EUROPEAN COMMISSION Brussels, 14.7.2021 SWD(2021) 643 final COMMISSION STAFF WORKING DOCUMENT



IMPACT ASSESSMENT REPORT

Accompanying the document Proposal for a regulation of the European Parliament and of the Council establishing a carbon border adjustment mechanism {COM(2021) 564 final}

{SWD(2021) 644 final}

{SWD(2021) 647 final}

{SEC(2021) 564 final}



Table of contents 1Introduction: Political and legal context 2problem definition 2.1What is the problem? 2.2How is the problem currently being addressed? 2.3What are the problem drivers? 2.4How will the problem evolve? 3Why should the EU act? 3.1Legal basis 3.2Subsidiarity: Necessity of EU action 3.3Subsidiarity: Added value of EU action 4Objectives: What is to be achieved? 4.1General objectives 4.2Specific objectives 4.3Ancillary effects 5What are the available policy options? 5.1What is the baseline from which options are assessed? 5.2Description of the policy options 5.3Options discarded at an early stage

6What are the impacts of the policy options? 6.1Introduction 6.2Environmental Impacts 6.3Impacts on the EU ETS 6.4Economic Impacts 6.5Social Impacts 6.6Administrative Impacts 6.7Revenue Generation Impacts 7How do the options compare? 8Preferred option 9How will actual impacts be monitored and evaluated?



Glossary Term or acronym Meaning or definition CAT Carbon Added Tax CBAM Carbon Border Adjustment Mechanism CN Combined Nomenclature CO2 Carbon Dioxide ETS Emissions Trading System GDP Gross Domestic Product GHG Greenhouse Gas MRV Monitoring, Reporting and Verification NDC Nationally Determined Contribution PEF Product Environmental Footprint SMEs Small and Medium-sized Enterprises TFEU Treaty on the Functioning of the European Union VAT Value Added Tax WTO World Trade Organisation





1Introduction: Political and legal context The world is facing a profound climate crisis and the challenges of climate change require a global response. Strong international cooperation will strengthen the joint climate action needed by all the Parties of the Paris Agreement to meet the goal of holding the increase in the global average temperature to well below 2 °C above pre-industrial levels and pursuing efforts to limit the temperature increase to 1.5 °C above pre-industrial levels. The European Union’s international leadership must go hand in hand with bold domestic action. To meet the objective of a climate-neutral EU by 2050 in line with the Paris Agreement, the EU needs to increase its ambition for the coming decade and update its climate and energy policy framework. As announced in the European Green Deal, the Commission has proposed a new EU target for 2030 of reducing greenhouse gas (‘GHG’) emissions by at least 55 % compared to levels in 1990, based on a comprehensive impact assessment. This objective has been endorsed by the European Council. To deliver on these GHG emissions reductions, the Commission proposes to revise where necessary all relevant policy instruments by June 2021 in a ‘Fit for 55 Package’, which covers in particular the review of sectorial legislation in the fields of climate, energy, transport, and taxation. The initiative for a Carbon Border Adjustment Mechanism (‘CBAM’), which is subject to examination in this impact assessment, is part of that package and will serve as an essential element of the EU toolbox to meet the objective of a climate-neutral EU by 2050 in line with the Paris Agreement by addressing risks of carbon leakage following the increased EU climate ambition. The European Green Deal underlined that ‘should differences in levels of ambition worldwide persist , as the EU increases its climate ambition, the Commission will propose a CBAM, for selected sectors, to reduce the risk of carbon leakage’. Indeed, carbon leakage could result in an overall increase in non EU emissions hence undermining the effectiveness of EU climate policies. The 2015 Paris Agreement on climate change, as well as strong international diplomacy and leadership, are part of the EU’s toolbox to achieve higher climate ambition globally. The Paris Agreement commits the international community to a continuous increase in the ambition of climate action to limit global average temperature rise in order to significantly reduce the risks and impacts of climate change. Each Party must prepare its own nationally determined contribution (‘NDC’) towards this global goal, reflecting its ‘highest possible ambition’ as well as its ‘common but differentiated responsibilities and respective capabilities, in the light of different national circumstances’. Heterogeneity in climate action among countries is therefore inevitable. However, a number of independent evaluations suggest that the aggregate impact of Parties’ current NDCs, if fully implemented, will not put the world on a pathway to achieve the Paris Agreement goals. Therefore, as long as the EU’s international partners do not share the same level of climate ambition, and differences in the price put on GHG emissions remain, there is a risk of what is generally referred to as carbon leakage. Carbon leakage refers to the situation that occurs if, for reasons of differing ambitions related to climate policies, businesses in certain industry sectors or subsectors were to transfer production to other countries with less stringent emission constraints or imports from these countries would replace equivalent but less GHG intensive products due to the difference in climate policy stringency. This could lead to an increase in their total non-EU emissions, thus jeopardising the reduction of GHG emissions that is urgently needed if the world is to keep the global average temperature to well below 2 degrees Celsius above pre-industrial levels. Currently, the risk of carbon leakage is being addressed in the EU under the EU Emissions Trading System (‘EU ETS’). This is the world's first international emissions trading system and it has been in place since 2005. For the sectors covered by this system in the EU and most at risk of carbon leakage, this risk is currently managed through the granting of free allowances and compensations for the increase in electricity costs under state aid rules. It should be noted that carbon pricing mechanisms can also include carbon taxation, which outside the EU may cover the same sectors that are covered in the EU by the ETS. Figure 1 shows the different carbon pricing mechanisms that exist or that are under consideration around the globe. Source: World Bank, summary map of regional, national and subnational carbon pricing initiatives (Last update: 1 April 2021), the World Bank Group, Washington. https://carbonpricingdashboard.worldbank.org/ The EU ETS revision is assessed by the European Commission in a separate impact assessment. Among others, this involves the possible extension of the EU ETS to maritime transport, as well as emissions from buildings and road transport. Most notably, a higher environmental contribution of the EU ETS translates into a more stringent cap on emissions, meaning that the volume of allowances available will decline. A more stringent cap will likely imply an increase of the EU ETS carbon price at which allowances’ supply and demand match. The EU objective of climate neutrality and the decision to raise climate ambition for 2030 also lead to a broader reconsideration of existing measures against carbon leakage. In particular, free allocation of allowances prevents carbon leakage risks but also weakens the carbon price signal for EU industry compared to full auctioning. As an alternative to free allocation, as indicated by the Green Deal Communication, the CBAM ‘would ensure that the price of imports reflects more accurately their carbon content. This measure will be designed to comply with World Trade Organization (WTO) rules, including as regards the principle of non-discrimination, and other international obligations of the EU’. Further, President von der Leyen has underlined that ‘Carbon must have its price – because nature cannot pay the price anymore. This Carbon Border Adjustment Mechanism should motivate foreign producers and EU importers to reduce their carbon emissions’. To this end, active outreach to third countries and businesses would be important with regard to the understanding of and compliance with CBAM requirements. In the special European Council of 17-21 July 2020 , EU leaders agreed on the recovery instrument NextGenerationEU. The instrument will provide the EU with the necessary means to address the challenges posed by the COVID-19 pandemic and, therein, support investment in the green and digital transitions. In order to finance it, the Commission will be able to borrow up to EUR 750 billion on financial markets. In that context, EU leaders agreed to provide the EU with new own resources, notably to facilitate the repayment of NextGenerationEU funds. As part of the mandate received, the Commission was invited to put forward a proposal for a CBAM in the first semester of 2021, with a view to its introduction at the latest by 1 January 2023. The envisaged timetable was confirmed in the roadmap towards the introduction of new own resources agreed by the European Parliament, the Council and the Commission on 16 December 2020 . 2problem definition

