This is an extract from a recent report “Climate Policies as a Soft- Power in Carbon- Based New World Paradigm” by KPMG

The EU is a global leader in the fight against climate change by producing strict regulations, innovative and binding policies and mechanisms within and outside its borders. These regulations are designed as sanctions on energy efficiency and sustainability covering all members for the reduction of greenhouse gas emissions with innovative green transformation technologies to achieve carbon neutrality targets. For example, as a party to international multilateral treaties on behalf of all members, EU enacts laws and launches encompassing climate regulations binding all members and occasionally non-member states by using the mechanisms such as Council of Europe and the European Parliament.

Paris Agreement, which holds a legally binding international treaty status, is a milestone in the fight against Global Climate Change. The agreement was an unprecedented global achievement on climate change action of the 21st Conference of the Parties (COP21) to the 1992 United Nations Framework Convention on Climate Change. The Paris Agreement aims to strengthen global sustainability and socio-economic resilience against the jeopardy of climate change and targets a long-term goal keeping the global temperature increase as below 2°C as much as possible (at 1.5 degrees if possible) compared to the pre-industrialization period. This goal requires gradually reducing the use of fossil fuels (oil, coal) by adapting innovative renewable energy sources (e.g., Wind and Solar) and systemic changes to shift towards net zero emissions world.

The European Green Deal, introduced in 2019 and entered into force in 2020, is a strategic policy roadmap designed to make the EU carbon-neutral by 2050. The strategy, which determines many dynamic and radical transformations, is a unique initiative for green transformation European-wide, aiming to transform the EU into a modern, resource-efficient and competitive economy with holistic and sustainable strategies against climate change. At the European level, its importance was recognised during and after the Covid-19 pandemic, which has shaken the world socio-economically and whose effects are still felt today. For instance, Green Deal is also seen as a safer part of the EU from COVID-19 pandemic, with almost €1.5 trillion investments in single market and innovation, cohesion and resilience from the Next Generation EU Recovery Plan.

Under the European Climate Law, aligning with the European Green Deal the EU has committed to reduce net greenhouse gas emissions by at least 55% compared to 1990 by 2030. The ‘Fit for 55’ legislative package is a framework making all sectors of the EU economy fit to achieve this goal. It puts the EU-members on track to achieve its climate goals in a fair, cost-effective and competitive way

Adapted and regulated 15 Fit for 55 proposals by EU:

  • EU Emissions Trading System (ETS) Reform: Adopted changes to the EU’s carbon market to make it more ambitious, including extending it to maritime transport and reducing emission allowances. 
  • New Emissions Trading System: Implemented for mainly building and road transport fuels.
  • Social Climate Fund: Established to support citizens in the transition. 
  • Effort Sharing Regulation: Adopted to ensure member states’ accountability for emissions reduction. 
  • Land Use, Forestry, and Agriculture Regulation (LULUCF): Adopted to address emissions and removals from land use and forestry. 
  • CO2 Emissions Standards: Updated for cars and vans to reduce emissions. 
  • Carbon Border Adjustment Mechanism (CBAM): Adopted to prevent carbon leakage and promote global decarbonization. 
  • Renewable Energy Directive: Adopted to increase the use of renewable energy sources.
  • Energy Efficiency Directive: Adopted to improve energy efficiency. 
  • Alternative Fuels Infrastructure Regulation (AFIR): Adopted to support the deployment of alternative fuel infrastructure. 
  • ReFuel EU Aviation Regulation: Adopted to promote sustainable aviation fuels.
  • FuelEU Maritime Regulation: Adopted to reduce the environmental impact of maritime transport. 
  • Energy Performance of Buildings Directive: Updated to improve the energy performance of buildings. 
  • Decarbonisation of Gas Markets: Adopted updated rules to promote hydrogen and decarbonize gas markets. 
  • EU Methane Regulation: Implemented for the energy sector to reduce methane emissions.

These measures are designed to track the progress of the EU’s commitment to the Paris Agreement and its own climate targets determined by the Green Deal. While “Fit for 55” brought radical regulations at the EU level, especially against climate change, its sanctions on global trade relations also had radical effects on countries and businesses exporting to the EU. Reminding EU’s Life Cycle Assessment (compilation and evaluation of the inputs, outputs and the potential environmental impacts of a product system throughout its life cycle), the Carbon Border Adjustment Mechanism (CBAM) has brought the obligation of exporting countries to EU to be a partner in global decarbonization efforts and, ultimately, the obligation to make intense systemic investments, if they want to maintain trade relations with the EU. 

Carbon Border Adjustment Mechanism (CBAM) 

CBAM was introduced as part of the European Green Deal and the Fit for 55 frameworks, and it is a tool designed for countries with less strict climate policies, carbon tracking mechanisms and regulations at the production stages. CBAM, which provides the EU with the characteristics of being a global regulatory power in climate policies, effectively exports environmental standards and forces exporter countries that trade or develop a trade strategy with the EU to implement sustainable climate policies. Essentially, it also encourages countries that are not parties to the Paris Agreement to coercive regulations. 

As a means of setting a fair price on carbon emitted during the production of carbon-intensive goods entering to the EU, the CBAM ensures that the carbon price of imports is equivalent to the carbon price of goods produced within the EU, preventing the EU’s Paris Agreement and European Green Deal goals from being undermined.

