July 28, 2021

CBAM and Revised EU ETS: Implications for the Aluminum Industry

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CBAM AND REVISED EU ETS: IMPLICATIONS FOR THE ALUMINUM INDUSTRY

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.

Key takeaways

  • CBAM will apply to aluminum products imported into the EU (as well as other industrial goods such as iron, steel, fertilizers, ammonia and cement).
  • Importers will need to declare and purchase CBAM certificates to cover the greenhouse gas (GHG) emissions associated with the production of the imported aluminum products.
  • CBAM certificates for imports of non-EU aluminum are only required in excess of the amount of free ETS allowances that EU aluminum producers receive.
  • Payment obligations under the CBAM are reduced to the extent non-EU aluminum producers have already paid an equivalent carbon price for emissions in the country of production.
  • Between 2023 and 2025, non-EU producers will need to report both direct and indirect emissions (i.e. emissions associated with the production of electricity, heating and cooling consumed during production).
  • Financial obligations (commencing from 2026) to account for emissions under CBAM only apply to direct emissions (at least initially) but CBAM may be extended to indirect emissions.
  • Responsibility for compliance with CBAM primarily rests with the importer of aluminum (not the non-EU producer, unless they are the same entity). The penalty regime under CBAM (which mirrors the penalties under the ETS) does not extend to non-EU aluminum producers (unless they are also the importer of the aluminum). However, non-EU producers will need to be conscious of other potential sources of liability for non-compliance (e.g. under customer contracts).
  • Free ETS allowances for EU aluminum producers will be phased out from 2026 to 2035 (10 percent reduction per year, reduced to zero by 2035).
  • Compensation granted to EU aluminum producers by Member States for indirect emissions costs embedded in electricity prices remains for now.
  • These proposals will only come into effect if and when they have been approved in accordance with the EU’s legislative processes.

What is the CBAM?

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:

  • producers of the affected goods move the relevant parts of the production process outside the EU; or
  • existing non-EU products (with a higher GHG footprint) undercut the price of equivalent EU goods (which have a lower GHG footprint but are more expensive).

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.

Existing Mechanisms for Preventing Carbon Leakage for the EU Aluminum Industry

The risk of carbon leakage is currently addressed under the EU ETS by both the allocation to EU producers of:

  • free emissions allowances; and
  • in some cases, compensation for indirect emissions costs (i.e. the cost of carbon passed on to EU aluminum producers through electricity prices) to certain sectors deemed to be at risk of carbon leakage.

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).

Direct and / or Indirect Emissions

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.

Overview of Key Provisions of CBAM

Some of the key features of the proposed CBAM for non-EU aluminum producers to be aware of are:

  • Between January 1, 2023 and December 31, 2025, importers of non-EU aluminum will be obliged to report both direct and indirect emissions. Non-EU producers will therefore need to be able to provide such emissions data, in accordance with the methodologies to be determined by the Commission.
  • Emissions to be reported under CBAM should be based on actual emissions (and only using default values, based on average country emissions or the 10 percent most-polluting EU installations, as a fallback to the extent that actual emissions cannot be determined). The use of actual emissions (rather than default values) is an important part of designing CBAM to be WTO-compliant and also incentivizes non-EU aluminum producers to decarbonize their operations, thereby reducing the payment obligations under CBAM on import of their products.
  • The responsibility for compliance with CBAM rests with the relevant importer of aluminum into the EU (not the non-EU producer directly unless it is also the importer of record). The penalty regime under CBAM (which mirrors the penalties under the ETS) does not extend to non-EU aluminum producers (unless they are also the importer of the aluminum). However, non-EU producers will need to be conscious of other potential sources of liability for non-compliance, for example, under contracts with its customers as the relevant contractual terms dealing with pass-through of CBAM compliance risk are developed.
  • From 2026, aluminum may only be imported into the EU by an importer that is registered and approved with the relevant authority (within each Member State). Non-EU aluminum producers will therefore need to engage with their EU customers and/or obtain registration as importers in their own right.
  • From January 1, 2026, the financial obligations under CBAM (i.e. of purchasing and declaring CBAM certificates against imports of aluminum) will apply. As the payment obligations rests with the importer and not with the non-EU producer, customers of non-EU aluminum producers will be incentivized to exercise their purchasing power to seek reductions in GHG emissions embedded in imported aluminum. There may therefore be increasing demand-side pressure for decarbonization of non-EU aluminum production to be imported into the EU.
  • Emissions embedded in imported aluminum products will need to be reported and verified by an approved verifier all in accordance with detailed methodologies to be determined by the Commission in subsequent delegated acts.
  • The price of CBAM certificates will be calculated as the average weekly auction price of the EU ETS allowances.
  • Non-EU producers may register in a central EU database on a one-time basis (valid for five years) and disclose the emissions data filed with that registry to their customers, who may use such data in their emissions declarations for the imported products of that non-EU producer. This should reduce the administrative burden on both importers and non-EU producers, compared to ad hoc information sharing on a per delivery basis.
  • Credit is given to a non-EU producer for any carbon price paid in the country of production. However, the details of the methodology for calculating the appropriate credit are still to be proposed by the Commission in subsequent delegated acts (e.g. it will be important to the proper functioning of the CBAM that the price of carbon emissions paid in a non-EU country is truly equivalent per ton of emissions to that payable under the CBAM).

Overview of Revisions to the ETS

The proposed revisions to the EU ETS include the following aspects which will be of interest to EU aluminum producers:

  • The overall supply of ETS allowances is tightened by applying a one-off reduction of the total allowances in circulation and increasing the linear reduction factor (i.e. the rate at which the total number of allowances in circulation is reduced) to 4.2 percent per year (from 2.2 percent per year under the current system), thereby restricting supply further and driving up prices of ETS allowances over time.
  • The benchmark values for free allowances will be revised before the period from 2026–30 (the benchmark values for free allowances have already been determined for the period from 2021–25). This will include revision of the definitions and system boundaries of existing product benchmarks for free allocation. This appears intended to ensure that the adopted product benchmarks for free allocation are technology neutral and give equal treatment to low- or zero-carbon technologies in producing the relevant products.
  • The maximum annual reduction rate used to set the free allocation benchmarks (and then reduce them each year) for the period from 2026–30 will be increased from 1.6 percent per year to 2.5 percent per year. This will accelerate the reduction of the benchmarks in the next free allocation period and so reduce the number of free allowances EU aluminum producers will receive.
  • Continued receipt of free allowances will be made conditional on complying with the decarbonization recommendations in their energy audits. Failure to do so will lead to a 25 percent reduction in their free allowances.

Conclusions

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.

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