This section will define and analyse the problems and the problem drivers as well as assess the evolution of the problems in the absence of EU policy intervention. The ‘Intervention Logic’ ( Figure 2 below) presents visually the problems, their drivers, as well as the objectives of the proposed mechanism. 2.1What is the problem? 2.1.1Overall positioning of the problem The problem addressed by this impact assessment is how to succeed in reducing GHG in the EU and avoiding that these emissions reduction efforts are offset by emissions increases outside the EU. As indicated in Section 1, if differences in levels of climate ambition are to persist worldwide, the EU’s increased ambitions will reinforce the risk of carbon leakage from the EU. Such leakage is caused by the relocation of production of energy-intensive products from the EU to other countries with lower environmental compliance costs, and of these same EU products being replaced by more carbon-intensive imports from these countries. These manifestations of carbon leakage are sometimes referred to as the increase or reallocation of GHG emissions embedded in imported goods. GHG emissions embedded in imports are a great concern as they are expected to increase both as a result of the relocation of production outside of the EU but also as there might be increased demand of such products due to price differences. The resulting overall increase in global emissions undermines the effectiveness of EU climate policies. The risk of carbon leakage increases as the EU raises the ambition of its climate policies above that of its trading partners. The public consultation on the CBAM, for which the Commission received over 600 contributions from companies and business associations, EU and non-EU citizens, civil society and public authorities suggested that carbon leakage is already perceived as a reality and that the risk is likely to increase in view of the raising of the EU climate ambition. Overall, respondents agreed that a CBAM can be justified by differences of ambition between EU and third countries to fight against climate change and can contribute to both EU and global climate efforts. The results of the consultation are highlighted throughout this report and discussed in more detail under Annex 2. Firstly, rising GHG emissions across the world are a global problem as they lead to climate change, which has a devastating effect on the planet and its people. In particular, carbon dioxide emissions from human activities contribute about 80 % to the anthropogenic warming of the atmosphere together with other GHGs such as methane or nitrous oxide. Recognising the need to address climate change, the EU and 189 countries have become Parties to the Paris Agreement in order to keep global temperature rise well below 2 °C above pre-industrial levels and to pursue efforts to limit the temperature increase even further to 1.5 °C. To contribute to this objective, the EU has increased its targets and efforts to reduce its GHG emissions, and to achieve climate neutrality (net zero emissions) by 2050. Secondly, the risk of EU effort being offset by relocating production and increase of carbon-intensive imports could increase due to a variety of factors. The evidence of the existence of carbon leakage is not always conclusive or suggests that it is difficult to isolate carbon leakage as a single factor in relocation decisions. One reason for this is because different studies use different methodologies. In particular, as explained in Annex 11, ex-post studies do not find substantial evidence of carbon leakage as a result of free allocation under the EU ETS and of the low carbon price until phase 3 of the EU ETS. By contrast ex-ante analyses using simulation models, often find a substantial risk of carbon leakage in the absence of protection mechanisms such as free allocation of carbon allowances. This is especially so, in studies focusing on specific industries (e.g. partial equilibrium) which tend to focus on emission-intensive and trade-exposed sectors and find higher leakage rates for these sectors in particular. The differences in results between the types of studies indicate that carbon leakage protection measures have been effective to date, while higher carbon prices and declining free allocation can result in an increased leakage risk and thus alter the results. These considerations align the results of ex-ante and ex-post studies by explaining the differences. Ex-ante studies often assume the absence of carbon-leakage protection mechanisms. However, in practice carbon pricing mechanisms have always been accompanied by special provisions, such as free allowance allocation or carbon tax exemptions, to avoid the risk of carbon leakage. In ex-post studies of existing carbon pricing mechanisms, these leakage protection measures are therefore included. Additionally, analytic and empirical evidence shows that as a result of the existing leakage protection mechanisms, the carbon price signal has been significantly reduced. Notwithstanding the above considerations, as the EU increases its climate ambitions, existing mechanisms in place to address carbon leakage are being reconsidered, allowances available for free allocation will become scarce, the carbon price signal will become stronger and industries will therefore have to reduce their emissions. This view is also supported by the OECD which argues that ‘this literature, however, has been, by definition, based on past climate policies, which have not embodied the same level of ambition that is now being put forward by some countries. Thus, while carbon leakage and competitiveness effects of climate policies have been very modest so far, increased policy stringency divergence in the future may amplify these issues. The small effects identified may partly reflect the low stringency of climate policies to date. Yet threats posed by climate change require policies that lie outside the bounds of past experience. Another explanation for the small effects observed so far is that the climate policies are designed so as to prevent potential competitiveness effects’. 2.1.2The CBAM in the context of the Paris Agreement While each Party to the Paris Agreement sets its own level of ambition, at the same time we need to make sure that Parties are not undermining the effectiveness of each other’s policies. By introducing a CBAM, the EU will ensure that goods imported into the EU follow the same rules as the goods produced in the EU without interfering with policy choices in third countries. In order to respect the Paris Agreement and the principle of nationally determined contributions (NDC) therein as well as the principle of Common but Differentiated responsibility, the CBAM would be designed in such a manner that it does not directly depend on the overall level of ambitions of a country nor on the policy choices made by a country. The CBAM would be designed to reduce the risk of carbon leakage resulting from the climate ambition of the EU while taking into account the effects of the policies carried out by our partners across the globe. As most of the CBAM options, considered in the sections bellow, would apply to the actual emissions of imported goods or offer the possibility to be applied to actual emissions of imported goods, this would imply that when a country decides to reduce emissions through a regulatory approach, its goods would be subject to a lesser CBAM obligation when exported to the EU. In addition, in practice the possibility to account for any carbon price effectively paid outside the Union will be taken into account when determining the CBAM obligation. Therefore, policies based on carbon pricing approaches will be taken into account. 2.2How is the problem currently being addressed? The risk of carbon leakage is inherent to any carbon pricing policy carried out in an open economy, unless all countries have the same level of ambition to fight against climate change. This risk has been identified from the beginning of the EU ETS and addressed through two mechanisms, namely the free allocation of ETS allowances to sectors at highest risk of carbon leakage and the possibility for Member States to give state aid to electro-intensive undertakings active in a sector exposed to international trade, compensating the higher electricity costs resulting from the ETS. Both of these mechanisms are described in the impact assessment of the ETS revision. The ETS Directive, however, clearly states that both mechanisms are to be transitional and the Commission is obliged to assess the effects of these measures by revision clauses in the ETS Directive. 2.2.1Free allocation of allowances Free allowances are an effective way to deal with carbon leakage. However, the combination of competition in global supply chains and the provision of free allowances results in a reduced and uncertain carbon price incentive for climate-neutral production processes and for the efficient use and choice of materials in manufacturing and recycling. Furthermore, they result in a situation where carbon emissions embedded in goods placed on the EU market are not priced consistently, but depending on the material and its origin, thus limiting the incentives to reduce emissions. The European Court of Auditors report 18/2020, ‘the EU’s ETS: free allocation of allowances need better targeting’, found that the share of free allowances still represented a very significant part of the total amount of ETS allowances, while the stated objective of the ETS is that auctioning should be the default method for attribution of allowances. In addition, the same report found that free allocation could have a negative effect on the incentive to decarbonise. The ETS revision impact assessment compares the results of the ETS in the power sector, where allocation is mostly auctioned, with the industry sector, where the vast majority of allowances are allocated for free, to note that decarbonisation has progressed faster in the former than in the latter. It should be noted that carbon leakage risks through relocation of production are also addressed in existing carbon pricing mechanisms outside the EU. The instrument of free allowance allocation is used in all major jurisdictions with emission trading systems in place. Besides the EU ETS, the emission trading schemes in California, Quebec, New Zealand and the Republic of Korea allocate parts of their allowances for free at varying methods and shares (between 21 % and 97 %). The same applies to the ETS pilots in China, which also allocate allowances to the covered power plants for free.

