CBAM: levelling the global carbon emissions playing field? | Responsible Investment| Investment management

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1 August 2024

The European Union (EU) has long seen itself as a leader in setting a price for – and thus helping to reduce – carbon emissions. Its Emissions Trading System (ETS), introduced in 2005, was the world’s first attempt at using the market to put a price on carbon, theoretically enabling companies – and society – to cut greenhouse gas emissions cost-effectively.

However, the EU issued free emissions allowances to compensate and protect manufacturers operating within its borders and manage the risk of carbon leakage – that is, when companies transfer production (along with employment and investment) from the EU to countries with laxer emission regulations and lower environmental costs. These allowances arguably allowed many carbonintensive industries to keep operating within the EU.

Now, the EU is going a regulatory step further. The transitional phase to its new Carbon Border Adjustment Mechanism (CBAM) regulation started on 1 October 2023 and runs until 31 December 2025. CBAM aims to address carbon leakage more effectively by putting a price on carbon emissions that originate outside the EU’s borders. And to do so without being deemed a barrier to trade, so as to comply with World Trade Organization rules.

During this transition phase, CBAM will apply to imports of certain goods and selected precursors whose production is carbon intensive and at greatest risk of carbon leakage: cement, iron and steel, aluminium, fertilisers, electricity and hydrogen. Then, from 1 January 2026 if all goes to plan, EU importers of goods covered by CBAM will buy and surrender CBAM certificates corresponding to the volume of emissions. The price of the certificates will be calculated on the weekly average auction price of EU ETS allowances expressed in euros per tonne of CO2 emitted. By 2030, the EU aims to extend the CBAM to all sectors covered by the ETS, whose current phase expires then.

If CBAM expands to greater coverage of sectors and greenhouse gases, the issuance of free allowances should contract. As the quid pro quo, EU companies will be able to deduct from their CBAM certificates any carbon price paid in the source country. The combined effects should be to spread carbon pricing, to increase investment in decarbonisation projects (along the supply chain) and to ensure companies account for a meaningful carbon price in their financial statements. Ultimately, it’s about implementing the EU’s target of reducing net greenhouse gas emissions by at least 55% before 2030.

Whilst CBAM may be the tip of the iceberg, the bulk lurking below the water could be the proposed EU Corporate Sustainability Due Diligence Directive (CSDDD) and the Corporate Sustainability Reporting Directive (CSRD). Collectively, these three instruments address the need for supply chain engagement, disclosure and accountability. After all, if importers need to pay for embedded emissions, the incentive is theoretically on them to calculate, disclose and certify the carbon footprint of existing, and alternative, suppliers. CBAM drives the engagement, whilst CSRD and CSDDD drive the reporting and disclosure.

Our analysis of CDP disclosure suggests that many EU companies have a long way to go in reporting their carbon footprints. Currently, we see three types of emissions calculation: spend-based, which rely on the reporting company’s expenditure data and representative emission factors from approved external sources; average data, which apply industry-average emission factors to the quantity of purchased materials; and supplier-specific, where the reporting company uses data provided directly by the supplier.

Supplier-specific (or primary) data is potentially the most accurate and the most useful for evaluating the performance of suppliers relative to their peers and meeting the EU’s requirements. As an incentive (or perhaps a deterrent), the EU plans to set default emission values at a mark-up over the average emission intensity of each exporting country, with a stick of fines or penalties for companies found to be misrepresenting their emissions profile.

There is a clear need for enhanced collaboration with suppliers to collect and improve the emissions data that feed into Scope 3 footprints. Although CBAM compliance is the immediate goal, wider adoption of the supplier-specific methodology should intensify competition in the supply chain. If EU importers, armed with a clearer understanding of relative product carbon footprints, think about switching suppliers, all upstream actors will face increasing pressure to invest in emission reduction. More reliable, more differentiated emissions data might also encourage customers of EU importers to elevate environmental credentials in their procurement decisions.

Of course, CBAM may result in unpredictable effects – for good or ill – on macro-economic indicators, trade flows, competitive response and positioning, and commodity prices. Governments outside the EU may feel compelled to capture the carbon penalty domestically rather than allow payments to flow into the EU. This could lead to a proliferation of carbon pricing regimes among EU trading partners. Or there could be a significant backlash against the EU on the grounds of protectionism.

But, as we have argued here, the micro implications are equally interesting. CBAM should spur improved carbon accounting. And this may raise the stakes for decarbonisation both within the EU, especially given meaningful financial penalties, and beyond, as governments, suppliers and purchasers pursue virtuous strategies contributing to cleaner, more equitable and more transparent value chains.

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Piers Wheeler

Director – Institutional

T +44 (0)20 7963 8258

Developing and executing asset management strategy for capital raising and strategic relationship management. Coverage includes EMEA, Asia and Australia. Piers joined Ruffer in 2021, having previously worked with asset management firms including Eastspring, AMP Capital and LEK as a strategic consultant. He holds a MA from the Bayes Business School and a BA (Hons) from the University of Oxford.

Annabel Paterson

Senior Associate – Institutional

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Joined Ruffer in 2021, having graduated with a first class honours degree in land economics from the University of Cambridge. After two years working with the UK Private Wealth team and completing her IMC and CFA Level I qualifications, she now supports Ruffer’s global business development and client servicing efforts.

Articles by Annabel

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