Will the EU CBAM Cover More Than What You Think? Complex Goods, System Boundaries, and Circumvention Under the Commission’s CBAM Proposal

On July 14, the European Commission presented its legislative proposal for a Carbon Border Adjustment Mechanism (“CBAM”).  This long-anticipated tool is intended to make importers pay for the greenhouse gas (“GHG”) emissions embedded in the covered goods that they market in the EU.  A Covington webinar on the main elements of the proposal and related policy considerations is available here.

The Commission’s proposal tries to carefully define the scope of the CBAM to ensure its integrity and effective link with the EU Emissions Trading System (“ETS”).  The CBAM proposal is designed to apply to specific industrial sectors for which the EU domestic industry is subject to the ETS, that are at high risk of carbon leakage, and for which it is feasible to calculate embedded GHG emissions.

However, the proposal’s current wording suggests that, once the CBAM is in force and the Commission adopts the necessary implementing legislation, it may also have an indirect coverage extending to many other products and sectors than those formally covered.  This is for the following reasons.

Formally, the proposed CBAM would apply to iron and steel, aluminium, cement, and fertilizer products and to electricity.  The exact types of goods that would be covered are those falling within the tariff classification lines of the EU’s Combined Nomenclature, so called CN Codes, that are listed in Annex I to the proposal.  Annex I also covers several complex goods that rely on precursor production steps.  For example, the following four types of complex goods would be subject to the CBAM: (i) white Portland cement [CN 2523 21 00], (ii) mineral or chemical fertilisers containing the three fertilising elements nitrogen, phosphorus, and potassium [CN 3105 20], (iii) tubes and pipes, having circular cross-sections, the external diameter of which exceeds 40.64 cm, of iron or steel [CN 7305], and (iv) aluminium foil [CN 7607].  (We provide a full table with the CN codes that determine which products are covered by the CBAM at the end of this blog post.)

In practice, however, the current wording of the proposal suggests that there is a risk that the CBAM may require including the embedded emissions of goods falling outside the industrial sectors explicitly covered (iron and steel, aluminium, cement, fertilizers ) when assessing the embedded emissions of goods that do fall within the CN Codes listed in the Annex to the proposal.  This is because manufacturing the complex goods listed, such as the examples above, will require a number of input materials, some of which may be outside the scope of Annex I.  For example, manufacturing aluminium foil may require the use of paper or biocides or other chemicals.

The current legal design of the CBAM Regulation appears to leave open the possibility that the CBAM would indirectly cover sectors and categories of goods not falling within the CN codes of Annex I.  The Commission’s proposal does not clearly define the boundaries of the calculation of embedded emissions for complex goods and therefore fails to make clear whether emissions from products in other categories (e.g., paper and biocides) are included in calculating the emissions from a complex good falling with the CN Codes of Annex I (e.g., aluminium foil).

Instead, once the CBAM Regulation is adopted, the proposal foresees that it would be for the European Commission to set the “system boundaries” that would define the exact input materials the embedded emissions of which must be added when calculating the embedded emissions of a complex good covered by the CBAM.  In short, only the Commission’s decision on the “system boundaries” would bring legal certainty with respect to the CBAM’s exact scope.

What is more, this indeterminacy of the CBAM’s scope before the Commission has set the “system boundaries” would extend the discussions on the potential impact of the CBAM years beyond the formal adoption of the CBAM Regulation.  This could also be a bargaining chip of the European Commission during its international climate change negotiations with third countries.

From an EU domestic law perspective, it is unclear whether the European Parliament and Council may empower the European Commission with such seemingly wide discretion.  Setting the “system boundaries” would effectively allow the Commission to determine the categories of goods that the CBAM indirectly covers.  Under the Treaty on the Functioning of the European Union, this could well be considered an “essential element” of the CBAM Regulation which goes beyond the powers the Parliament and Council may grant to the Commission.  It remains to be seen whether the Parliament and Council will agree with this broad grant of authority when they consider the Commission’s proposal for adoption within the next months.

The uncertainty about the CBAM’s scope goes even further.  The Commission’s proposal empowers the Commission to take action in cases of circumvention, i.e., in situations where a change in the pattern of trade has insufficient due cause or economic justification other than avoiding the obligations of the CBAM.  For example, if the pattern of trade to the EU from a third country would show a marked decrease in the goods covered by Annex I (such as iron pipes) and a related increase of downstream goods that use the Annex I goods covered by the CBAM as inputs (such as tables using such iron pipes for framing), the Commission may act.  Such circumvention related action could, again, extend the CBAM’s scope.

Table with the CN Codes that Determine which Products are Covered by the CBAM

 Cement

Electricity

Fertilisers

Iron and Steel

Aluminium