The CBAM instrument, which came into effect on October 1, 2023, with the reporting requirement phase and will be fully operational as of January 1, 2026, applies to the import of selected products which have carbon-intensive production phases: Fertilizer, energy (sectors like battery, EVs, green technologies) hydrogen, cement, iron and steel and aluminium.

According to KPMG’s recent report, these products account for 45% of the EU ETS sectors. EU importers of these goods under the CBAM will register with the national authorities where they can purchase the CBAM certificates by 1st January 2025 with CBAM Authorization. The price of the CBAM certificates will be calculated based on the weekly average auction price of the EU ETS allowances (which will be replaced by CBAM by 2034), expressed in CO2 €/tonne emitted during the production of the product to be imported. 

CBAM Influence on Global Trade and Green Transition

Since the introduction of the CBAM in 2019, its multifaceted implications for global trade and green transition are still being debated. The EU’s regulatory effects in terms of global climate action; The development of Data and Traceability Based New Business Models, its role in advancing EU integration, its compelling effects on encouraging Green Transition Innovations and technological transformations within and outside Europe are the main ones. Announcing CBAM, UNTAD (2021)’s comprehensive report based on 2019 Export value of CBAM-relevant commodities to the EU included very striking trading data findings, especially for the 20 countries that will be most exposed to the CBAM’s devastating and expensive impacts.

A broad perspective on the 2026 – 2040 projections on the countries and sectors that will be exposed to the CBAM from 2026 onwards was provided by S&P Global Commodity Insights in February 2023. While China and the United States, which are the subject of the 2021 UNTAD report above, are expected to reduce their exposure. However, it shows that countries such as Canada, Turkiye and South Africa will be most exposed to the CBAM mechanism, with iron and steel being by far the largest targeted sector with 2.586 million tonnes CO2. Nonetheless, reports and research reveal that the CBAM’s mechanism for carbon leakage will have positive results on carbon emissions with diverse challenges.

In particular, the commodity exporting countries to the EU face various challenges in addition to the expected high cost of CBAM exposure. Although it is difficult to anticipate the long term effects of these restrictions, CBAM adaptation phases for Developing and Low Developing exporting countries can be summarized within four main challenges:

1. Inadequate Resources: One of the key challenges is the lack of accountable and transparent systems for tracking carbon emission metrics in non-EU countries especially in developing countries. Further, they tend to be constantly funded for integration into large-scale regulatory systems such as CBAM.

2. Lack of Skilled Experts and Conceptual Complexity: The technical complexity of EU regulations requires an inclusive collaborative effort of highly skilled experts, especially in the interpretation and integration of these regulations. In fact, the World Bank has published a special technical note to overcome the slippage in these technical issues. Technical Note on the CBAM Exposure Index aims to clarify the confusion of technical concepts such as the mathematical measurement of CBAM exposure, the Relative CBAM Exposure Index, and even the aggregate relative CBAM exposure index. 

3. Long-run Trade Sanctions in EU: EU-SMEs operating such as in the fertiliser, iron and steel and especially green energy sectors might experience major impacts within the scope of necessary imported intermediate goods. Although some structural initiatives have been made by the EU on how these expected structural problems in imported minerals and commodities required to produce such as batteries, especially in the energy sector, will affect the production systems of SMEs operating in the EU, there is no concrete study on the long-term effects of CBAM on EU-SMEs.

4. Regulatory Differences: Plausibly the most problematic challenge is the differentiating regulatory emission frameworks. While countries such as Russia, China, South Africa, Brazil and Turkey are among the main exporters of CBAM’s commodities to the EU, the EU is not the only market for those countries’ businesses operating in these sectors. These SMEs export commodities, which are included in the CBAM, also to non-EU countries. In this regard, evidently, those SMEs are put in a single-preference strategy development position in the face of differing regulations. 

Impact on China and US

With the European Green Deal, the EU has included the CBAM mechanism in its regional climate targeting regulations within the framework of “Fit for 55” and has enabled almost all countries that have trade relations in the commodities included in the scope of CBAM to focus on carbon mechanisms. Designed to operate in accordance with World Trade Organization rules, CBAM has also increased the risks of retaliation from other countries to the EU. Based on 2022 trade data, CBAM covers only about 3.5 billion euros with a rate of 1.1% of the total volume of approximately 340 billion euros that the USA exports to the EU, while China’s CBAM-based exports reach approximately 17 billion euros. When we examine the expected emission values of the sectors that will be exposed to CBAM in the long term between 2024 and 2040, it is expected that total emission of China is likely to be 224 million tons of CO2, whilst total emission is 105 million tons of CO2 for the US. 

It is projected that by the end of the 2030 carbon allowances under EU ETS would be almost 150 euros/tCO₂e, before reaching nearly 200 euros/tCO₂e by 2035. Considering the low volume of CBAM-based exports of the United States, the United States is a much larger producer of carbon-efficient CBAM comprehensive products than its Chinese competitors. Further there is an ambiguity of the verification and integrity of emission data under the China Certified Emission Reduction scheme (CCER) and China ETS mechanism and China’s national ETS mechanism only covers electricity and it is effective only in some regions. Given these circumstances, while CBAM will impose heavy burdens, especially on China during importers start to pay, it seems that U.S. companies, which have the most integrated trade relations with EU, are already competitive in the CBAM-covered sectors in Europe and their market penetration will be increasing in the long term. 

Access the complete report here