Need to Know: The Carbon Border Adjustment Mechanism
As Alain de Botton once said, “a good half of the art of living is resilience.” For carbon exposed businesses, the road to surviving net zero may need a heftier dose.
For industrial companies witnessing the increasing international commitments each month, and wondering when Safeguard and its associated cost imposts will begin to hit monthly profit and loss statements, setting strategy over the last 24 months has been almost impossible.
Sectors such as cement, iron and steel, aluminium, and fertilisers which compete internationally against imports have been raising publicly for some time a sense of deep foreboding that Australia would go harder, faster and more aggressively than other countries. Becoming a net zero economy will hit hardest those sectors which are the most difficult to abate, and many companies in those sectors operate at thin margins. Policies which ease the pain of transition are therefore of intense corporate interest.
Last week brought an announcement from the Australian Federal Minister for Climate Change, Chris Bowen, that Australia may impose a carbon border adjustment mechanism (CBAM) with timing expected to be sometime after 2026, in line with similar mechanisms overseas. This article provides the need-to-know details about the mechanism and how it might work.
What is a Carbon Border Adjustment Mechanism and why is it being considered?
When global and national net zero targets are converted into policy pathways, for example through the Safeguard Mechanism, costs are imposed on companies through taxes and penalties on carbon emissions, thus providing a strong signal to ertilizer. For some sectors, reducing carbon emissions can be achieved by substituting production inputs at costs that do not threaten economic viability – for example, companies for whom electricity costs are a low proportion of their input costs (corporates, for example) can change from “normal” to “green power” via higher cost supply. For companies where electricity is a more significant component of costs, or where critical elements of production processes use gas intensively as an input, the impacts are more serious. In the absence of transition policies, carbon abatement for carbon intensive, costly to abate sectors mostly requires new technology to become available and economic.
There is a significant advantage to countries taking a slower road to carbon abatement policies, because carbon intensive companies in those countries are able to continue to make and export products directly to countries in which their competitors face stiffer carbon penalties. As net zero targets become more onerous over the next 10-15 years, these advantages will become much more significant, and many Governments are now considering leveling the playing field to ensure that sovereign manufacturing capacity is maintained, and to avoid becoming dependent on imports if local production becomes uneconomic.
A Carbon Border Adjustment Mechanism (CBAM) is one mechanism for doing this, as it works to address the risk of ‘carbon leakage’ caused by asymmetrical climate policies of an overseas country (where policies applied to mitigate climate change are less ambitious than domestic policies). A CBAM also has the benefit of encouraging other countries to develop more ambitious carbon reduction policy positions once the benefit of “going slow” has been removed.
In June 2022, the European Parliament made clear it would establish the world’s first Carbon Border Adjustment Mechanism, and other countries, including the US and the UK, are also considering introducing such a scheme. The Australian announcement is therefore consistent with its major trading allies.
How Does it Work in Europe?
The European CBAM is the first. It will begin on 1 October 2023 in a transitional phase, and will initially apply to imports of cement, iron and steel, aluminium, fertilisers, electricity, and hydrogen. The transitional phase is designed to allow for a learning period for importers, producers, and authorities to collect information on embedded emissions to refine the next steps. During the transitional period, importers will have to report greenhouse gas emissions (GHG) embedded in their imports (direct and indirect emissions), without making any financial payments or adjustments.
During the first year of implementation, companies will have the choice of reporting in three ways: (a) full reporting according to a new methodology (the “EU method”); (b) reporting based on equivalent third country national systems; and (c) reporting based on reference values. As of 1 January 2025, only the “EU method” will be accepted.
A permanent system will come into force on 1 January 2026, when importers will need to declare each year the quantity of goods imported into the EU in the preceding year and their embedded GHG. They will then surrender a corresponding number of CBAM certificates. The price of the certificates will be calculated depending on the weekly average auction price of EU Emissions Trading Scheme (ETS) allowances expressed in €/tonne of CO2 emitted. The phasing-out of free allocations under the EU ETS will take place in parallel with the phasing-in of CBAM in the period 2026-2034.
