How Will the EU Carbon Border Adjustment Mechanism Impact China Businesses?
China faces limited exposure to increased costs under the EU Carbon Border Adjustment Mechanism in the near term due to the nature of its export trade with the region, but that could change in the long term as the scheme goes into full implementation mode. We discuss how the EU’s carbon allowance cost assessment may push China to adopt stringent policies on its own industries and steps that businesses can take in advance as more markets get serious about their emissions targets.
On April 18, 2023, the European Parliament approved the legislation for the implementation of a Carbon Border Adjustment Mechanism (CBAM) as part of the European Union’s (EU) “Fit for 55 in 2030 package”, which is aimed at reducing greenhouse gas (GHG) emissions by 55 percent before 2030.
According to the official press release of the European Parliament, the CBAM will be rolled out in phases from 2026 to 2034 and will enable the EU to impose a Carbon Border Tax (CBT) on specific imports, such as steel, aluminum, fertilizers, electricity, cement, and hydrogen, as well as indirect emissions under certain conditions.
The CBAM aims to incentivize non-EU countries to increase their climate ambition and to ensure that EU and global climate efforts are not undermined by production being relocated from the EU to countries with less ambitious policies. Correspondingly, it will also help to balances the differences in carbon costs between the EU and exporting regions.
As a major exporter to the EU, China is among the countries that will be the most affected, particularly export-oriented businesses in the industries identified for climate action. The introduction of CBAM may stimulate the Chinese government to implement more stringent policies so that industries match EU standards. Nevertheless, the CBAM’s short-term impact on China is expected to be limited, as it affects only a small portion of China-EU trade.
What is the EU carbon border adjustment mechanism and how will it work?
As carbon prices look set to grow further and the need for greater long-term investment in low carbon production increases, the EU has developed the CBAM to level the playing field between EU industries and importers and reduce the risk of carbon leakage (emissions increasing from the relocation of production to countries with less restrictive policies).
While free allowance distribution has been used in the past to address competitiveness concerns, there is growing evidence that border adjustments are a more effective policy tool. Free allocation can create subsidies that encourage increased production, leading to a suboptimal price signal. The perceived risk is that carbon allowance costs will make domestic industries uncompetitive relative to producers in jurisdictions without emissions standards. The introduction of the CBAM aims to directly account for carbon cost differences and level the competition for domestic and international producers, counteracting leakage and addressing competitiveness concerns.
Under the EU’s CBAM, importers of the specified goods would have to pay any price difference between the carbon price paid in the country of production and the price of carbon allowances in the EU countries.
Successful implementation of CBAM will help the EU maximize emissions reductions and minimize international backlash. It will however result in carbon cost pass-through to retail prices, as EU producers and exporters to the EU will seek to manage revenue margins.
The price of the CBAM certificate is based on the average price of EU Emission Trading System (ETS), giving the EU the ability to influence global carbon pricing.
Transitional phase for the Carbon Border Adjustment Mechanism: 2023-2025
The first stage of CBAM is a transitional phase, which starts October 1, 2023. This phase targets carbon-intensive goods and precursors that are most vulnerable to carbon leakage, including cement, iron and steel, aluminum, fertilizers, electricity, and hydrogen. In the transitional phase, importers of goods falling within the scope of the new regulations will only have to disclose the embedded greenhouse gas emissions (GHG), both direct and indirect, without incurring any financial obligations or adjustments.
The agreement foresees that indirect emissions will be covered in the scope after the transitional period for some sectors (cement and fertilizers), based on a methodology to be defined in the meantime. Companies will be required to disclose the carbon emissions of their own energy consumption and that of their suppliers. This means they will have to ask their suppliers overseas to report the supply chain carbon footprints of the products sold in the EU.
The purpose of this transitional period is to serve as a pilot and learning phases for all stakeholders, including importers, producers, and authorities, and to collect valuable information on embedded emissions to refine the methodology for the final phase.
