August 10, 2021

CBAM and revised EU ETS: Implications for the Steel Industry

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CBAM AND REVISED EU ETS: IMPLICATIONS FOR THE STEEL INDUSTRY

On July 14, 2021, the European Commission released a package of regulatory proposals as part of its “Fit for 55” initiative that aims to achieve the European Green Deal target of 55 percent net reduction in greenhouse gas (GHG) emissions by 2030. The package includes a proposal for a Carbon Border Adjustment Mechanism (CBAM) and revisions to the EU’s Emission Trading System (ETS).

This article focuses on the implications for both EU and non-EU steel producers of the proposed CBAM and the revisions to the ETS.

Key Takeaways

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

Overview of Revisions to the ETS

The ETS is the EU’s cap-and-trade carbon market. It applies to the EU steel industry as well as the production of other industrial products which will be relevant to the production of green steel in the EU (e.g. hydrogen and electricity). The proposed revisions to the EU ETS include the following aspects which will be of interest to EU steel producers:

The overall supply of ETS allowances is reduced 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 and driving up prices of ETS allowances over time for EU steel producers.
The benchmark values for free allowances will be revised for the period 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 to ensure that they capture innovative and low- or zero-carbon technologies in producing the relevant products. This aims to rebase the allocation benchmarks so that they better incentivize decarbonization of the steel industry (e.g. electrified steel production does not receive free allocation equivalent to competing fossil fuel technologies, thereby reducing the incentive on steel producers to electrify and slowing down the decarbonization of the industry).
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 steel producers will receive.
The scope of the ETS is expanded to include fully decarbonized industries, which increases for the incentives for these industries to decarbonize (e.g. through the ability to sell their increasingly valuable free allowances, albeit these will reduce over time in the steel sector).
Free allocation of ETS allowances will no longer be available to installations operating in a sector that is also covered by CBAM, as steel will be. However, a transitional phasing-out period will apply between 2026 and 2035 (with the allocation being reduced by ten percent each year).
From 2026, continued receipt of free allowances will be made conditional on complying with the decarbonization recommendations in the energy audits conducted for EU steel producers (that are subject to the requirement of conduct such audits). Failure to comply with the recommendations of the auditor will lead to a 25 percent reduction in free allowances for the relevant EU steel producer.

In general, the revisions to the ETS are designed to gradually drive up the price of ETS allowances, which are already over 50 Euros per tonne, increasing the costs of ETS compliance for EU steel producers. For green and low-carbon steel producers, this will make the ability to sell free allowances (until 2035) increasingly valuable. Furthermore, the costs to brown steel producers of complying with their obligations to purchase ETS allowances will increase over time with the rising ETS price and the reduction of free allowances, which will be a competitive advantage to EU green steel projects. In addition, financial support from Member States for indirect emissions costs remains for now (albeit this is not consistently granted by all Member States). However, the trajectory of the ETS appears to be to gradually phase out support for industries at risk of carbon leakage from the EU (including the steel industry). Therefore, EU steel producers will need to examine their production processes and ensure that they are well-positioned to be able to operate to remain competitive in this changing regulatory environment.

Other Considerations for Green Steel Producers

The revisions to the ETS also propose an expansion of the Innovation Fund, which will be provided increased funding from the auctioning of allowances. The purpose of this expansion is to increase investment in innovative low-carbon technologies. The Commission will also launch competitive tenders for carbon contracts for difference (in subsequent funding rounds), which will support innovative technologies capable of being deployed at commercial scale. EU green steel producers should consider what support may be available (now or for future expansions of projects) under the Innovation Fund.

As discussed in our article, “Green hydrogen use in industry promoted by revised RED II,” the Commission has proposed new conditions on the use of green hydrogen in industry which will extend to how hydrogen is produced. This raises important considerations for EU green steel production projects (e.g. using the hydrogen-DRI technology) in relation to how the renewable electricity supply used for hydrogen production is structured. There are also other aspects of the Commission’s regulatory proposals that may further motivate both EU and non-EU green steel producers to adopt similar structuring solutions (e.g. the obligation to identify on the packaging of steel products the portion of RED II compliant green hydrogen used in their production).

