal target of 55 percent net reduction in greenhouse gas emissions by 2030. The package also includes proposed revisions to the EU’s Emission Trading System (ETS).
This article focuses on the implications for both EU and non-EU aluminum producers of the proposed CBAM and the revisions to the ETS.
The CBAM applies a carbon price at the border to imports of certain products into the EU. In theory, the CBAM is designed to set an equivalent carbon price on imports of non-EU products to that paid by EU producers for making the same products. This aims to achieve compatibility with World Trade Organization (WTO) rules, by ensuring that EU producers are not treated more favorably than non-EU producers.
The objective of CBAM is to protect against the risk of so-called ‘carbon leakage.’ Carbon leakage is the phenomenon whereby, in response to increases in costs of production caused by the EU’s climate regulation:
A secondary aim of the CBAM is to encourage non-EU countries to adopt more ambitious climate-related regulation and encourage decarbonization outside the EU’s borders.
The risk of carbon leakage is currently addressed under the EU ETS by both the allocation to EU producers of:
According to industry experts, indirect emissions costs equate to approximately 40 percent of aluminum production costs in the EU, making them a significant area of concern for the EU aluminum sector and the chief factor when considering the risk of carbon leakage.
For this reason, the EU’s State aid regulatory regime allows EU Member States (countries) to compensate their local aluminum producers for indirect emissions costs, to reduce the cost of carbon that the producers incur in their electricity consumption. In addition, there is a separate State aid regulatory regime for energy intensive users, which allows Member States to provide subsidies to certain industrial users for electricity consumption, which reduces electricity prices (by discounting renewable energy levies) for beneficiaries of such aid.
The recitals to the CBAM state that the CBAM is intended to replace existing carbon leakage prevention mechanisms. As a result, the Commission proposes phasing out the current provision of free ETS allowances between 2026 and 2035. The CBAM provides that, until free allowances are completely phased out, the financial obligations under CBAM will only apply to the excess emissions costs after taking into account a theoretical allocation of free allowances to non-EU producers equivalent to the free allowances granted to EU producers under the ETS, thus ensuring that non-EU aluminum producers are treated no worse than EU producers.
However, the Commission is silent on how the compensation for indirect emissions (i.e. electricity-related) costs will be phased out. In the meantime, the financial obligations under the CBAM will not apply to indirect emissions of non-EU producers and, it appears, EU aluminum producers will continue to be eligible for compensation from the relevant Member States for their indirect emissions costs (albeit such compensation is at the discretion of each Member State and is not consistently applied).
In both the European Parliament’s March 2021 resolution on a WTO-compatible CBAM and the preliminary draft CBAM that became public earlier this year, the CBAM was intended to apply to both direct and indirect emissions.
The proposed application of the CBAM to indirect emissions has been of particular concern to EU aluminum producers because of the likelihood that the compensation they receive for indirect emissions costs would be phased out as a result, to ensure compliance with WTO rules.
However, the Commission’s proposal limits the financial obligations imposed on non-EU products to direct emissions; albeit that during the transitional period of 2023–25, importers of non-EU aluminum will need to report emissions data covering both direct and indirect emissions embedded in relevant products.
Non-EU aluminum producers will therefore need to have in place systems for measuring both direct and indirect emissions from 2023, even though there are no financial obligations from this date.
In the immediate term, this should provide some certainty to EU aluminum producers as it appears that Member State compensation for indirect emissions costs will be permitted to continue until at least the end of 2025.
However, the CBAM proposal requires the Commission to collect information necessary “with a view to extending the scope of [the CBAM] to indirect emissions” as well as potentially other goods. This language, together with the legislative history of the CBAM proposal, suggests that it is only a matter of time before the Commission makes a proposal for extending the scope of the CBAM to cover indirect emissions and (as a necessary consequence) revises the State aid regime applicable to indirect emissions costs compensation.
Both EU and non-EU aluminum producers will need to consider the consequences of such potential future changes on their operations and, in particular, how their electricity supply is structured.
For non-EU aluminum producers, although the detailed methodology and system boundaries for carrying out both direct and indirect emissions assessments under CBAM are yet to be defined by the Commission, there is some instructive commentary on how such assessments should be carried out (e.g. by analogy to the EU ETS for direct emissions and to relevant international standards, such as ISO 14067:2018, for indirect emissions), though this guidance is not legally binding and lacks detail. Non-EU aluminum producers should therefore carefully consider the impact on their supply chain and the need to obtain (and verify) relevant GHG emissions data both internally and (as applicable) from third parties.
Some of the key features of the proposed CBAM for non-EU aluminum producers to be aware of are:
The proposed revisions to the EU ETS include the following aspects which will be of interest to EU aluminum producers:
The CBAM and the revisions to the EU ETS create opportunities for aluminum producers to accelerate the decarbonization of their operations, thereby taking advantage of the potential premiums available for early movers in the sector and limiting the costs of complying with CBAM. Given the highly-electrified nature of aluminum production, aluminum producers with access to abundant low-cost renewable energy will be best placed to take advantage of the opportunities created by these regulatory initiatives.
This is likely to be an advantage, in particular, to non-EU producers (in regions where renewable energy is cheaper than in the EU and given the relatively high cost of renewable energy in the EU) for whom CBAM will represent a significant opportunity to differentiate and compete with production from regions with more expensive and/or fossil-derived electricity generation.
However, especially given the increasing price of ETS allowances, non-EU aluminum producers should start assessing their potential exposure to the requirement to purchase CBAM certificates for direct emissions and carefully consider the possible impact on their competitiveness from 2026.
In addition, given the possibility (as discussed above) of the CBAM being extended to indirect emissions, non-EU aluminum producers should also assess the consequences of such an extension on their GHG emissions footprint and potentially commence contingency planning to assess possible strategies for greening their electricity supply.
EU aluminum producers will need to carefully understand the incentives available under the EU’s revised regulatory regime to ensure they are taking advantage of all possible measures to improve competitiveness and to accelerate the decarbonization of their business (e.g. the expanded scope of the Innovation Fund, which may competitively tender awards for contracts for difference to incentivize decarbonization projects).
The CBAM proposal and the revisions to the ETS will now be debated and will need to be approved by the EU Parliament and the EU Council and, in the case of the revisions to the ETS, will need to be implemented by all of the Member States.
This process is likely to be highly politicized. For example, considering the differences between the scope of the CBAM described in the Parliament’s March 2021 resolution and the Commission’s proposal in relation to indirect emissions, the Parliament may seek to broaden the scope of the CBAM through revisions to the Commission’s draft. In addition, opposition from the EU’s international trading partners to the CBAM has already been loud and this international pressure may eventually impact on the design or scope of the final CBAM if and when adopted.
As part of our work representing key players in the aluminum industry, we are at the forefront of the complex and evolving regulatory issues affecting aluminum production and the aluminum value chain and are happy to speak with you if you would like further information as these matters evolve.
This is the second article in the series that Shearman & Sterling is publishing on the regulatory developments flowing from the EU Green Deal and the Commission’s Fit for 55 proposals. The first looked at green hydrogen use in industry under RED II.