In 2021, the European Union introduced a ‘Fit for 55’ package which was a part of a set of proposals that would assist the European Commission in the delivery of the European Green Deal. The Carbon Border Adjustment Mechanism (CBAM), which is a part of the package, is a proposed border tariff on imports of carbon intensive products into the European Union (EU).

The transitional phase of the implementation of the CBAM will kick in on January 2023 and will cover five industrial sectors, namely: iron and steel; cement; fertilisers; aluminium; and electricity generation. During this time, importers in these sectors will be subjected to the EU’s carbon emissions calculations and reporting requirements. This will allow the European Commission to collect accurate CO2-equivalent emissions data from the importers concerned. At this point, importers need not worry about payment of the financial adjustments.

After the transition period ranging from January 2023 to December 2025, the European Commission will evaluate if the ambit of the CBAM should be expanded to include indirect emissions and to products further down the supply chain. Thereafter, from January 2026, EU importers of iron and steel; cement; fertilisers; aluminium; and electricity products will need to obtain the relevant authorisation from a CBAM authority. This authorisation will comprise purchasing carbon certificates which will be priced in correspondence to carbon prices that would have been paid to produce the same in the EU.

While the current EU Emissions Trading System (ETS) covers EU countries, the CBAM will apply to goods produced outside the EU and will indirectly impact supply chains and the manufacturing sector based in Asia that heavily imports goods to the EU. The prices of CBAM certification would be derived from the weekly average auction price of EU ETS allowances, which would be denoted in € / tonne of CO2 emitted. Importers will have to register with national authorities where they can buy CBAM certificates, either individually or through a representative. The CBAM would be gradually implemented, meaning that the number of required certificates would be adjusted to reflect any free allowances still allocated under the ETS. The rationale of the law is to address carbon leakage – a situation wherein companies move production of goods abroad, to countries with less rigorous emissions policies, predominantly to save costs associated with carbon pricing.

Companies in the identified sectors will have to be mindful that CBAM levies will undeniably increase the cost of exporting to the EU and place them at a relative disadvantage. South Asian and ASEAN economies export greatly to the EU market in the identified sectors, exposing them to the potential CBAM charges. In 2019, of the US$40 billion CBAM-related exports from six South Asian countries, around 14 per cent were sent to the EU. India alone accounted for just above 80 per cent of these exports, while Malaysia accounted for around 15 per cent.

Thus, in order to comply with the new law, affected companies in Asia will have to, at the very least:

• Calculate their current GHG emissions and report it appropriately;
• Conduct a cost-benefit analysis between offsetting their emissions and paying the border tax adjustment.

Practical implications of the CBAM on the manufacturing sector in Asia

Asian economies which export to the EU market will feel the brunt of the CBAM charges. Only a handful of economies in the Asia-Pacific region have a carbon pricing infrastructure in place and even ones that do are significantly lower than the EU or might not cover all the relevant sectors. For example, India has a de-facto carbon tax (levied as coal cess) of around USD 5per tonne, which is applicable only on the production of coal. On the contrary, carbon taxes in the EU range from USD 0.08 to USD 129 per tonne, depending on the country the tax is levied in.

China has ambitious targets for net-zero emissions and adopts one of the world’s most robust emissions trading schemes (a rate-based system) which targets reductions in CO2 emissions per unit of output rather than total CO2 emissions (a mass-based system). The Chinese system covers more than twice the CO2 emissions accounted for under the EU ETS. As of June 2022, Chinese carbon credits cost 8.5% the price of EU ETS credits, with a growth rate of just 10% year-on-year compared to 53% in EU ETS credit prices. This disparity will impact Chinese cement exporters, for instance, who will have to comply with Chinese law as well as the CBAM, and increase in costs anticipating the inclusion of indirect emissions which could potentially target China’s 57% coal-powered economy.

What this means for stakeholders are rising costs, which are likely to see a year-on-year increase, especially as the carbon footprint of more products are taken into consideration after the initial phase. The cost to calculate, monitor, report, and verify emissions will be on the exporter.

What do companies in Asia need to be aware of?

1. CBAM compliance-related measures including but not limited to regulatory changes, calculation and reporting of carbon emissions, and perhaps offsetting will have to be done once the CBAM becomes operational, if companies want to continue exporting to the EU.

Whist the CBAM will be borne by the importer, market practices in the sustainability sector show that the cost for carbon compliance often gets shifted further down to counterparties by back-to-back contracts. This will add to the exporter’s accounting and operational costs as there will be an imminent need to plan for supply chain management and carbon accounting.

Importers and exporters alike should be mindful of other ancillary issues such as customs declarations and the origin of goods. As it stands, the customs authorities have the obligation to ensure that each importer also known as a customs declarant has been previously registered with the central CBAM authority. In addition to this, the recommendation clarifies that non-preferential rules of origin as per the Union Customs Code shall apply. In theory, this means that goods with a production line encompassing multiple countries will be deemed to originate from the country wherein the last material manufacturing was undergone. This could potentially shift the cost of compliance on manufacturers and exporters based in Asia. Compliance might also become part of the exporters’ contractual obligations, based on which the importer will comply with the CBAM in the EU.

2. International trade law, carbon finance, and on-going government negotiations

The Paris Agreement is the key driver behind the CBAM, and was negotiated and adopted by 196 countries at the United Nations’ COP 21 meeting in Paris in December 2015, and entered into force in November 2016. Jurisprudentially and historically (under the common but differentiated responsibility principle), developing countries have maintained that since industrialised nations such as the EU created the problem of global warming through their historic emissions, developing nations should not have to support the cost of mitigating impacts of climate change. In this way, the CBAM may conflict with the Paris Agreement which is based on nationally determined contributions, and by extension individual countries’ goals on emissions reductions. The CBAM, through its charges, is making developing countries (through their export markets) align with the EU, failing which they will bear extra charges on their exports to the EU. It is important, therefore, to follow international negotiations on the application of the CBAM to developing countries, which will ultimately impact the private sector.

3. Domestic regulations on carbon pricing, taxation, and subsidies

It is crucial to note that some Governments may intend to subsidise the impact of the CBAM on exporters by internal budgeting policies, while others may have contrasting budget policies. Further, compliance under domestic law as well as CBAM may be tricky considering different methods of calculating emissions, harmonising laws, as well as financing offsets.

The CBAM and carbon pricing in Asia in general as well, are fast-developing areas. We are closely monitoring this space to be able to assist our clients in not only compliance with carbon pricing mechanisms but also in helping them avoid legal risk in all aspects of carbon emissions and offsets management.