Carbon Border Adjustment Mechanism (CBAM) – What is it and what does it mean for companies in China?

As the EU’s Carbon Border Adjustment Mechanism (CBAM) comes into force, with reporting requirements starting from October 2023, we take a closer look at what CBAM is and what it means for companies in China.

The Carbon Border Adjustment Mechanism (CBAM) is a policy tool introduced by the European Union (EU) to address the issue of carbon leakage in the context of the EU’s climate change mitigation efforts. Essentially, it works as a tax on imports to the EU to equalize the carbon costs for imported and domestic goods.

Carbon leakage is when companies in one region subject to stringent emissions regulations and carbon pricing such as the EU, relocate their production overseas (out of the EU) to areas with weaker or non-existent climate policies to avoid higher costs. As a result, the EU Emissions Trading System (EU ETS) was less effective.

CBAM is designed to combat carbon leakage by imposing a carbon price on certain imported goods, effectively aligning the carbon costs of domestic and imported products. It currently only covers seven categories of raw materials: iron and steel, aluminium, fertilizers, cement, electricity, and hydrogen. It also currently only covers Scope 1 emissions and some Scope 3 emissions but may expand to include Scope 2 in the future. The intention is to create a trend away from carbon intensive products, towards products that produce less carbon.

How does CBAM work?

Companies will pay for CBAM tax through the purchase of certificates from the EU. CBAM certificates will be priced based on the prices of the EU ETS allowances auctions. Every quarter the number of CBAM certificates must correspond to 80% of emissions. Annually, the number of CBAM certificates must correspond to total emissions, and CBAM certificates must be surrendered at the end of each year.

Here’s how it will work:

1. Carbon Pricing: Under CBAM, the EU requires importers of certain goods to purchase emission allowances, just like companies within the EU Emissions Trading System (EU ETS) already do. These allowances would be based on the carbon emissions associated with the production of those goods.

2. Emissions Assessment: The carbon content of the imported products is assessed, considering emissions from the entire supply chain, including production processes and transportation.

3. Allowance Requirement: Importers must surrender emission allowances equivalent to the carbon content of the imported goods. If the importer cannot prove that the products were made with the same level of carbon emissions as EU-produced goods, they would need to purchase additional allowances.

4. Adjustment Mechanism: The CBAM aims to prevent both overcharging and undercharging. It includes provisions to refund or collect the difference between the carbon price paid by the importer and the actual carbon content of the goods.

When will CBAM be implemented?

A transitional period for CBAM began on 1 October 2023 and extends through 2025, during which time quarterly emissions reporting will be required.

What does this mean for Chinese companies:

How ready is China?

Along with the rest of Asia, many large companies in China may have already done Scope 1 and 2 inventory and annual accounting. However, decarbonization efforts must increase and Scope 3 accounting must be conducted.

For small and medium-sized enterprises it may be more challenging, due to unfamiliarity with GHG accounting and scopes.

China may have more difficulties with CBAM compared to some other countries because much of China’s electricity comes from coal, which produces more GHG per each unit of heat energy produced. And electricity generation is responsible for 40% of China’s total emissions. So, it could be argued that China is less prepared in terms of renewables.

What is the impact?

In terms of the immediate impact, it’s still quite limited as CBAM-covered products only account for less than 2% of China’s total exports. However, almost 99% of China’s CBAM-covered exports to the EU are iron, steel or aluminium. As a result, it could impact $3.5 billion worth of aluminium, iron, and steel trade.

It is also anticipated that CBAM could expand to cover more goods, such as polymers (plastics), certain finished/semi-finished products like cars, organic chemicals widely used in medicine and battery precursors, of which China is a large producer.

In the long term, if CBAM expands to all sectors under the EU carbon market, $35 billion worth of China trade could be affected. The US, UK and Canada are also exploring similar policies to CBAM.

CBAM could incentivise investment in clean energy tech and shift China towards higher-value goods rather than raw materials that are affected by CBAM.

Our View?

• The recent CBAM update is a positive step in the right direction. The policy not only complements the existing emission trading system but it also strengthens the overall policy framework, making it more comprehensive and effective.

• CBAM sends a powerful message to companies: carbon emissions come with a price tag. This encourages businesses to prioritise mitigation measures to avoid these costs, fostering responsible emissions reduction

Next Steps

How can companies affected by CBAM prepare for the reporting requirements?

1. Assess the potential impact of CBAM on operations by examining sales data, potential costs, logistic flows etc.

2. Consider the impact on the business model and identify opportunities to stay competitive.

3. Analyse the impact on the supply chain and procurement strategies

4. Examine the global footprint and value chain in relation to the EU region and CBAM

What if your company isn’t currently affected?

Companies should proactively prepare, especially if their operations involve the production of goods that CBAM might potentially encompass in the future. Additionally, businesses that currently export to regions like the US, UK, and Canada should be mindful of the potential for similar regulations on greenhouse gas (GHG) emissions in the near future. Being well-versed in GHG scopes and accounting will prevent any unanticipated challenges.

Taking these preparatory steps positions businesses strongly to navigate and respond effectively to evolving regulatory landscapes.

Our recommendations for proactively taking control:

1. Review CBAM Documents and Bridge Business Gaps:

Thoroughly review CBAM documents, including the “Guidance Document on CBAM Installations for Importers of Goods into the EU.” Identify and address gaps between current business practices and CBAM requirements.

2. Stay Prepared for Methodological Changes:

Stay informed and be prepared for potential CBAM methodology changes. The transition period serves as a pilot phase for learning; readiness is key to adapting effectively.

3. Proactively Adopt CBAM Methodology:

Embrace CBAM methodology, even if your company is not directly affected. Demonstrate commitment to sustainability and responsible business practices.

4. Integrate Cost Analysis into Decisions:

Factor potential cost analysis into your decision-making. This speeds up the adoption of mitigation measures and ensures alignment between financial considerations and environmental responsibility.

Looking to take a proactive step? Connect with our teams across Greater China to guide you through the process.