Implementation phases of the Carbon Border Adjustment Mechanism: 2026-2035
The scheme will enter a full implementation phase from January 1, 2026. Importers in the EU then will need to surrender an equivalent number of CBAM certificates, in addition to reporting the quantity of goods and embedded GHG emissions. The price of the certificate will be determined by the average weekly auction price of EU ETS allowances expressed in €/ton of CO2 emitted. As of February 2023, the trading price of EU carbon emission was around €100 (US$106.57) per metric ton, hitting a record high, according to Reuters.
Under CBAM, importers will pay a carbon price equivalent to what they would have paid if the goods had been produced under the EU ETS rules. If importers can demonstrate that a carbon price has already been paid, they may deduct that amount from the CBAM charge.
The phasing-out of free allocation under the EU ETS will occur simultaneously with the introduction of CBAM from 2026 to 2034. This means that CBAM will coexist with EU ETS Free Allowances until 2035. With this enlarged scope, CBAM will eventually cover more than 50 percent of emissions in ETS-covered sectors once fully phased in.
How does the CBAM affect China?
Immediate impact is limited
From a trade perspective, the current CBAM will not have much impact on Chinese goods. China’s exports of CBAM-covered products account for less than 2 percent of its total exports to the EU, worth around €6.5 billion (US$7.18 billion). To be clearer, aluminum and iron & steel comprise almost 99 percent of those exports. This number remains low because most of the products covered under the EU’s adjustment mechanism are located in the upstream of the industrial value chain and are energy-intensive, which is not encouraged by Chinese policies due to domestic supply security and environmental considerations. The EU’s other safeguard measures that are aimed at protecting its domestic industries, such as the steel industry, also drive the number low.
A report in 2021 from the innovative Green Development Program, a consultancy in China, estimated that China’s aluminum and iron & steel industries would have to pay a combined RMB 2–2.8 billion (US$295–413 million) in CBT to the EU every year. This would mean incurring increased costs in the range of RMB 652–690 (US$96–102) per ton on iron and steel, and RMB 4,295–4,909 (US$634–725) per ton on aluminum.
Long-term concerns remain
While the immediate trade impact may seem limited, the implementation of CBAM will have a significant impact on export-oriented manufacturers. As the CBAM covers both direct and indirect emissions, manufacturers will need to find ways to reduce their product carbon intensity to remain competitive, such as improving energy efficiency, using lower-carbon fuels, and optimizing production processes. As China still relies largely on coal for power generation now, the CBAM may further foster Chinese companies to increase their use of renewable energy from the current carbon intensive source base.
Currently, the CBAM targets selected precursors whose production is carbon intensive and at most significant risk of carbon leakage. This may include battery precursor chemicals, such nickel, but this has not been confirmed by the EU. China accounts for a significant portion of the world’s production of battery precursor chemicals of ternary cathode active materials containing nickel, cobalt, lithium, and manganese. Chinese companies in this industry must remain vigilant and adaptable to potential future changes.
On the other hand, the EU’s continued efforts to promote low-carbon rules and enhance its own industrial competitiveness may formulate policies that restrict China’s advantageous industries. In this regard, the CBAM can be a trade barrier. On March 15, China suggested holding multilateral talks on environmental measures, beginning with the CBAM, at the World Trade Organization (WTO), citing that the CBT tax does not comply with global trading rules.
Riccardo Benussi, Head of European Business Development at Dezan Shira & Associates, comments: “The regulation, which is the world’s first carbon import tax law, requires companies that export iron, steel, fertilizers, or cement to EU businesses to calculate and pay for the greenhouse and carbon emissions associated with each product. If companies are unable to absorb the additional costs, they may need to explore trading with countries that do not impose such a tax or modify their production methods to reduce greenhouse gas or carbon emissions. Although this measure may benefit the environment, it could also result in supply chain fragmentation and higher costs.”