All economic literature confirms that free allocation is an effective instrument to address the risk of carbon leakage, however handing allowances for free has a cost both financially and in terms of effectiveness of the ETS. As the EU is raising its climate ambition, both these costs will increase, which will risk to make it more difficult for the EU to reach the set climate targets. 2.2.2Compensation of indirect carbon costs The guidelines on certain State aid measures in the context of the system for greenhouse gas emission allowance trading post 2021 identify the sectors found at risk of carbon leakage due to their indirect emissions, and the Member States which are allowed to provide compensation for indirect carbon costs. Like free allowances, state aids by nature are a regime of exception. This is outlined in the excerpt of the Communication: ‘The primary objective of State aid control in the context of implementation of the EU ETS is to ensure that the positive effects of the aid outweigh its negative effects in terms of distortions of competition in the internal market. State aid must be necessary to achieve the environmental objective of the EU ETS (necessity of the aid) and must be limited to the minimum needed to achieve the environmental protection sought (proportionality of the aid) without creating undue distortions of competition and trade in the internal market.’ It should be noted that only 13 Member States and Norway avail this possibility to grant indirect cost compensation. 2.3What are the problem drivers? There are three interconnected drivers that may induce an increased risk of carbon leakage, namely: the different levels of climate ambitions in the world and the actions in place to achieve them, the increased EU ambitions and the reconsideration of existing carbon leakage protection mechanisms, in particular the gradual decrease of allowances available for free allocation under the EU ETS. When looking at those drivers in the context of the globalised value chain, the risk of carbon leakage becomes even more acute. 2.3.1Different levels of climate achievements in the world At present, international climate action is characterised by different stages of achievements. The Paris Agreement, however, aims to create a coherent dynamic by strengthening the global response to the threat of climate change. Each Party to the Paris Agreement defines its own NDCs to reduce GHG emissions. While NDCs reflect Parties’ ‘highest possible ambition’, they also reflect their ‘common but differentiated responsibilities and respective capabilities in the light of different national circumstances’. This means that the global response to the climate challenge will inevitably differ between the Parties in the short and medium term perspectives. However, this does not mean that these differentiated approaches should be an obstacle to each Party’s achievement of its own objectives. As pricing carbon emissions is a key instrument to reach emission reductions in a cost-effective way, global cooperation aiming at agreements on such mechanisms could serve as a powerful tool in the fight against climate change. Such agreements would also level the global playing field and reduce potential negative effects following from differences in compliance costs across the economies of different Parties. 2.3.2Increased EU climate ambition The EU is increasing its climate ambition consistently with the goal of reaching climate neutrality by 2050, in accordance with its commitment to the Paris Agreement. This is the key climate target set by the European Green Deal. In the process of achieving this target, intermediate goals for 2030 have been proposed to reflect the increased ambition. On 11 December 2020, the European Council raised the EU target for 2030 from 40 % to 55 % compared to 1990 and this new target was communicated to the UNFCCC as the EU’s NDCs under the Paris Agreement. This new target will put the EU on a path to climate neutrality. Higher emissions reduction targets require revisions of existing climate policy instruments to achieve the new objectives. 2.3.3Review of existing carbon leakage protection mechanisms In order to achieve these targets, the EU considers the pricing of GHG emissions as an important instrument of a cost-effective policy package to support the transformation of industries towards climate neutrality. Since 2005, direct GHG emissions of industrial installations and the power sectors are priced in the EU ETS. The risk of carbon leakage has been effectively addressed for those sectors regulated under the EU ETS that are exposed to the risk of carbon leakage. This was done by granting free emissions allowances up to 100 % of determined benchmarks representing the average emissions per unit of the relevant product of the best 10 % producers in the EU. The EU ETS Directive provides for this system to continue at least until 2030. Free allocation of allowances is an effective tool to address the risk of carbon leakage; however, it has two principal drawbacks: first it is a costly measure, second it limits the carbon price signal for industry and hence the incentive to decarbonise. In addition, in the context of the EU’s higher 2030 target and objective to become carbon neutral by 2050, the level of free allowances available will decline further as a function of the overall declining EU ETS cap. Moreover, since the carbon price is passed on in electricity prices and as such on to consumers, possibly becoming an indirect driver of carbon leakage for some energy-intensive sectors, Member States have the possibility to compensate some electro-intensive industries for the increase in electricity prices resulting from the EU ETS, provided they comply with EU state aid rules. 2.4How will the problem evolve? 2.4.1Carbon leakage in view of the evolution of leakage protection in the EU The EU’s leadership in reducing its GHG emissions may result in higher carbon cost differences with its trading partners. This increases the risk of carbon leakage. As discussed in the previous section, the current approach to addressing the risk of carbon leakage relies on free allocation of allowances, and in some cases financial measures to compensate for the carbon cost of indirect emissions to operators of installations from sectors and sub-sectors at a significant risk of carbon leakage. For that purpose, the EU has established a list of such sectors and sub-sectors. This means that there are currently mechanisms in place to address the risk of carbon leakage in these sectors. However, two already ongoing developments may reduce leakage protection. First, as laid out in the intervention logic, the increasingly ambitious GHG emissions reduction targets should reduce the overall number of allowances. This may lead to a higher carbon price in the EU ETS, which in turn creates an even larger difference to countries without carbon pricing mechanisms. Second, the cap on emissions and therefore the total amount of allowances will be reduced to meet new targets under the increased ambition. This means that free allocation will also decline over time and therefore carbon costs should increase for industrial installations, which may lead to an increase in the risk of carbon leakage. Therefore, domestic industries may face higher production costs compared to international producers. In the absence of action, businesses could transfer their production to countries with laxer emission constraints, thus increasing GHG emissions in third countries, or import more as carbon-intensive products of EU firms are being replaced by carbon-intensive imported products from non-EU firms. The effectiveness of the EU’s climate policies could thus be undermined and the ultimate outcome could then be no effect or even an increase in global emissions. The above is also reflected in the views of stakeholders, as recorded in the CBAM public consultation. On the whole, stakeholders participating in the consultation believe that carbon leakage is already a reality and, to some extent, that the CBAM can address carbon leakage, foster consumption of the less-carbon intensive product in the EU and stimulate the deployment of low-carbon technologies and ambitious climate policies in third countries. They have a mixed opinion on the effectiveness of current measures in the context of the EU ETS and state aid rules to limit carbon leakage and on the ability of other regulatory measures (e.g. performance standards for products placed on the EU market) to effectively reduce greenhouse gas emissions. The analysis of the CBAM public consultation results by geographic area indicates that respondents from bordering countries are relatively more convinced that current mitigation measures for carbon leakage in the context of the EU ETS are effective and will also stay effective in the future. By contrast, stakeholders based in other non-EU countries are relatively more sceptical about the current measures to address the risk of carbon leakage and more convinced about the effectiveness of an EU CBAM.

2.4.2Interdependence of the CBAM and the EU ETS revision in the context of problem evolution In the context of the ‘Fit for 55 Package’ the CBAM is not a self-standing measure. It is a support measure aiming at enabling the climate ambition of the EU. Under the assumptions of this impact assessment, the CBAM would be complementary to the EU ETS, with a view to addressing the risk of carbon leakage and reinforcing the EU ETS itself. There is a strong interdependence between the revision of the EU ETS and the possible introduction of a CBAM. Indeed, in case a CBAM is introduced it will have an effect on the share between auctioning and free allocation in the ETS. Since phase 3 of the EU ETS, auctioning is the default approach to allocating allowances and free allocation remains as a transitional derogation aiming at addressing the risk of carbon leakage. Under phase 4, 43 % of allowances are still allocated for free. This illustrates the size of the derogation, which is reflected in the ETS impact assessment quoting the European Court of Auditors report on the ETS, whereby 94 % of the emissions from industry come from sectors considered at risk of carbon leakage. The ETS impact assessment presents approaches to better target free allocation, either to sectors where the risk of carbon leakage is the highest or by reinforcing benchmarks. The CBAM, as an alternative to free allocation, builds on the ETS logic that auctioning is the default ETS approach, starting with sectors where emissions are the highest and therefore where it would matter most. The criteria used in the CBAM impact assessment to select sectors to which the CBAM should apply are aligned to the criteria used to better target free allowances. Notwithstanding the above, the EU has set itself the very ambitious goal of becoming climate neutral by 2050 and of reducing its emissions by 55 % by 2030. This will necessarily have an impact on the availably of free allowances and will require increasing the effectiveness of all instruments aiming at reducing greenhouse gas emissions. It is in this context of a phase-out of the current measures to avoid carbon leakage that the CBAM becomes a necessary tool to mitigate the risk of carbon leakage as long as third countries do not share the same level of ambition, or in other words that they do not have a similar carbon price in place. The question is not whether one measure or the other is more effective to deal with the risk of carbon leakage but whether the CBAM will be an effective tool in a new scenario without the current measures. However, as also stated in the ETS revision impact assessment, the CBAM and options presented in the ETS revision impact assessment are complementary. 3Why should the EU act? 3.1Legal basis The Treaty on the Functioning of the European Union (‘TFEU’) confers to the European institutions the competence to lay down appropriate provisions intended, inter alia, to preserve and protect the environment (Article 192(1) TFEU), including, in particular, measures combating climate change at global level. Appropriate provisions of fiscal nature intended for environmental purposes can be adopted by the EU according to Article 192(2), first paragraph, of the TFEU. Article 113 of the TFEU permits the EU to lay down harmonised rules in order to ensure the proper functioning of the internal market. Depending on the nature of the instrument proposed the legal basis may be Article 192 or Article 113 of the TFEU. 3.2Subsidiarity: Necessity of EU action Reducing GHG emissions is fundamentally a trans-boundary issue that requires effective action at the largest possible scale. The EU as a supranational organisation is well-placed to establish effective climate policy in the EU, like it has done with the EU ETS. There exists already a harmonised carbon price at EU level. This consists of the price resulting from the EU ETS for the sectors covered by the system. These sectors are energy-intensive and subject to international competition. In order to ensure a well-functioning single market when the EU increases its climate ambition, it is essential that a level playing field is created for the relevant sectors in the internal market. The single effective way to do this is by taking action at the level of the EU. Any initiative needs to be implemented in a way that provides importers, regardless of country of origin and port of entry or destination within the EU, with uniform conditions and incentives for carbon emission reductions that are equivalent to those of domestic producers. The only meaningful way to ensure equivalence between the carbon pricing policy applied in the EU’s internal market and the carbon pricing policy applied on imports is to take action at the level of the Union. 3.3Subsidiarity: Added value of EU action In parallel to the EU ETS, reduction of GHG emissions and protection against the risk of carbon leakage in the EU single market can be established most adequately at the EU level. Additionally, the need for minimal administrative costs is best achieved by establishing consistent rules for the entire single market, further underlining the added value of an intervention at the EU level. Moreover, as the CBAM is inherently a border measure there is a clear added value in placing the intervention at EU level in view of the fact that external trade is an exclusive competence of the EU. At the same time, as the CBAM also needs to be implemented consistently in the EU market and in view of its close links to the EU ETS there is further justification of intervention at EU level. The public consultation has confirmed the added value of taking action on the CBAM at EU level. In particular, stakeholders agree that a CBAM is needed due to existing differences of ambition between the EU and the rest of the world and in order to support the global climate efforts. In addition, in view of the EU’s position in international trade, if it introduces a CBAM the environmental effect on international climate ambitions will be most effective as a potential example to follow. Thus, the objective of reducing emissions and climate neutrality requires – without equally ambitious global policies by third countries – action by the European Union. 4Objectives: What is to be achieved? 4.1General objectives

