Most Favoured Nation: Won’t Somebody Think Of (Carbon-Intensive) The Exporters

CBAM, batteries and the importance of proper formatting

The EU’s attempt to unilaterally impose a level-playing field on the rest of the world is going to be a running theme of 2022, and this newsletter. At the forefront of the EU agenda is its carbon-border adjustment mechanism (CBAM) and we are starting to get a flavour of where the discussion is going to go.

Last week, Mohammed Chahim, the European Parliament’s Environment Committee’s CBAM rapporteur released a draft of his report. There’s a lot in there, but in brief: he wants to fundamentally re-write the European Commission’s CBAM proposal and, for example, extend protection hydrogen and polymer imports, quickly extend the CBAM to cover indirect emissions, and rules out exemptions based on implicit foreign carbon prices (for example, regulation).

Most interestingly he, as expected, wants to shorten the CBAM transitional phase (which would see companies faced with reporting requirements, but no need to purchase and surrender so-called CBAM certificates) from three to two years, and phase out Emissions Trading System free allowances entirely by 2028.

On the face of it, the speedy phase out of free allowances makes sense. The CBAM is intended to replace ETS free allowances as the EU’s primary instrument to guard against carbon-leakage, and the potential offshoring of heavy industry. Running both in tandem over-complicates things and runs the risk of giving heavy industry twice the protection, potentially disincentivising decarbonisation.

But … (there is always a but) …. There is a more-justifiable reason some industry wants both the CBAM and the free allowances: CBAM and the free allowances do slightly different things.

The CBAM, which will see (some) imported goods hit with an additional charge proportionate to the amount of CO2 embodied within them (subject to terms and conditions) levels the playing field for European manufactures when selling their product within the EU.

ETS free allowances, on the other hand, reduce the carbon cost of production for those installations that receive them, ensuring their products can remain competitive when competing with foreign (less carbon-costly) goods both in the EU and abroad.

To illustrate, let’s say that emitting one tonne of CO2 cost an EU-based manufacturer €80 and one tonne of steel produces about 2 tonnes of CO2.

In this scenario, making one tonne of steel in the EU has a carbon cost of about €160.

However, European steel must compete with steel produced in the country of Samtopia, which has a carbon price of €0.

An EU CBAM would ensure that one tonne of steel sourced from Samtopia would be subject to the EU carbon price of around €160 when it enters the EU. This means that the effective carbon price for both EU-sourced, and Samtopia-sourced, steel when placed on the EU market is €160. All is well.

However, under the current Commission CBAM proposal, EU companies exporting one tonne of steel to say, the US, would still have paid a carbon price of €160, but would be competing for US business with Samtopian steel subject to a carbon price of €0.

ETS free allowances, on the other hand, reduce the carbon price of EU production directly by, for example, allowing a firm to produce one tonne of CO2 for free. In this hypothetical example, a one tonne free allowance would reduce the carbon cost of producing one tonne of steel in the EU from €160 to €80. This saving applies no matter whether the steel is eventually sold in the EU, or elsewhere. Ergo, free allowances guard against a loss of competitiveness both in the home market, and abroad.

Of course, the CBAM could be tweaked to address this issue. EU exporters of goods covered by the CBAM could receive carbon-rebates. But allowing exporters to pollute as much as they want so long as the final product isn’t sold in the EU would kinda undermine the climate-effectiveness, and legal justification, of the CBAM …

Anyway, my expectation is that this question of export rebates is where a lot of the lobbying action over the next 6 months is going to take place … particularly if the phase out period for ETS free allowances is shortened.