Carbon Border Adjustment Mechanism: Implications for China

The EU's Carbon Border Adjustment Mechanism (CBAM) aims to combat climate change by aligning carbon costs globally, affecting trade and encouraging sustainable practices. While its immediate impact on China's EU exports appears minimal, the long-term implications for Chinese industries are profound, necessitating shifts towards sustainability. The CBAM encourages global alignment with EU environmental standards, presenting China with both challenges and opportunities to lead in the transition to a low-carbon economy and refine its carbon pricing strategies. 

What is the CBAM? 

On April 18, 2023, the European Parliament passed a law to implement a Carbon Border Adjustment Mechanism (CBAM), a key component of the European Union's (EU) "Fit for 55 in 2030 package." This initiative targets a reduction in greenhouse gas (GHG) emissions by 55 percent by the year 2030. The CBAM is a policy tool designed to mitigate carbon leakage by levelling the playing field between domestic industries that have stringent carbon emissions regulations and those in countries with less stringent or no such regulations. Initially, the new regulations will target imports from outside the EU that are notably high in carbon emissions. This includes certain goods in the sectors of cement, electricity, fertilisers, aluminum, iron, steel and hydrogen, along with some related upstream and downstream products (primarily iron, steel, and aluminum). The CBAM applies to imports of these specified goods from non-EU countries, with the exception of those countries that are part of, or connected to, the EU Emission Trading Scheme (ETS) (at present, this includes Iceland, Norway, Liechtenstein, Switzerland and five additional smaller territories). Companies exporting these goods to the EU have to purchase certificates for the CO2 emissions embedded in these products. Under the CBAM, importers of these specified goods will be required to cover the cost difference between the carbon price paid in the production country and the cost of carbon allowances within the EU. The CBAM certificate's price reflects the average price of the ETS, thereby granting the EU leverage to affect worldwide carbon pricing. The CBAM is divided into two implementation phases, the transitional phase and the implementation phase, with some overlap in 2025. 

Transitional Phase: 2023-2026 

The initial phase of the CBAM, beginning on October 1st 2023 and ending in 2026 serves as a transitional period. During this introductory phase, importers of these specified goods will be required to report the GHG emissions associated with their products, covering both direct and indirect emissions. However, they will not face any financial charges or need to make any adjustments based on these disclosures. The agreement anticipates that after the transitional period, indirect emissions will be included in the scope for certain sectors, using a methodology that will be developed in the interim period. Businesses will need to report not only the carbon emissions from their own energy use, but also those of their suppliers. Consequently, this will require companies to request their overseas suppliers to disclose the carbon footprints associated with the supply chain of the products they sell within the EU. In the initial year of its rollout companies will have three options for how they report emissions, 1) Comprehensive reporting following the new CBAM methodology (the EU method); 2) Reporting based on equivalent national systems of third countries; and 3) Reporting using reference or default values (the minimum requirement). The aim of this transitional period is to act as both a pilot and an educational phase for all involved parties, such as importers, producers and regulatory bodies. It is designed to gather crucial data on embedded emissions, which will assist in fine-tuning the methodology to be applied in the final phase. 

Implementation phase: from 2026 

The program will progress to its full implementation stage starting January 1, 2026. Starting from January 1, 2025, only the EU method for reporting will be permissible, and estimates (including default values) may be utilised solely for complex goods when these estimated figures account for less than 20% of the total embedded emissions. At this point, EU importers will be required to both report the volume of goods and the associated GHG emissions and to purchase the necessary number of CBAM certificates. The cost of these certificates will be linked to the average weekly auction price of EU ETS allowances, calculated in euros per ton of CO2 emitted. As reported by Reuters in February 2023, the EU's carbon emission trading price reached a record high of approximately €100 (US$106.57 and ¥766.80) per metric ton. Under the CBAM, importers will be charged a carbon price that mirrors the cost they would incur if the imported goods were produced in compliance with EU ETS regulations. Crucially, CBAM reporting will need to be detailed on a per-product and per-production facility basis. Not meeting the required reporting standards and not making a sincere attempt to correctly report embedded emissions, could result in a monetary fine. This fine could vary between €10 and €50 for every tonne of embedded emissions that goes unreported. The specific fine amount will be based on the severity and length of the reporting failure, with penalties increasing for failures lasting more than six months. However, if importers can prove that they have already paid a carbon price elsewhere (such as a domestic carbon tax), this amount can be subtracted from their CBAM fee. While the EU may acknowledge China's implementation of a specific carbon pricing mechanism, the exact nature of this recognition remains unclear due to China's use of an intensity-based cap that applies to only certain sectors. At the micro level, the challenge lies in ensuring corporate adherence to data reporting and disclosure. To address this, there is a necessity for policy frameworks that bolster data verification, maintain emission factor databases with real-time updates, and enforce carbon emission disclosures among private enterprises. The gradual elimination of free allowances under the EU ETS will be synchronised with the roll-out of CBAM from 2026 to 2034, this approach will enable both systems to function simultaneously until 2035. As CBAM fully integrates, it will extend its reach to cover over 50 percent of the emissions from sectors currently under the EU ETS, marking a significant expansion of its scope. 