Considering the problems described above, a CBAM has the overarching objective of addressing the risk of carbon leakage in order to fight climate change by reducing GHG emissions in the EU and globally. 4.2Specific objectives The overarching objective of addressing climate change is further articulated in a number of specific objectives, namely: –Addressing the risk of carbon leakage under increased EU ambition, which would ensure that EU climate policies, as translated in the carbon price of the EU ETS, can be fully effective without resulting in increasing emissions abroad, which would undermine climate mitigation efforts. The applied carbon price reflects the polluter-pays-principle and supports the reduction of GHG emissions from industry through the internalisation of external costs from GHG emissions that is achieved by the carbon price; –Contributing to the provision of a stable and secure policy framework for investments in low or zero carbon technologies; –Ensuring that domestic production and imports are subject to similar level of carbon pricing; –Encouraging producers in third countries who export to the EU to adopt low carbon technologies. –Minimising the risk of the measure being circumvented, thus providing environmental integrity; 4.3Ancillary effects The CBAM, as envisaged by the above-mentioned objectives, may also give rise to a number of secondary and ancillary positive effects. These refer to the relevance of the CBAM as a climate tool to push third countries to adopt more stringent climate measures, as well as to the possibility to obtain revenues from the introduction of the measure. Specifically the ancillary positive effects of the CBAM include: –Strengthening the joint climate action needed by all the Parties of the Paris Agreement to meet the goal of holding the increase in the global average temperature to well below 2 °C above pre-industrial levels and pursuing efforts to limit the temperature increase to 1.5 °C above pre-industrial levels; –While not introduced with revenue raising as its purpose and it not playing a role in the design of the measure, the CBAM will raise revenue on GHG emissions at the border. This is acknowledged in the Interinstitutional agreement including the CBAM in the list of future own resources in the context of NextGenerationEU . The introduction of a CBAM would also incentivise key trading partners to consider the revenue generation dimension of carbon pricing policies. 5What are the available policy options? 5.1What is the baseline from which options are assessed? The basis against which the different CBAM options are analysed in this impact assessment reflects the dynamic framework against which the CBAM is proposed. In particular, it aims at capturing the fact that the measure is put forward in the context of existing climate legislation that implements the ‘at least 40 % GHG emission reduction target’ by 2030, but also against the new agreed upon EU target of reducing GHG emissions by at least 55 %, and an evolving policy framework to implement the latter, which at the time of preparing this impact assessment is under consideration within the ‘Fit for 55 Package’. Calibrating the analysis and modelling of the CBAM, to account for the above considerations necessitates a stepwise approach. This first involves setting the foundations based on the current policy framework, and second an additional counterfactual based on the new agreed climate targets for 2030 - the latter balanced to account for policies that are under an ongoing assessment and which will, in turn, have an impact on the specific objective of the CBAM, namely to address the risk of carbon leakage. The first step therefore involves setting the baseline of this assessment consistently with all other exercises under the ‘Fit for 55 Package’. This consists of the EU Reference Scenario 2020 (‘REF’), the main elements of which are depicted in Annex of the impact assessment for the revision of EU ETS Directive. The baseline as reflected in the REF assumes the continuation of free allocation of allowances to operators of installations from sectors and sub-sectors at a significant risk of carbon leakage. At the same time, the baseline includes current climate and energy legislation that implements the ‘at least 40 % GHG emission reduction target’, notably the revised EU ETS Directive which regulates GHG emissions mainly from the power and industry sectors plus aviation, the Effort Sharing Regulation that sets national targets for emissions outside of the EU ETS and the Regulation on the inclusion of GHG emissions and removals from land use, land use change and forestry (‘LULUCF’). With regard energy, the baseline includes the Energy Efficiency Directive and the Renewable Energy Directive, as well as other key policies covered in the Energy Union and the ‘Clean Energy for All Europeans’ package, including the internal electricity market policy. The second step involves a counterfactual to account for the raising of EU ambition and thereby the motivation for the CBAM itself. Under this counterfactual, emission allowances under the EU ETS will be reduced in the coming years, to achieve an overall reduction of at least 55 % by 2030 and beyond, so as to ensure a balanced pathway to reaching climate neutrality by 2050. In the modelling, this result is achieved, until 2030, through a mix of measures consisting of both an expansion in carbon pricing, be it via EU ETS or other instruments, to the transport and buildings sectors and a moderate ambition in regulatory-based measures including energy efficiency, renewables and transport policies. For the purposes of modelling the impacts of alternative CBAM options, this counterfactual is based on the MIX scenario as depicted in the impact assessment for the revision of EU ETS Directive. Under the MIX scenario the free allowances to industry at risk of carbon leakage continues as the main instrument to address this risk. As such, free allowances are assumed to cover 100 % of emissions at benchmark level of the industries in question. In modelling terms, this results in the MIX scenario keeping carbon leakage at a relatively low level. In view of this, the third step of the analysis involves a variant to the counterfactual, which allows for the disentangling of impacts. Specifically a variant of the MIX is also modelled depicting the case of complete removal of free allowances in the CBAM sectors, in the absence of a CBAM.

This full auctioning variant of the MIX serves as an additional reference point to compare different leakage protection options under the CBAM. The motivation of this derives from the fact that under the European Green Deal free allocation in the CBAM sectors and a CBAM at the border are clear alternatives. The impact assessment of the EU ETS extension does not include any scenario in which free allocation is phased-out by 2030. Therefore, it would not be possible to assess with fairness any of the CBAM options if the case of full auctioning in the absence of a CBAM was not also presented for comparative purposes. 5.2Description of the policy options 5.2.1Design elements common to all options This sub-section outlines certain design elements which are common to all of the policy options and are applied in a similar manner across the options. In identifying the options, account has been taken of WTO requirements and of the EU’s international commitments such as free trade agreements concluded by the EU or the Energy Community Treaty. It should also be noted that a number of notions are used in the analysis below which call for specified definitions which can be found in Annex 5. 5.2.1.1Scope of emissions The emissions to be covered by the CBAM should correspond to those covered by the EU ETS Directive, namely carbon dioxide (CO2) as well as, where relevant, nitrous oxide (N2O) and perfluorocarbons (PFCs). Regarding the scope of those emissions, different possibilities can be envisaged: –Direct emissions are emissions taking place as part of a production process on which the producer has direct control. These include emissions from heating and cooling. –Indirect emissions refer to emissions from the production of electricity which is consumed in a certain production process. –Full carbon footprint (often termed a ‘cradle to grave’ approach) includes all GHG emissions relating to the mining of raw materials, all emissions from the production of materials and components needed for manufacture of the product, the emissions caused by the production process, including emissions from providing the necessary energy, emissions from the transport of raw materials and interim products to the site of the production process and of the product to the consumer, emissions caused during the use phase and emissions related to the disposal / end-of-life phase of the product. As an instrument to prevent carbon leakage, the CBAM seeks to ensure that imported products are subject to a carbon price equivalent to the one they would have paid under the EU ETS, had they been produced in the EU. In the EU, the EU ETS applies to the direct emissions of installations where carbon intensive products are produced. The EU ETS also applies to the production of electricity that may be used in the production process. Conversely, the EU ETS does not apply to mining activities in the EU, neither does it, for now, directly apply to transport in the EU other than air transport. While the EU ETS may apply to certain activities related to the disposal and recycling of products, this is not related to whether these products are produced in the EU or imported. Therefore, the most appropriate scope when the CBAM is applied in the EU is to include direct emissions from the production of basic materials and basic material products up to the time of import, as well as related indirect emissions when they are significant. A threshold will have to be defined to determine when indirect emissions constitute an important part of an imported product’s embedded emissions in order to limit the administrative burden. This is the approach that will be followed in most CBAM options. In the longer term, when the material scope of the CBAM would be extended, as more information will be easily available on the carbon content of products and as carbon pricing policies of different countries may become more easily comparable, an extension of the carbon emission scope to cover the full carbon footprint of imported products may be considered. Such a possible future extension would also be of relevance to transport emissions as the EU ETS may be extended to transport. Indeed, emissions resulting from transport may be significant for imported goods and are certainly a relevant issue in the fight against climate change. However, as long as emissions from transport are not included in the scope of the EU ETS, it would be complicated to include them in the scope of the CBAM. As the ETS revision impact assessment foresees such extension, there is a case for including transport emissions in the CBAM. This could be done when the CBAM will be revised. Respondents to the Open Public Consultation somewhat agree that the CBAM should cover direct emissions and indirect emissions from electricity used in the production process, emissions recorded in all links of the value chains and emissions from international transport of goods. Conversely, they somewhat disagree that the CBAM should differentiate the treatment of imports of finished products, intermediate products and primary inputs. 5.2.1.2Measuring the carbon content The carbon content of products is an essential element of the CBAM as it indicates the GHG emissions released during the production of the materials produced abroad. This is used to ensure that imported products are treated no less favourably than domestic products produced in EU ETS installations. The carbon content of products will be multiplied by the reference carbon price for determining the obligation to be paid under the CBAM. Carbon content does not refer to carbon physically contained in a product in any chemical state, but rather to the GHG emissions released during the production of the material or product subject to the CBAM, or indirectly during the production of electricity used in the process. A carbon content is usually expressed with respect to the corresponding scope of emissions, products and sectors. As installations covered by the EU ETS are subject to a carbon price assessed on their actual emissions, imported products in the scope of CBAM may also be assessed based on their actual GHG emissions. Such an approach offers advantages relating to a fair and equal treatment and would also serve well to give incentives to foreign producers to develop low-carbon production. Furthermore, requesting to document the carbon content of all imports could serve well to fulfil the aim to closely mimic the functioning of the EU ETS. It may, however, also entail a significant administrative burden for importers. To limit this, a default value representing the emissions of imported products may be established with the possibility for the importer to demonstrate that its products were produced with actual emissions lower than the default value, and therefore be subject to a lower adjustment. Both approaches will be explored in this impact assessment. For options where imported products in the scope of the CBAM are to be assessed based on actual GHG emissions, there would still be a need to set objectively determined default values to be used in situations when sufficient data to determine the actual GHG emissions are not available. This could be the case when importers cannot provide actual emission data or when the CBAM monitoring and verification of those given are not considered to fulfil laid down criteria. For options where the default value is predominantly used, the level of this default value for each covered sector/product will have to be set taking into account the level of emissions attributable to a given sector in the EU, comparing it to the emissions of this sector outside of the EU. In addition, the higher the default value will be set, the more claims for individual treatment there may be, generating an additional administrative burden. This latter element also needs to be taken into account in setting the level of the default values. The level of the default values may be defined as dynamic values, for example taking the EU average or median per sector as a reference. Alternatively, it could be a fixed value subject to revision after a defined number of years. Both default values and actual emissions must be calculated on the basis of robust Monitoring, Reporting and Verification (MRV) procedures. These can be based on major elements of existing EU ETS mechanisms such as the Monitoring and Reporting Regulation, Free Allocation Rules Regulation and Allocation Level Change Regulation of the EU ETS, and complemented by further data requirements.