In addition, green hydrogen has also been brought within the scope of the ETS (which currently only refers to hydrogen produced from fossil fuel sources). In the longer term, this may create opportunities for EU green steel projects to optimize their structure to benefit from free allowances for their different product sub-installations (e.g. production of hydrogen as an interim process before production of green steel). For the time being the practical benefit of this for green hydrogen production may be limited because the regime on exchangeability of fuel and electricity remains in place (thereby reducing the availability of free allowances for green hydrogen produced with large amounts of electricity). However, as this regime is adapted overtime, together with the relevant product benchmarks under the ETS, this may increasingly become a viable revenue stream for green steel projects.

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 Steel 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 steel producers through electricity prices) to certain sectors deemed to be at risk of carbon leakage.

The CBAM is intended to replace the existing carbon leakage protection under the ETS in the sectors to which it will apply, including steel. As noted above, 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 steel 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, though they will remain in place for now. In the meantime, the financial obligations under the CBAM will not apply to indirect emissions of non-EU producers.

Scope of Emissions Reporting Obligations

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. 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 steel will need to report emissions data covering both direct and indirect emissions embedded in relevant products.

Non-EU steel 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.

By 2025, the Commission will make a proposal for extending the scope of the CBAM to cover indirect emissions. Both EU and non-EU steel 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 steel 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 steel 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 steel producers to be aware of are:

Between January 1, 2023 and December 31, 2025, importers of non-EU steel 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 embedded in imported steel products will need to be reported and verified by an approved verifier.
Emissions to be reported under CBAM should be based on actual emissions (and only using default values, based on average country emissions or the ten percent most-polluting EU installations, as a fallback to the extent that actual emissions cannot be determined). The use of actual emissions is an important part of designing CBAM to be WTO-compliant and incentivizes non-EU steel producers to decarbonize their operations, thereby reducing the payment obligations under CBAM on import of their products.
The responsibility for compliance with CBAM and liability for penalties for non-compliance rests with the relevant importer of steel into the EU (not the non-EU producer directly unless it is also the importer of record). 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, steel 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 steel 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 steel) will apply. As the payment obligations rest with the importer and not with the non-EU producer, customers of non-EU steel producers will be incentivized to exercise their purchasing power to seek reductions in GHG emissions embedded in imported steel. There may therefore be increasing demand-side pressure for decarbonization of non-EU steel production to be imported into the EU.
The price of CBAM certificates will be calculated as the average weekly auction price of the EU ETS allowances.
Non-EU producers may seek central registration in an EU database to reduce the administrative burden both on 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. 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.
During the transition period to phase out free allocations under the EU ETS between 2026–2035, importers will only be required to purchase CBAM certificates to the extent the carbon emissions are in excess of the ETS free allowance benchmark for that product (i.e. it gives importers an exemption from the need to purchase and surrender CBAM certificates to the extent they would have received free allowances had they been subject to the ETS).

Conclusions

The CBAM and the revisions to the EU ETS create opportunities for steel 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. Importers of non-EU steel will benefit from a reduction in the CBAM certificates they are required to purchase, equal to the free allocations received by the EU producers. It is intended that this will ensure an even playing field as the free allocation system is phased out.
The Commission is clear in its proposals that it wishes to incentivize the adoption of low-carbon technologies in sectors such as steel. The revisions to the ETS as a whole and the introduction of the CBAM should drive up production costs for non-green steel producers, which will make green steel production increasingly competitive. EU steel producers should carefully consider (and keep under regular review) all potential mechanisms for optimizing financial support under the evolving ETS system (e.g. sub-installation free allowances under the ETS and applications for support under the Innovation Fund). In addition, green steel projects will need to carefully consider the impacts of RED II on their proposed project structure to cater for the impact of RED II potentially applying to the method of hydrogen production, with such impacts potentially increasing over time.
Non-EU steel 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 (including in the event CBAM is extended to cover indirect emissions).
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 and opposition from the EU’s international trading partners to the CBAM has already been loud. 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 metals industry and in the energy transition, we are at the forefront of the complex and evolving regulatory issues affecting steel production and are happy to speak with you if you would like further information as these matters evolve.

This is the third 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 and the second addressed the impacts of the package on the aluminum sector.