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December 21, 2022
2022-6248

European Parliament and Council reach provisional agreement on EU Emission Trading System reform with implications for EU Carbon Border Adjustment Mechanism

  • On 13 December 2022, the European Parliament reached a provisional agreement with the Council of the European Union (EU) to implement an EU Carbon Border Adjustment Mechanism (CBAM), covering product categories of iron and steel, aluminum, fertilizers, hydrogen, and electricity, effective from 1 October 2023.

  • On 18 December 2022, the European Parliament and the Council reached a provisional agreement on EU Emission Trading System (ETS) reform and phasing out of free allowances, which will start in 2026 and end by 2034. Businesses will therefore be required to purchase CBAM certificates for covered imports from 2027.

  • EU ETS reform notably includes extensions of scope to maritime transport and municipal waste incineration.

  • A parallel carbon market will be established to cover fossil fuels used to power cars and heat buildings.

Executive summary

On 13 December 2022, the European Parliament (EP) reached a provisional agreement with the Council of the EU (Council) to implement an EU Carbon Border Adjustment Mechanism from 1 October 2023 (see EY Global Tax Alert, European Parliament and European Council reach provisional agreement on EU Carbon Border Adjustment Mechanism, dated 13 December 2022).

The CBAM is essentially a levy applied on imports of products in certain product categories namely iron and steel, cement, aluminum, fertilizer, hydrogen, and electricity. CBAM works in a similar manner to the EU ETS, i.e., through certificates that mirror the allowances under the EU ETS.

On 18 December 2022, the EP and Council reached provisional agreement on the reform of the EU ETS. The timeline for phasing out of free allowances as part of the EU ETS was agreed from 2026 to 2034 and importers will therefore be required to purchase CBAM certificates from 2027.

The political agreement reached is provisional pending formal endorsement. The EP and then the Council will adopt the pieces of legislation, after which they will be published in the EU's Official Journal and enter into force.

Detailed discussion

Background

In July 2021, the European Commission introduced its climate package of 13 interconnected legislative proposals and revisions. The package is a key enabler for a climate-neutral Europe by 2050 and in reducing emissions by 55% from 1990 levels by 2030.

As part of the Fit for 55 package, two key elements are the proposed EU CBAM and reforming the EU ETS.

Linking EU ETS to CBAM – phasing out of free allowances

The CBAM charges for impacted product categories will be calculated based on “embedded emissions,” which refers to emissions occurring upon manufacture, as well as indirect emissions under certain conditions. Payment of CBAM charges will be facilitated through the purchase and surrender of CBAM certificates upon final implementation (CBAM certificates cannot be traded on the EU ETS market).

The provisional agreement of 18 December 2022 sets out the transitional timeline for the phasing out of free EU ETS allowances from 2026 to 2034, and consequently phasing in of CBAM certificates from 2026. Importers will therefore be required to purchase CBAM certificates from 2027 for the proportion of emissions that do not benefit from free allowances under the EU ETS. EU importers are required to register at the competent authorities in advance.

Progressive phasing will provide for a slower rate initially, meaning CBAM amounts will increase year on year. For goods imported into the EU that have been subject to carbon pricing regimes in the country of production, the CBAM charge will take these charges into account.

The topic of export rebates was under discussion, however, was not introduced in the agreement reached. Instead, EU Member States will be granted the right to ring-fence revenues to support companies at risk of being harmed by the phase-out of free allowances.

Key elements of EU ETS reform

In addition to the timing for the phasing out of free allowances, other elements were provisionally agreed including:

  • Increasing overall ambition of emissions reductions: 62% reduction compared to 2005 levels by 2030
  • Increasing speed of annual reduction rate of the cap: 4.3% per year from 2024 to 2027, and 4.4% from 2028 to 2030
  • Reinforcing mechanism on excessive price fluctuations, including providing for an automatic release of allowances from the MSR to the market
  • Reinforcing conditionality requirements for installations benefiting from free allowances, notably energy audits and in some cases, climate neutrality plans
  • Removal of derogation for installations for electricity generation, instead used for Modernization Fund to support decarbonization of energy sector
  • Scope extended to maritime transport from 2024:
    • Gradual phase-in: 40% of verified emissions from 2024, extending to 75% for 2025 and 100% for 2026
    • Most large vessels will be included from the start in EU ETS, with other vessels included in “MRV regulation” (monitoring, reporting and verification of CO2 emissions) and included at a later stage in EU ETS
    • Agreement takes into account geographic specificities
    • Non-CO2 emissions (methane and nitrous oxide) will be included in the MRV regulation from 2024 and EU ETS from 2026
  • Scope extended to municipal waste incineration from 2026
  • Parallel carbon market (EU ETS II) to cover buildings and road transport by 2027:
    • Applies to distributors supplying fuels to the buildings, road transport and certain other sectors
    • Gradual increasing of linear reduction rate: 5.10% from 2024 and 5.38 from 2028
    • Some “frontloading” anticipated in the first year
    • Possibility for delay by one year in the case of carbon prices per ton exceeding €90
    • Anticipated prices will be capped at €45 per ton until at least 2030
    • Temporary exemption possible in the case where suppliers are subject to a carbon tax at a national level equal or higher than auction price for allowances
    • Simplified requirements for smaller suppliers
  • All revenues generated by the carbon market is to be spent on climate and energy-related projects

Social Climate Fund, Modernization Fund, and Innovation Fund

The provisional agreement of 18 December 2022 also saw more details confirmed on the Social Climate Fund (SCF). The SCF will established from 2026 to 2032 with €60b available for EU Member States to use to finance measures and investments – which are to be set out in a plan – to support vulnerable groups impacted by higher carbon pricing and to enable the wider transition. A maximum of 37.5% can be used to offer citizens direct income support. Additionally, there is an element of co-financing as EU Member States will be required to contribute 25% to the social climate plans.

Funding available under the Modernization Fund and the Innovation Fund will be increased through further auctioning of allowances, and the inclusion of maritime transport, and buildings and road transport being included in scope.

The Modernization Fund was established to support lower-income EU Member States in their transition to climate neutrality, specifically modernization of energy systems and improving energy efficiency. The Innovation Fund provides funding for businesses investing in innovative low-carbon technologies).

Implications

CBAM and the reform of the EU ETS will impact businesses both in the EU and across the globe, from an operational perspective and in terms of strategic decision-making. Impacts may be either direct or indirect. A holistic approach across the value chain and supply chain is recommended. It is worth noting the European Commission intends to review the scope of products covered during the transition period and decide whether to extend to additional product categories covered under the EU ETS.

The transition phase including CBAM reporting obligations is planned to be effective from 1 October 2023. Initial steps include: (i) assigning internal responsibility for management of the regime; (ii) reviewing the EU import footprint and potential (cost and process) impacts considering the new proposed scope of CBAM; and (iii) starting to prepare to comply under the transitional period requirements. In particular, this includes reviewing required data (e.g., on embedded emissions and carbon price at the location of manufacturing), identifying potential gaps and gathering information.

Also, additional revenues from the carbon market means further funding opportunities are available via the EU Innovation Fund for businesses investing in innovative low-carbon technologies.

It will be important for businesses to monitor developments as the legislative process continues for CBAM and the closely interlinked EU ETS reform.

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For additional information with respect to this Alert, please contact the following:

Carbon Border Adjustment Mechanism

Emission Trading System

Innovation Fund

EMEIA Sustainability Tax Services

 
 

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