The reference flow/declared unit for the calculation of the carbon content should be the unit of weight (e.g., tonne CO2eq/tonne material), specific per production site. Once the digital product passport announced in the Circular economy action plan will have become operational, the information could be specific to the produced consignment. In the meantime, it could be acceptable to declare the yearly average carbon content. It may be necessary to develop sectoral rules (for the sectors in the scope of the CBAM) detailing how to calculate both direct and indirect emissions. These rules could be developed following the approach already used for PEF Category Rules and international standards on carbon footprint, focusing on the production steps in scope. For direct emissions, the calculation should follow the principles of the EU ETS calculation rules. For indirect emissions (related to electricity use), the approach may build on PEF rules. The existing rules cover both the use of electricity from the grid and from specific producers, as well as the production of own electricity (including through Guarantees of Origin certificates). The sectoral rules would also include the verification procedure to be followed. The above considerations highlight the underlying compromises inherent in the design of the CBAM. Determining the CBAM obligation based on actual GHG emissions could more closely reflect the functioning of the EU ETS, but would involve higher administrative costs. Methods need to be developed and communicated to traders, while the costs associated with the management of the system are higher. In addition, verifiers in third countries may be limited in number in the short term and this could create bottlenecks for the verification of emission in these countries, which would have consequences on the functioning of the system. Default values would allow for determining the CBAM debt based on the volume of product imported according to an average of emissions in the EU. Considering that the average carbon intensity outside the EU is higher, most importers would accept these estimations, which would reduce costs upon them but also upon the EU. In any case, importers would still have the possibility to claim that the emissions embedded in their products are below the default value, however the burden to prove it could be placed on them. 5.2.1.3Sectors The specification of the CBAM’s sectoral scope will be central to its effective implementation. The methodological approach to the specification of this sectoral coverage should not differ between the different options considered. In this respect, the measure may be understood as sector-neutral in its design – allowing for its potential extension to further sectors and products in the future. However, as discussed later, it is also recognised that some of the design options would allow the measure to move further down the value chain. Reaching further downstream of the supply chain may help mitigating certain weaknesses of some CBAM options, such as the risk of substitution of domestic products by imports downstream of the supply chain. In the modelling exercise, variants of the main options considered allow for exploring this effect. The focus of the measure is on basic materials and basic material products. The choice of the CBAM’s coverage is framed by the sectors and emissions covered by the EU ETS. This is dictated by the motivation behind the measure, namely to ensure that imports of energy intensive products into the EU are on equal footing with EU products in terms of EU ETS carbon pricing, and to mitigate risks of carbon leakage. In this regard, it makes sense to ensure a coherent administrative approach with EU ETS sectors, as the EU ETS price is fully harmonised at EU level and also covers emission-intensive activities competing globally. Furthermore, narrowing the scope to a first shortlist of aggregated sectors relies on three additional criteria. The first is relevance in terms of emissions, namely whether the sector is one of the largest aggregate emitters of GHG emissions; the second is the sector’s exposure to a significant risk of carbon leakage, as defined pursuant to the EU ETS Directive; and the third is balancing broad coverage in terms of GHG emissions while limiting complexity and administrative effort. This results in the 12 aggregated sectors illustrated in Figure 3 . As can be seen, a few sectors are responsible for the majority of the emissions. Source: Commission Analysis

Sectoral emissions as share of the EU ETS industry sectors emissions. Comprehensiveness in the CBAM’s scope has to be further balanced with the technical feasibility and the actual enforceability of the system. As discussed in more detail in Annex 7, when an imported material or product becomes subject to the CBAM, it will be necessary that the authority in charge can identify the product imported, check whether it is to be covered by the measure, and then determine the relevant amount of embedded emissions which are to be covered by CBAM certificates or an excise duty. Two key dimensions are critical in this respect. The first dimension relates to the need to unambiguously identify and distinguish materials or products, and not sectors per se, that will be covered by the measure. By way of example, we could note pig iron or ‘iron and steel primary forms’ as opposed to the iron and steel sector, or for the case of cement, clinker as opposed to the cement sector. This needs to be defined to a sufficient degree in order to allow for easily determining the amount of emissions that should be subject to the CBAM when goods enter in the EU. The second dimension relates to whether materials or products can be sufficiently identified in practice to make the CBAM enforceable. This means that for the effective application of the CBAM, it will be critical that a product or material is unambiguously linkable to its definition and that sufficient information is available to determine its reference values of embedded emissions. For example, ‘clinker’ under the cement could be linked to the EU ETS benchmark of grey cement clinker and, based on good availability of data, allow for the calculation of embedded emissions based on clinker. These benchmarks could then be linked to specific imported products determined at Combined Nomenclature (CN) codes level such as cement clinkers (2523 10 00) and Portland cement (2523 29 00), cement, whether or not coloured (2523 90 00). Once products or materials are defined and it is ensured that they can be identified, the next critical step involves the ability to define reference levels for the embedded emissions of materials and products. The feasibility to define reference values for the embedded emissions is indeed the decisive argument for a product or material’s inclusion in the CBAM. Without such reference values it is impossible to calculate the CBAM obligation to be paid upon import. Some high-emission industrial processes such as those of refineries produce several products simultaneously. For such processes, in order to define reference values that may be used for output products, a decision would first have to be made on how to attribute the emissions of the industrial process to the different output products. For this reason these products are not considered for the first stage of the CBAM. These considerations and key steps in assessing the feasibility of different sectors are discussed in greater detail in Annex 7. On the basis of this, a possible initial shortlist of materials and material products scope of the CBAM is presented below. Based on the criteria set out above, in particular their carbon intensity, their trade intensity and the availability of necessary reference data to apply a CBAM, the list includes specified basic materials of the sectors of cement, iron & steel, aluminium and fertilisers. As noted earlier, in the future and conditional on whether data requirements for determining embedded emissions can be satisfied, further products in these sectors as well as other sectors at risk of carbon leakage could be covered by the measure. In addition, electricity generation may also be a relevant sector to include in our analysis, although for different reasons. Electricity generation is the most important sector included in the EU ETS in terms of direct carbon emissions, and is also the largest sector responsible for carbon emissions in the wider economy. Additionally, electricity generators in principle do not receive free allowances, but have to buy them via auctions or on the secondary market. This distinguishes them from other EU ETS participants whose exposure to the risks of carbon leakage are currently mitigated with the allocation of free allowances. Finally, the infrastructure to exchange electricity with partner countries outside of the EU has been expanding over the past years, and this trend is expected to continue. Due to these physical characteristics and organisational aspects of the electricity market, the approach to electricity generation and trade differs from the approach proposed for material products. More details on this approach are given in Annex 8.



Sector Materials or material products Cement Clinker Portland cement Iron & Steel Iron & steel primary forms Hot rolled & further steps Coated hot rolled & further steps Forged, extruded and wire Aluminium Aluminium unwrought Aluminium unwrought alloyed Aluminium products Alloyed aluminium products Fertilisers Ammonia Urea Nitric acid AN (Ammonium Nitrate) Electricity generation Electricity Source: Commission Analysis Figure 4 indicates the volume of imports and exports into and from the EU in the sectors identified as potentially falling under the initial shortlist ( Table 1 above). It can be seen that in terms of the volume of imports iron & steel is the leading sector, followed by fertilisers, cement and aluminium.