The CBAM can bridge the gap between energy trading systems in China and the EU
In 2021, the Shanghai Environment and Energy Exchange launched China’s national ETS. The scheme currently only covers the power sector, responsible for 40 percent of China’s annual carbon emissions. Many agree that CBAM can boost the Chinese market – by aligning with China’s economic strategy, the CBAM can stimulate technology innovation and expanding higher-value manufactured goods as exports. The CBAM may stimulate Chinese exporters to improve their competitiveness by reducing their product carbon intensity and optimizing production processes. This could help to promote a shift towards cleaner energy production. As China is already a major producer of clean technologies, such as solar panels and wind turbines, the CBAM could provide a further incentive for Chinese companies to invest in these technologies and export to the EU.
In practice, this development entails the Chinese government making companies pay for their carbon emissions. Currently, an energy company’s costs per ton of CO2 emissions in China averaged less than US$9 in 2022, significantly lower than US$85 in the EU, according to Bloomberg. CBAM’s full implementation in 2026 will directly expose the difference in carbon prices between the EU and China.
Some speculate that China could strengthen its carbon market by including more energy-intensive sectors and raising the emission prices, resulting in a smaller difference between the two carbon prices. This would reduce CBAM fees for Chinese enterprises, enhancing their competitiveness in a carbon-constrained world and accelerating the learning curve effect to boost domestic innovation.
However, while the China’s ETS has achieved its initial objectives of creating a carbon trading system and raising grassroots awareness, it faces challenges. The country’s tendency to rely on command-and-control measures means that the ETS may only play a complementary role, with domestic carbon prices likely to remain structurally weaker than many other markets where carbon pricing plays a larger role.
How can Chinese businesses prepare for the implementation of the Carbon Border Adjustment Mechanism?
In recent years, industries promoting low-carbon emissions, energy efficiency, and carbon neutrality have been identified as strategic priorities for economic development. The introduction of the CBAM will further foster domestic technological innovation in China, moving Chinese firms up in the global value chain, thereby reaping significant economic benefits.
These emissions reduction requirements will encourage companies to become more creative and efficient, leading to economies of scale and new learning. Industries affected by CBAM may need to enhance their capabilities for managing carbon-related affairs to remain competitive. They will be incentivized to increase renewables consumption to mitigate indirect emissions from electricity consumption under CBAM. On the other hand, those that fail to develop a sustainability strategy risk losing funding, thus making it essential for all industries to have a roadmap for carbon neutrality.
Although CBAM costs may be passed on through increased prices, low-carbon producers in China may seize this opportunity. Either in upstream or downstream, sustainable producers may see certain growth for their businesses.
To better adjust to the CBAM, Chinese businesses should consider the below actions:
- Assess the potential impact of CBAM on their operations by examining their sales data, potential costs, transactional model, and logistic flows to determine CBAM applicability.
- Consider the impact of CBAM on their business model and identify opportunities for strategic transformation to reduce its impact, particularly in terms of their competitiveness in the EU market and corporate value.
- Analyze the impact on supply chain and procurement strategies to inform future strategic analysis.
- Review their global value chain and footprint as they relate to the EU region and CBAM.
Benussi adds: “Businesses should carefully assess the potential impact of CBAM on their operations and explore ways to become more environmentally sustainable in the long term to avoid potential disruptions to their business activities. The CBAM is just the first such potential disruptor.”
China Briefing is written and produced by Dezan Shira & Associates. The practice assists foreign investors into China and has done so since 1992 through offices in Beijing, Tianjin, Dalian, Qingdao, Shanghai, Hangzhou, Ningbo, Suzhou, Guangzhou, Dongguan, Zhongshan, Shenzhen, and Hong Kong. Please contact the firm for assistance in China at firstname.lastname@example.org.
Dezan Shira & Associates has offices in Vietnam, Indonesia, Singapore, United States, Germany, Italy, India, and Russia, in addition to our trade research facilities along the Belt & Road Initiative. We also have partner firms assisting foreign investors in The Philippines, Malaysia, Thailand, Bangladesh.
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