During the transitional period, the scope of sectors will be reviewed to assess the feasibility of including other goods produced in sectors covered by the EU ETS in the scope of the CBAM mechanism, such as certain downstream products and those identified as suitable candidates during negotiations.
How Might it Work in Australia?
There are many sectors that would meet the broad criteria set out in the EU, where Australia competes locally with imported goods and where international policies may be more lenient. China is a major exporter of steel to Australia, while cement imports are heavily sourced from countries including Vietnam and India. Like the EU, ammonia imports are critical to the market price of fertiliser in Australia, while local hydrogen production will be heavily impacted by the increasing costs of baseload firmed renewable power and the buildout of the national electricity network. This would suggest a starting line-up similar to the EU; ertilizer, hydrogen, cement, iron, steel, aluminium, with the potential for critical minerals to be included. Many large companies in these sectors already report emissions through either NGER or the Safeguard Mechanism, but for those companies which do not collect and report emissions, new action will be required.
The principal barrier to a CBAM is what it might mean for global trade, and the consequential impacts on Australian companies from a trade war caused by CBAMs. Most of the large emitting companies operating in Australia already export to the US and Europe and may face CBAM as an importer of products, meaning they will be facing penalties as a consequence of a lack of Australian policy. We do not know however, what will happen when differential levels of CBAM in countries start to become relevant in considering CBAM design in others, and how companies will respond to their companies being disadvantaged over time. It is easy to distinguish between countries which have carbon policy and those what don’t – it is harder to distinguish between carbon policy designs in two countries and to use the differences as a basis to penalise importers because one country believes it is more progressive than another.
It is also very difficult to see the point when relative carbon policy becomes protectionism – and it will be terribly difficult for well-meaning Governments to avoid this. If this was to occur, many of the agreements that have opened up trade over the last 50 years will be threatened. The General Agreement on Tariffs and Trade (GATT) details the core tenets of the World Trade Organisation requirements, such as the most-favoured nation (MFN) and non-discrimination principles. CBAMs have not been tested by a WTO dispute settlement panel, so it is difficult to know exactly how a panel would rule on questions as to whether a CBAM might run foul of WTO or GATT requirements. As the American Impact Forum notes “there do seem to be three principles to follow to have a “reduced risk of violating WTO law” when considering a CBAM: (1) the carbon tax must apply to domestic goods and imports; (2) imports from all WTO members must be treated the same; and (3) rebates for exports cannot exceed the carbon tax. These are likely to be challenged once the competitive CBAM era begins.
What does it mean for Australian companies?
It is critical for companies to know where they stand on three factors:
Firstly, it is critical to understand scope 1 and 2 GHG emissions, and to be get a handle on Scope 3. Much of this work in in the mid-market, not already subject to reporting, is through spreadsheets with variable data quality and a lack of adherence to the appropriate standards. Moving to a cloud-based platform which collects, stores and reports GHG emissions, allows visibility across functions and uses sector benchmarks to drive decarbonisation strategy;
Secondly, it is no longer enough to understand and lobby for local policy levers; international awareness is key. The European Union, the UK and the US provide the path forward for Australian policy makers, and our country is too reliant on global trade to be materially different. As our recent work on methane policy showed, policy pathways are being developed elsewhere and provide clear choices for the Australian Government; and
Thirdly, Boards must know that transition strategy is about more than decarbonisation. Markets are changing and evolving, and the array of most likely long-term scenarios need to be considered carefully when deciding on vision, mission, corporate and business unit strategy, targets and KPIs.
Keen to continue the conversation? Our Strategy team advises clients nationally on market outlooks, market entry, acquisition strategy, and corporate strategy. Our Policy and Reform team advises on international policy settings, and lessons that can be learned when preparing for the future. Our ESG team uses cloud based platforms to measure and report emissions and designs decarbonization policies and marginal abatement curves. Our Business Advisory team designs the suite of capability required, operating models and guides the necessary transformations to achieve success. For more information about the EU CBAM and how it might apply in Australia, please contact a member of our senior team.
Message Matt Rennie for more information or to arrange a meeting.