Source: Commission analysis based on data from Eurostat COMEXT Regarding the scope of the CBAM, respondents to the Open Public Consultation somewhat agreed that the mechanism should focus on products from activities already included in the EU ETS (especially those with the highest risk of carbon leakage), and account for the entire value chain. In terms of sectoral coverage, five sectors are selected more than 50 times by the 609 consultation respondents (each respondent was allowed to select up to 10 sectors), i.e. i) electric power generation, transmission and distribution; ii) manufacture of cement, lime and plaster; iii) manufacture of iron and steel and of ferro-alloys; iv) manufacture of basic chemicals, fertilisers and nitrogen compounds, plastics and synthetic rubber; and v) extraction of crude petroleum. 5.2.1.4Future-proofing design of the CBAM The CBAM will need to be fit for the future and its design should be flexible in order to meet any new targets beyond 2030 and address the rapidly changing reality of global climate politics. As indicated earlier, among measures deployed by the EU to achieve its ambition of carbon neutrality, there needs to be a consistent carbon price to incentivise low-carbon production processes, material efficiency and substitution, as well as enhanced recycling. To that end, and while different reform options are considered for the EU ETS, a CBAM should provide protection against carbon leakage risks. It is expected that the EU ETS price will rise until 2030 and beyond, and the need for carbon leakage protection will therefore continue. CBAM and possibly other measure will be necessary, their scope may need to be extended and the mechanism reinforced. As highlighted in section 5.2.1.3, in a first phase, the mechanism could apply to a limited number of sectors. A second phase could apply the CBAM to materials further down the carbon leakage list based on the intensity of their carbon leakage indicator. This gradual approach could then cover the entire list of sectors subject to carbon leakage. Additionally, downstream products in the EU may also be or become at risk of carbon leakage. For example, if the mechanism covers basic materials and basic material products, then downstream domestic producers whose products are not included in the scope (e.g. manufacturers of components and final products) would face higher input costs irrespective of whether they source their (covered) material inputs domestically or from abroad. If climate ambitions diverge, carbon leakage may move down the supply chain, as final consumers may decide to source their purchase from abroad. To avoid this risk of carbon leakage further down the value chain, a broad product coverage is being considered in the design of the mechanism, which could foresee an extension to downstream sectors. Some of the options considered envisage including downstream sectors in the scope of the CBAM from the beginning. In the options where it is not the case, extension to downstream sectors should be considered at a later stage as the use of international standards on defining carbon footprint will pick up and data will become more easily available for all sorts of products. Extending the CBAM to downstream products faces the challenge of the complexity of value chains and the varying possibilities on the transformation of the product in later stages. Certain CBAM imports such as fertilisers and electricity may reach directly the final consumer with limited transformation or added value. However, for other CBAM materials such as steel and aluminium, as more manufacturing steps included downstream and the final product becomes more complex, the content of the basic material in it becomes diluted. It thus becomes difficult to monitor and verify, as well as easier to circumvent through minor transformation. At the same time, the value added of the basic material in the value of the imported product is also critical, as it would determine the importance of transferring of carbon pricing downstream. Addressing these challenge would raise two key considerations in practice. The first relates to the number of production steps involved in the manufacturing of each product that uses the CBAM basic material downstream. This would involve intermediate products, which use more than one material or product but require more complex manufacturing steps, and final products, which are made of components and further materials and is ready for sales to end consumers. Tracing the CBAM basic material downstream of these products would involve an analysis of the value chains to determine a reasonable limit for the reach of the measure. The second consideration relates to the value of carbon relative to value generation downstream. At lower CO2 prices during initial phases, this may be negligible. However, at higher carbon prices in the future, more complex products down the value chain may become relevant for the CBAM. 5.2.1.5Reference carbon price All options refer to a carbon price so as to align, to the extent possible, the price paid under the CBAM with the price paid under the EU ETS. Under different policy options, the actual reference carbon price may differ depending on the administrative feasibility and specific design of each option. However, it should be noted that the starting point would be the price of allowances in the EU ETS. This reference carbon price may be: –The average EU ETS allowance auctioning price over a given period (previous year, quarter, month or week). –The daily allowance price based on the previous day auctioning price of the EU ETS. 5.2.1.6 Taking into account carbon pricing in third countries In an ideal world, all countries would put in place the measures necessary to phase out fossil fuels in a fair and effective manner. While the Paris Agreement sets a shared goal of limiting global emissions in order to avoid a dangerous rise in global average temperature, each Party sets its own nationally determined contribution to limit its greenhouse gas emissions, reflecting its highest possible ambition. The EU has set ambitious targets in line with preventing dangerous climate change, and among other measures has put in place a carbon pricing system, through the EU ETS, to achieve its targets in as cost effective manner as possible. However, in order to achieve its targets, the EU must also ensure that its efforts at home do not lead to emissions increases elsewhere through the risk of carbon leakage. A CBAM that ensures that covered imported products bear a comparable carbon price to domestically produced products will help manage that risk. The CBAM as proposed would use the EU ETS price as the default value for comparing and adjusting prices at the border. Importers would have the opportunity to claim that the prevailing explicit carbon price in the country of production have addressed the risk of carbon leakage, and hence that their CBAM obligation should be reduced by this amount. The CBAM should favour global cooperation in fighting climate change, and it should avoid situations of double carbon pricing by subjecting goods which have already paid a carbon price outside the EU based on GHG emissions in third countries to the CBAM. Therefore, the CBAM should be designed in such way that it takes into account climate policies in the form of explicit carbon pricing policies in our trading partner countries. While we recognise that reduction of GHG emissions by countries all over the globe is pursued through regulations other than carbon pricing, due to the conceptual difficulties in determining the equivalence between carbon pricing and non-price regulatory measures, and the fact that, like the EU, most countries will have both pricing and non-pricing approaches to reducing carbon emissions, the CBAM only focuses on carbon pricing. In practice, this means through a cost under an emission trading scheme or by a carbon tax, in both cases covering emissions having occurred during the production of imported materials. A carbon tax can be designed to tax the carbon content of fuels used or be more targeted at actual emissions occurring from the combustion of such fuels. In either case, the tax amount paid does not relate to the produced material being exported to the EU, and the tax would normally not be reimbursed upon export to the EU of the produced material (being for example steel).

Taking into account the carbon price paid abroad can be done either at country level or at transaction level for each individual consignment of imported materials. At country level, exemptions from having the CBAM applying to imports from such countries could be granted to countries who have in place a carbon pricing system that imposes a carbon price at least equivalent to the price resulting from the EU ETS on products subject to the CBAM. In practice, and in view of current carbon pricing policies around the world, such an approach may be considered for countries with an ETS linked to the EU ETS (e.g. Switzerland). At transaction level, the CBAM should allow importers to claim that they have paid a carbon price abroad on the GHG emissions embedded in the production of the goods they import. This carbon price effectively paid abroad should be deducted from the amount they would have to pay under CBAM. It should be noted that the different CBAM options – outlined in section 6 below – will entail different obligations with regards to third countries pricing measures. Regulation-based options (‘Import certificates’) will require taking into account such measures, while indirect taxation options (‘Excise Duty’) will not. 5.2.1.7The CBAM applied to imports and free allowances in the EU ETS The CBAM and free allowances are two mechanism that serve a similar purpose, preventing the risk of carbon leakage. The two mechanisms cannot offer ‘double protection’ and should not coexist in the long run as this would diminish the environmental objectives of both EU ETS and the CBAM. In the options considered, either the CBAM replaces free allowances at once or the CBAM is phased in as free allowances are phased out during a limited transition period. For sectors not covered by the CBAM, protection against carbon leakage would remain under the EU ETS framework. For sectors covered by the CBAM, protection against carbon leakage would come from the CBAM. 5.2.1.8Reconciliation procedure As indicated under section 5.2.1.2 ‘Measuring the carbon content’, imported products in the scope of the CBAM could either be assessed based on their actual GHG emissions or by using a default value representing the emissions of the imported products. In the case of setting default values, importers will be given the option to claim that the emissions resulting from the production of their imports are below the default value by providing verifiable data as to their actual emissions. Furthermore, even in an option where imported products are assessed based on actual GHG emissions, there would still be a need to set objective default values to be used in situations where sufficient data to determine the actual GHG emissions is not available. Claims that actual GHG emissions are below the default value may, depending on the actual administrative design chosen for the CBAM, be treated either when goods are imported for each individual shipment or through an annual reconciliation procedure inspired by the procedure in place in the context of the EU ETS. 5.2.1.9Elements related to administrative design There are essentially two main options in the institutional design necessary to support the implementation and management of the CBAM. The first rests on a centralised system and consists of a CBAM authority at EU level. This could rely on an existing agency or a Commission service. The second is a decentralised system resting on Member States’ national authorities, which could be the national climate authorities or any authority specifically appointed for this task. Overall, both approaches have their respective merits and drawbacks. A decentralised approach could facilitate faster implementation, as it would not require the establishment of new institutional structures. It would rest and build upon the competencies and tasks of the Member States’ existing national climate authorities. However, it may entail a long lead time to a fully harmonised implementation of the rules. Depending on the functions foreseen for the registration of traders and foreign industrial installations, the assessment and verification of declarations of actual emissions and the collection of the CBAM obligation, coordination across 27 different national authorities could be difficult to manage. Moreover, a decentralised approach could face difficulties in view of the rigidity of the national systems and respective IT infrastructure needs. Potential changes and fine-tuning would require changes across Member States which could increase costs both at national and central levels. A centralised approach would be based on a Central Administrative CBAM Body. Such an approach may reduce coordination burdens and have the merits of one unique approach, which could facilitate the operation of the mechanism. It may also downsize the necessary information flows, thus potentially simplifying system requirements. However, such an authority does not exist at this moment and would need to be hosted by an existing agency or a Commission service. A central authority at EU level would also need to meet a number of specifications, which would affect the pace for this establishment. In view of the above, the envisaged institutional architecture for the CBAM would have important implications as regards the costs of its operation. Commission research estimates that the CBAM would in its first phase concern 1 000 traders realising 239 000 import transactions on an annual basis from 510 production sites outside the EU. While this represents a large number of transactions, the estimate also indicates that they are undertaken by a fairly a limited number of traders and concern a limited number of sites. To obtain a rough estimate of the potential staffing needs to operate the CBAM at EU level, we consider three core functional areas that will need to be supported. Depending on the level of centralisation these could be carried out either by a Central CBAM Authority or shared with the Member States’ national authorities. In the latter case, estimates of staffing needs would depend on the capacities of the national authorities, and thereby their ability to cover the necessary administrative requirements arising from the CBAM with current staff - or if additional positions would be needed. The first functional area relates to the core function of reviewing, assessing and approving declarations presented by traders, including issuing requests for supplementary information and clarification. Assuming a maximum of 10 working days for the handling of each, this would require 50 full time equivalent positions. The second functional area relates to the handling of complains submitted by traders. Assuming that around one third of declarations could be subject to litigation and a maximum of 5 working days would be needed for the handling of each, this would require an additional 7.5 full time equivalent positions. For these two functional areas, the impact of a centralised versus a decentralised approach can vary. In the case of a decentralised approach, the estimated 57.5 full time equivalent positions may not be equally distributed across Member States. Given the location of traders, certain Member States may face higher administrative costs relative to this function. In addition, a decentralised approach may possibly require a slightly higher aggregated number of full time equivalent positions, due to forgone possibilities of economies of scale. The third functional area relates to the maintenance of the IT system, including the keeping and updating of registries and handling of CBAM obligations (selling and buy back of certificates). It is estimated that this would require an additional 18 full time equivalent positions if the management system was fully centralised. In case of a decentralised approach, the selling and buying of certificates would need to be carried out by national authorities, which would imply a higher number of full time equivalent positions in aggregate for this functional area, with only a portion retained centrally to support the management of the central IT system. The above considerations would imply a requirement of 75 staff on a full time basis to implement the CBAM according to the centralised approach. This number would be higher in aggregate under a decentralised approach, yet this would depend on the current human resource capacities within the national authorities that would be tasked with handling the CBAM. 5.2.1.10Resource shuffling Resource shuffling refers to the allocation or attribution of less emissions-intensive materials production (including materials embedded in manufactured goods) towards markets with higher carbon costs, while the overall carbon intensity of production in the home market remains constant. There exist three main mechanisms through which resource shuffling can take place:

-Attribution of low-carbon input factors (low-carbon electricity, low-carbon heat, biomass) to imported materials. -Attribution of GHG emissions of a production process to co-products (e.g. slag, heat, flue-gases) to improve the reported carbon intensity of basic material production (unless strict MRV rules would limit such approaches). -Attribution of shares of recycled material to imported or exported goods. Incentives for resource shuffling exist for any emissions-related policy that includes traded goods (e.g. CBAM or product standards) where the carbon intensity of imported or exported products does not rely on default values only, but on actual emissions. For a CBAM, non-EU producers have an incentive to re-route carbon-intensive products to other markets in the world economy to avoid the levy imposed by the border measure. On the other hand, exporting low-carbon products to the EU would imply lowering the carbon costs these importers face and therefore undermine the carbon leakage protection which the CBAM provides, without leading to a decrease of global emissions. Resource shuffling has emerged as an important problem in the Californian CBAM on electricity. In addition, recent academic literature focusing on the EU approximates the scale of potential risk from resource shuffling from a CBAM at around 50 % for steel and 80 % for aluminium - the latter driven by the higher opportunities to source or attribute the production of aluminium to clean electricity. Notwithstanding the above, it should be noted that importers are perfectly entitled to direct lower-carbon products to the EU. That being said, and while resource shuffling of this scale would improve the EU’s carbon footprint, it could result in higher carbon leakage, thereby undermining the effectiveness of the CBAM. At the same time, the negative implications of resource shuffling should also be balanced with the fact that third countries have to make an effort to produce low carbon-intensive products for the EU market and this will be positive from a climate perspective. As a matter of fact, beyond mere resource shuffling, third countries will have to invest in clean technologies if they want to export less polluting goods to the EU, which could result in less overall emissions and in internal synergies that will make it less expensive to shift to less polluting production for all markets. This positive effect will be larger and trigger changes more quickly the more relevant the EU market is for the total exports from that particular country. 5.2.1.11The CBAM for Least Developed Countries (LDCs) LDCs currently account for a minimal share of EU-external trade in the commodities that could be covered by a CBAM. Yet, it should be recognised that exports to the EU from LDCs can provide important foreign exchange earnings for these countries and represent a significant share of their GNI. Many countries in the Global South, and on the African continent in particular, are exposed to possible risks (see more detailed data in Annex 3). While preferential treatment for LDCs is an established procedure in other areas of trade policy, it raises questions in the case of a CBAM. For example, blanket exemptions from a CBAM should be avoided, as setting up a mechanism that will encourage LDCs to increase their level of emission and run counter to the overarching objective of the CBAM. In addition, these exemptions would be temporary in nature, and would therefore prove counterproductive for LDCs in the long run: the carbon intensive industry would have to be dismantled, and if exempted now, adaptation costs for LDCs would be higher. To sum up, neither the EU nor the trading partners would have an interest in fostering the growth of carbon-intensive, industries in these countries. To avoid new global dividing lines between countries with a low and high-carbon export structure, recent analyses have highlighted the need for targeted ways to support LDCs. These could take the form of technical assistance, technology transfer, extensive capacity building and financial support, with the objective to develop industrial production structures that are compatible with long-term climate objectives. This assistance could be carried out through existing support channels (e.g. bilaterally and multilaterally, including through the mechanisms established under the UNFCCC). In the absence of such compensating mechanisms, LDCs could argue that the introduction of a CBAM will be a disproportionate burden for them and that they conflict with the UNFCCC principle of common but differentiated responsibilities and respective capabilities, in light of different national circumstances. Finally, to ease the transition, a gradual phasing in of the CBAM could be considered for existing production capacities in LDCs. 5.2.2Option 1: Import Carbon Tax on basic materials based on EU average Depth of value chain: Basic materials and basic material products Coverage of CBAM: Imports only Free allocation in the EU ETS: No (full auctioning of allowances for the CBAM sectors) Type of payment: Domestic producers buy EU ETS allowances; importers pay a tax Reflection of actual emissions in carbon pricing: Yes for domestic production; importers pay based on a default value reflecting EU average but may opt to demonstrate actual carbon intensity of imported products The first option for a CBAM is an import carbon tax, paid by the importer when products enter the EU. Practically, the tax would be collected by customs at the border and based on a tax reflecting the price of carbon in the EU combined with a default carbon intensity of the products. An annual average price could be favoured over e.g. daily adjusted prices, as this would provide for a simpler implementation and higher predictability for importers. For simplicity considerations, the reference value for carbon intensity would be a default value based on EU producers’ averages. However, importers will have the opportunity to claim for individual treatment, which would be administered by a reconciliation exercise and could result in a deduction or refund of a proportion of the amount of tax to be paid. This involves the importer providing proof for any carbon price paid abroad and/or actual performance from carbon efficient technologies. Information will be subject to monitoring and verification procedures to assess whether a partial or full reimbursement of the tax should be granted. Under option 1, a credible enforcement mechanism must be established. This would involve an existing entity with its seat in the EU, for instance an existing Agency or the Commission, to be vested with additional powers for compliance with the CBAM. In practice, the enforcement mechanism would require that for every import that falls within the scope of the CBAM, the importer nominates in the customs declaration a ‘CBAM importer’ (being in a similar situation as the installation operator in the EU ETS) with a business address in the EU, who would be responsible for paying the CBAM tax obligation and engaging in the reconciliation procedure. This option assumes that the CBAM would be limited to specific imported carbon-intensive materials and basic material products. In an initial phase, in order to keep the measure simple and manageable, semi-finished and finished products would not be covered, with regard to neither the emissions from their production, nor the fact that they contain carbon-intensive materials. Option 1 reflects a scenario with full auctioning of emission allowances for the concerned sectors under the ETS. The free allocation of allowances contained in the current EU ETS would thus not be retained for the selected sectors. Under Option 1, the leakage protection currently resulting from free allocation of EU ETS allowances would therefore have to come from the CBAM. 5.2.3Option 2: Import certificates for basic materials based on EU average Depth of value chain: Basic materials and basic material products Coverage of CBAM: Imports only Free allocation in the EU ETS: No (full auctioning of allowances for the CBAM sectors) Type of payment: Domestic producers buy EU ETS allowances; importers buy import certificates (CBAM certificates) Reflection of actual emissions in carbon pricing: Yes for domestic production; importers pay based on a default value reflecting EU average emissions or may opt to demonstrate actual carbon intensity of imported products

