EU Carbon Border Adjustment Mechanism (CBAM): Ensuring your supply chain is compliant

In June 2022, the European Parliament voted on its position on CBAM.  The parliament’s amendments include (amongst other things) a broader product scope, the establishment of a centralized CBAM authority, a broader emission scope (including indirect emissions) and a shorter transition period.

The proposal for the CBAM regulation by the European Commission can be found here. The amendments on the proposal adopted on 22 June 2022 in a plenary session by the European Parliament can be found here. On 13 December 2022, the Council and the European Parliament reached an agreement of a provisional and conditional nature on the CBAM. The agreement needs to be confirmed by ambassadors of the EU member states, and by the European Parliament, and adopted by both institutions before it is final.

CBAM – Part of a larger package

Along with its environmental and social target, Fit for 55 is the largest legislative package ever submitted by the European Commission. This package emphasizes the importance that the European Commission gives to environmental issues.  It also includes significant proposals in the area of taxation that either update the existing directives or provide completely new legal solutions aiming to decrease greenhouse emissions by 2030.

Observing Fit for 55 from a tax perspective, there is a significant link with the European Union Communication on Business Taxation for the 21^st century. In this plan, the European Commission put forward its vision for corporate taxation in the 21^st century and emphasized that taxes will play a key role in shifting towards more behavioral corporate taxes on a polluter-based principle. To support this shift, the European Green Deal Investment Plan will be established from which the EU Member States will be able to draw on to help finance the costs of this energy transition.

The most important proposal within Fit for 55 from a tax perspective is the revision of the Energy Taxation Directive (covered in our previous blog ) and CBAM, which is linked to already operating the EU Emission Trading System (ETS), covered by the ETS Directive.

CBAM and how does it work?

The European Commission has taken into account that some non-EU countries may have less strict environmental and climate policies for their industries. Increasingly stringent EU climate policies could therefore trigger a high risk of carbon leakage. Companies based in the EU could relocate their carbon intensive production abroad to take advantage of lower environmental compliance costs and replace their EU-produced products with more carbon-intensive imported products from these third countries. As a result, emissions in these third countries could increase, undermining EU climate efforts to decrease overall global emissions.

One of the primary goals of CBAM is to equalize the prices between goods produced in the EU and goods imported from third countries, ultimately to establish a level playing field. This can ensure that the EU climate goals are not undermined by shifting production to countries outside the EU with less ambitious environmental policies. CBAM can also incentivize producers from third countries to invest in emissions-efficient technologies, as well as encourage governments of third countries to adopt policies for their emission intensive industries, all in all while ensuring compatibility with WTO rules.

The European Commission comments that CBAM is an important instrument to support the reduction of net greenhouse gases by 55% by 2030, while enabling industries in the EU to remain competitive. To meet the environmental targets set by the European Commission, industries based in the EU will need to make substantial investments in green energy in order to downsize greenhouse gas emissions. On the other side, industries outside the EU might not yet be burdened by stringent environmental policies or measures similar to EU ETS. This is where CBAM steps in.

Under the provisional agreement from 13 December 2022, CBAM will become effective from October 2023 onwards. From then, importers can request an import authorization for products under the scope of CBAM, as well as comply with reporting standards. Between 2023 and 2026, there will be a transition period. After the transition period importers will need to receive authorization from a centralized EU CBAM authority to import goods under the scope of CBAM into the customs territory of the Union. Importers will need to comply with reporting obligations and identify the emissions embedded in the imported goods and purchase CBAM-certificates accordingly. The free allocation of CBAM-certificates will be slowly phased out, ending in 2032.

Broadened product scope

The European Commission initially proposed to impact EU importers of cement, electricity generation, certain fertilizers, iron, steel and aluminum. The European Commissions considers these industries to have a high carbon footprint as well as an increased risk of displacement outside the EU. In the parliamentary session in June 2022, The European parliament has amended the proposal to include organic chemicals, plastics, hydrogen and ammonia under the product scope. It is expected that the goods subject to the CBAM-regulation will be extended later to include ferro-alloys and initially exempt fertilizers.

CBAM will refer to the combined nomenclature (“CN”) codes in place for customs in order to determine the nature of the product imported. Determining the CN-code of goods will therefore become more important for importers in the EU.

Importance of the Country of Origin

CBAM will not apply to imported goods from all third countries. EEA-EFTA states including Iceland, Switzerland, and Norway, which currently fall under EU-ETS, will be exempt from CBAM. For products with a CN-code that currently does not attract any customs duties, prior to the CBAM one might be neglecting to pay attention to Rules of Origin. It will therefore become increasingly more relevant for importers to collect evidence to prove the country of origin of imported goods, especially for goods with a CN-code that currently don’t attract any customs or anti-dumping duties.

WTO Global Trade rules

As it will impact international trade, CBAM needs to be compliant with the WTO rules. Several counties including the U.S., China, Russia, Brazil, South Africa, and India have already raised their concerns with the EC proposals. They argue that CBAM breaches:

• The rule of non‐discrimination (MFN or the Most Favored Nation Clause) that enforces countries to treat imported products from different WTO members alike;
• The national treatment rule which says that foreign products cannot be put at a disadvantage to domestic products.

Moreover, CBAM could lead the EU to apply higher charges on imported goods than the agreed customs duty ceilings in WTO agreements. Other comments recommend the EU should also make sure that it evaluates imports on their actual emission content rather than generic metrics based on averages or promises made by the country of origin.

Deputy Director-General of the WTO: Jean-Marie Paugam, has addressed these concerns. He underlines that, environmental policies, insofar they don’t discriminate between WTO members and are not disguised as protectionism, are not a breach of multilateral trade rules.

Furthermore, the EU environmental policy is targeted at industries rather than countries. CBAM is also intended to complement EU-ETS to create a level playing field for the relevant sectors, regardless of the country of origin. Also, in order to ensure compatibility with WTO rules, CBAM certificates should reasonable reflect closely to the EU ETS price. Moreover, the goal of CBAM is not to establish quantitative limits to import, which means trade flows will not be restricted or disrupted.

Key Takeaways

The significance of ‘green taxes’ such as the CBAM is increasing in importance. The focus of tax teams will need to shift to take account of green taxes and the growing environmental, social and governance (ESG) reporting requirements. With regards to CBAM, the primary issues of concern for organizations will be intra-company pricing, ensuring an adequate view on customs legislation in terms of CN codes and Rules of Origin, and the choice of applicable transfer pricing method in case of an import of raw materials within the scope of CBAM.  Organizations will need to:

• consider whether they should still apply the comparability method and how they will deal with benchmarking;
• consider whether and how to pass increasing costs of compliance to their customers;
• fully understand their global supply chain and the geographic composition of their emissions.

It is critical for organizations to address these issues now and start reviewing their supply chain to ensure they are fully ready for CBAM as of October 2023.  Please get in touch with your usual Mazars contact for a further discussion on how to prepare for these changes.