Why the CBAM? 

The general aim of this policy is to encourage cleaner industrial practices globally by ensuring that imported goods bear a similar carbon cost as goods produced within the EU, thereby preventing companies from relocating their production to countries with less stringent emission standards. Moreover, the CBAM aims to encourage countries outside the EU to enhance their climate goals and ensure that the EU's and the world's efforts to combat climate change are not weakened by companies moving their production from the EU to countries with less strict climate policies. Additionally, it aims to even out the disparities in carbon pricing between the EU and the countries that export to them. This mechanism is seen as a critical step towards achieving global carbon reduction targets by promoting fair competition and encouraging the adoption of greener technologies worldwide, without disadvantaging domestic industries that are subject to stricter environmental regulations. 

EU-China trade implications  

As a key exporter to the EU, China is among the countries expected to be significantly impacted, particularly its industries focused on exports and identified for climate initiatives. The implementation of the CBAM might encourage the Chinese government to enforce stricter  environmental policies to meet EU criteria. Yet, the near-term influence of the CBAM on China is projected to be minor, as it applies to only a limited segment of the trade between China and the EU. Currently, the existing CBAM is unlikely to significantly affect Chinese exports. The value of China's exports to the EU that fall under the CBAM's scope represents less than 2 percent of its total exports to the EU, amounting to approximately €6.5 billion (US$7.18 billion; ¥51.94 billion). However, although the direct trade effects might appear minimal at first, the introduction of CBAM is expected to substantially influence manufacturers that are focused on exports. Since the CBAM encompasses both direct and indirect emissions, manufacturers will be compelled to seek methods to lower the carbon intensity of their products to stay competitive. This could involve enhancing energy efficiency, switching to fuels with lower carbon content, and refining production processes. In fact, during recent years industries that focus on reducing carbon emissions, improving energy efficiency, and achieving carbon neutrality are now identified as key areas for economic growth. To stay competitive in the face of CBAM regulations, affected industries will need to improve their management of carbon-related issues. They will be encouraged to use more renewable energy sources to lower the indirect emissions associated with electricity use under CBAM. On the other hand, industries that do not adopt a sustainability strategy may face the risk of losing financial support, highlighting the importance for all sectors to develop a clear plan towards achieving carbon neutrality. While the expenses associated with CBAM might lead to higher prices, low-carbon producers in China could find this situation advantageous. Whether in the upstream or downstream sectors, producers committed to sustainability could experience growth in their businesses as a result. Moreover, industries that are heavily reliant on fossil fuels and have high carbon emissions may find themselves at a competitive disadvantage. This could lead to a market shift within China, where low-carbon and green industries gain a competitive edge, especially those that can innovate and reduce their carbon intensity to meet the EU standards. Furthermore, the CBAM may prompt Chinese policymakers to adjust national policies to align more closely with international carbon pricing mechanisms. This could include enhancing China's own carbon market and increasing the cost of carbon domestically, thereby reducing the discrepancy between the costs faced by Chinese exporters and their international competitors. Lastly, the CBAM has set a precedent that is influencing other countries to consider or enhance their own carbon pricing mechanisms, including carbon taxes. This global shift towards carbon pricing as a tool to combat climate change includes notable examples such as Canada's carbon pricing framework, which encompasses a carbon levy and output-based pricing system for heavy emitters, and the carbon tax in Singapore, which directly charges facilities for their greenhouse gas emissions. Observing these international trends, it could be advantageous for China to either implement its own carbon tax or align its existing carbon market more closely with these international systems. The Chinese government has already taken significant steps in this direction with the establishment of its national carbon trading scheme, which launched in 2021 and is currently the world's largest carbon market by volume of emissions covered. By adjusting its carbon pricing policies to be more in line with international standards, China could not only facilitate its industries' competitiveness in the global market but also reinforce its commitment to reducing carbon emissions. 

Conclusion 

Thus, the CBAM represents a pivotal shift in the European Union's approach to combating climate change and promoting sustainable industrial practices. By aligning the cost of carbon across borders, the CBAM seeks to ensure that global trade does not undermine the EU's ambitious environmental standards and climate objectives. This mechanism not only incentivizes cleaner production processes within the EU but also encourages non-EU countries to elevate their environmental policies to avoid economic disadvantages in one of the world's largest markets. For China, a major trading partner of the EU, the CBAM presents both challenges and opportunities. While the immediate impact on Chinese exports to the EU may be limited, the long-term implications for Chinese industries, particularly those in carbon-intensive sectors, are significant. The CBAM underscores the necessity for these industries to adopt more sustainable practices and for China to possibly align its carbon pricing mechanisms more closely with global standards. Doing so could enhance the competitiveness of Chinese exports and affirm China's role as a leader in the global transition to a low-carbon economy. Furthermore, the CBAM's influence on international carbon pricing trends offers a compelling reason for China to refine its own carbon market, potentially setting a benchmark for environmental governance worldwide. As countries around the globe grapple with the urgent need to reduce greenhouse gas emissions, the CBAM exemplifies how trade policies can be leveraged to foster a greener, more sustainable future. 

Author: Lucy van Eck

Editor: Jonathan Xu