The second option involves the application on imports of a system that replicates the EU ETS regime applicable to domestic production. This option entails – similarly to the system of allowances under the EU ETS – the surrendering of certificates (‘CBAM certificates’) by importers, based on the embedded emission intensity of the products they import in the EU and purchased at a price corresponding to that of the EU ETS allowances at any given point in time. These certificates will not be linked to the EU ETS system of allowances but will mirror the price of these allowances to ensure a coherent approach to the pricing under the EU ETS. There are a number of reasons not to use EU ETS allowances in the CBAM, all relating to the possible impact on the ETS, in terms of the functioning but also of the underlying logic. The ETS is a cap and trade system where the cap represents a total amount of greenhouse gas emissions for a given year. In line with the principle of the Kyoto protocol on accounting emissions of its parties, the cap is linked to the emissions taking place as a result of releasing greenhouse gases on the territory of the EU exclusively. Using ETS allowances to account for emissions taking place outside of the EU’s territory would bring a significant number of new actors on the ETS market at the same time, as it would require revising the logic used to set the ETS cap. In general, it is preferable to carry out extensions of the ETS scope in a prudent manner involving specific pools of allowances, as it was the case for aviation and as it may be the case for buildings and transport. Finally, as the ETS sets a maximum to the emissions taking place in the EU, using its allowance for imports could result in quantitative restrictions on imports that would raise WTO concerns. In other words, the CBAM cannot introduce a cap on emissions outside the EU, in order to avoid restricting international trade. Importers will submit declarations of verified embedded emissions in the imported products and surrender a number of CBAM certificates corresponding to the declared emissions to a CBAM authority. Depending on the level of centralisation, this authority could be either the central CBAM authority or the national authorities tasked with managing the CBAM. Such declaration and surrendering will occur – similar to that under the EU ETS – at a yearly reconciliation exercise taking place in the year following the year of importation and based on yearly trade import volumes. The carbon emission intensity of products would be based on a default value; however, importers would be given the opportunity, at the moment of the yearly reconciliation exercise, to claim a reduction of the CBAM on the basis of their individual emission performance. They would also be entitled to claim a reduction of the CBAM for any carbon price paid in the country of production (which is not rebated nor compensated in other ways upon export). The data necessary to calculate the amount of CBAM certificates to be surrendered should be provided by the ‘CBAM importer’ to the CBAM authority. If the importer intends to provide its own emission figures for the CBAM, the relevant information is also to be provided. Depending on MRV requirements defined, the relevant information here would be either: –the confirmation from the CBAM authority that the imported good falls under the CBAM; –the specific embedded emissions determined in line with the CBAM requirements on MRV, as well as information on the carbon price paid abroad – in this case, some form of verification report would have to be attached by the importer. At regular intervals (e.g. annually like in the EU ETS), the CBAM importer would perform a calculation (or ‘reconciliation’) of its CBAM obligation by adding up all its reported embedded emissions for the previous period (e.g. the calendar year) and for all imported products covered by the CBAM, and report them. 5.2.4Option 3: Import certificates for basic materials based on actual emissions Depth of value chain: Basic materials and basic material products Coverage of CBAM: Imports only Free allocation in the EU ETS: No (full auctioning of allowances for the CBAM sectors) Type of payment: Domestic producers buy EU ETS allowances; importers buy import certificates (CBAM certificates) Reflection of actual emissions in carbon pricing: For both domestic production and imports, importers declare the actual carbon intensity of imported products Option 3 operates in the same way as option 2, however the carbon price of imports is based on actual emissions from third country producers rather than on a default value based on EU producers’ averages. Under this option, the importer will have to report the actual emissions embedded in the product and surrender a corresponding number of CBAM certificates. In the event that a carbon price was paid abroad, the importer would be entitled to claim a reduction of his CBAM obligation corresponding to the carbon price paid abroad. Information will be subject to monitoring and verification procedures to assess the number of CBAM certificates to be purchased, as explained in option 2 above. Under this option, free allocation in the EU ETS would be discontinued. Even if the general principle in this option is that imported products in the scope of the CBAM are to be assessed based on actual GHG emissions, there would still be a need to set default values to be used in situations when sufficient data to determine the actual GHG emissions is not available. 5.2.5Option 4: Import certificates for basic materials based on actual emissions with parallel continuation of free allowances for a transitional period Depth of value chain: Basic materials and basic material products Coverage of CBAM: Imports only Free allocation in the EU ETS: Phased out for the CBAM sectors - gradual phased-out after 2025 over 10 years Mode of payment: Domestic producers buy EU ETS allowances needed beyond free allocation; importers buy import certificates (CBAM certificates) Reflection of actual emissions in carbon pricing: Only partially for domestic production and imports during the transition period; importers declare the actual carbon intensity of imported products Option 4 would apply in the same way as option 3. It consists of surrendering CBAM certificates on imported goods. However, this option considers a more gradual phasing out of free allowances, which shall start after 2025, so that they decline up to 50 % in 2030 and eventually to 0 % by 2035 at the earliest. On the basis of this, the CBAM would be phased in after 2025 and reduced proportionally to the amount of free allowances distributed in a given sector.

The CBAM after 2025 would apply to the difference between actual emissions and the proportion of emissions under the EU benchmark which remain covered by free allowances. This way, at any point in time, imports benefit from the same level of free allowances as domestic productions. Such a transitional period is designed to allow businesses with installations subject to the EU ETS to have more time to adjust to a situation where the carbon price will apply fully to their production. 5.2.6Option 5: Import certificates for basic materials also as part of components and finished products based on actual emissions Box 5: Option 5 in Brief Depth of value chain: Basic materials also as part of components and finished products Coverage of CBAM: Imports only Free allocation in the EU ETS: No (full auctioning of allowances for the CBAM sectors) Mode of payment: Domestic producers buy EU ETS allowances; importers buy import certificates (CBAM certificates) Reflection of actual emissions in carbon pricing: Yes for domestic production; importers will declare the actual carbon intensity of imported products Option 5 is a variant of Option 3 with a scope extended further down in the value chain. Adjustments would not be limited to specific imported carbon-intensive materials and basic material products. Instead, carbon-intensive materials that are part of semi-finished as well as finished products would also be covered along the value chain. For imports, the CBAM would again be based on the actual emissions from third country producers. Under this option, no free allocation would be given to EU ETS operators. 5.2.7Option 6: Excise duty Depth of value chain: Basic materials also as part of components and final products Coverage of CBAM: Domestic products, imports and waiving of liability for exports of EU producers (symmetric) Free allocation in the EU ETS: Yes (continued) Mode of payment: EU ETS coverage for domestic producers plus liability created upon production and import, paid when product is released for consumption Reflection of actual emissions in carbon pricing: Yes for domestic production; not for imports Option 6 goes beyond the introduction of a CBAM reflecting the effects of the EU ETS at the border. It consists of an excise duty on carbon-intensive materials covering consumption of both domestic and imported products, besides the continuation of the EU ETS including the free allocation of allowances covering production in the EU. An excise duty would be levied on the consumption in the EU of carbon-intensive materials, regardless of whether they are produced in the EU or imported. The excise duty would be calculated by applying the relevant carbon price to the base of the assessment, i.e. the quantity of the carbon intensive material produced or imported multiplied by a carbon intensity factor. The latter would represent an irrefutable value, so that only default values are used for embedded emissions of domestic and imported goods. The carbon intensity factor should reflect the carbon content of each covered material. In order to ensure administrative feasibility across the value chain, the carbon content should not reflect the specific production processes of the specific material at hand, but be determined according to material specific reference values. Initially, such reference values could, where available, correspond to or be derived from the EU ETS product benchmarks already used for free allocation of allowances. The relevant carbon price should be determined in relation with the EU ETS allowance price. For imports, the destination principle would be achieved by making the importation of basic materials, as well as goods containing a significant share of such materials, a taxable event. The importation would thus create the same liability as if the materials had been produced in the EU, i.e. dependent on the weight of the material and independent of the actual production process. Exports of materials and manufactured products, on the other hand, would not be subject to the excise duty. Hence, as with the excise duties on alcoholic beverages, manufactured tobacco products and energy products, firms could be allowed a duty suspension for the liability created upon production or import. Thus, the excise duty could be waived where materials, including as part of products, are exported. Duty suspension arrangements allow authorised entities to produce, process, hold, transport and trade excise duty goods between producers of different production stages without triggering excise duty. The duty is transferred along the supply chain until excise duty goods are finally released for consumption. As duty suspension arrangements allow for the transfer of liabilities along the value chain, efficient control mechanisms need to be in place. As with other excise duties, this duty would become due when materials are released for consumption, as part of more processed products. A system for monitoring and verification of the carbon intensity of the products will have to be established, taking into account the material composition of the products and the carbon intensity of the materials contained therein. Free allocation of allowances would continue, and operators of installations would receive free allowances based on the benchmark levels and the production volume of tonnes of the basic material. This approach would be compatible with the present system whereby EU operators would need to buy allowances to cover emissions exceeding the benchmark levels. 5.2.8Options for the electricity sector Electricity generation is analysed separately due to several factors which make it unique among the sectors considered for inclusion in the CBAM. Not only is it the most important sector included in the EU ETS in terms of direct carbon emissions, it is also the largest sector responsible for carbon emissions in the wider economy. Additionally, electricity generators in principle do not receive free allowances, but have to buy them via auctions or on the secondary market. This distinguishes them from other EU ETS participants, whose exposure to the risks of carbon leakage can be mitigated with the allocation of free allowances. At the same time, as electricity generated in third countries can only be delivered into the EU through interconnectors which are subject to capacity constraints, the exported volumes are subject to the limitations of physical infrastructure. Electricity imports in the EU make up 1–2 % of total EU consumption on average, which means that exposure to international trade in this case is lower than in other EU ETS sectors. The interconnection infrastructure has, however, been expanding over the past years and the trend is expected to continue. The net physical inflows of electricity into the EU from third countries without an equivalent carbon pricing mechanism increased from 3 TWh in 2017 to 20 TWh in 2019. In fact, a growing body of evidence points to carbon leakage already occu