How Europe's ETS and CBAM Intersect

The European Union Emissions Trading System (EU ETS) has been a cornerstone of EU climate policy since 2005, operating as the world's first and largest international carbon market. This cap-and-trade system sets a limit on total greenhouse gas emissions from covered installations, including electricity generation, heavy industry, and intra-EU aviation. Companies receive or purchase emission allowances, each representing one tonne of CO₂-equivalent, and must surrender enough allowances to cover their actual emissions annually. This mechanism creates a market price for carbon, incentivizing firms to reduce emissions and allowing those who exceed their limits to purchase additional allowances. The shrinking emissions cap over time drives up the carbon price, promoting cost-effective emissions reductions. The EU ETS has significantly contributed to emission cuts, with emissions from power plants and industrial installations falling by roughly 47% by 2023 compared to 2005 levels. It plays a pivotal role in the EU’s Green Deal strategy, aiming for a 62% reduction in covered emissions by 2030.

Complementing the EU ETS, the Carbon Border Adjustment Mechanism (CBAM) is a new policy tool designed to address carbon leakage. This occurs when carbon-intensive production shifts to countries with weaker climate regulations, or when EU markets are flooded with high-emission imports. CBAM places a carbon price on certain imported goods, ensuring foreign producers face costs comparable to EU producers under the ETS. This equalizes carbon costs between domestic and imported products, safeguarding the EU’s climate objectives. Designed to comply with WTO rules, CBAM applies the same standard to all trading partners and mirrors internal carbon costs. Introduced as part of the EU’s Fit for 55 climate package, CBAM is being phased in gradually. A transitional period from October 2023 to 2025 requires importers to report embedded emissions without paying fees. Starting in 2026, importers will purchase and surrender CBAM certificates for their imports, effectively paying a carbon price at the border. Initially, CBAM applies to highly carbon-intensive sectors like iron and steel, cement, aluminum, fertilizers, electricity, and hydrogen, with potential expansion to other sectors.

CBAM effectively extends the EU ETS beyond EU borders, creating a carbon cost for imports equivalent to that faced by EU manufacturers. The price of CBAM certificates is pegged to the EU ETS allowance price, ensuring a consistent carbon price for emissions, whether produced within or outside the EU. This aligns external producers’ incentives with those of EU producers, closing the gap that previously allowed overseas firms to undercut EU prices by avoiding carbon costs. The introduction of CBAM is closely coordinated with reforms to the ETS, particularly the phasing out of free allowances for domestic industries. As CBAM ramps up, free emission permits for EU producers will be gradually withdrawn, reaching full elimination by 2034. This ensures EU industries face the full carbon price without being competitively disadvantaged, as importers will pay the same price at the border.

The pricing of CBAM certificates is directly linked to the EU carbon market, with the price based on the weekly average EU ETS allowance price. This ensures that CBAM costs fluctuate with the carbon market, sending a dynamic price signal to foreign producers. When an importer brings a covered product into the EU, they must report the total greenhouse gas emissions embedded in the imported goods, typically accounting for direct CO₂ emissions. The reported emissions are then multiplied by the EU carbon price to calculate the CBAM liability. Importers must purchase and surrender CBAM certificates equal to the embedded emissions. If the foreign producer has already paid a carbon price on those emissions in their home country, the mechanism credits that amount, ensuring no double payment of carbon costs. This design ensures that the carbon price applied to imports matches the EU ETS price, after accounting for any carbon costs already paid internationally.

By aligning carbon costs for domestic and imported goods, CBAM has significant implications for industries and global trade. For EU-based industries, CBAM neutralizes unfair competition from imports produced without climate constraints, bolstering their competitiveness. Industries outside the EU will face new costs, incentivizing them to reduce the carbon intensity of their production. Importers within the EU will need to adapt by implementing robust carbon accounting for their supply chains and potentially favoring suppliers with lower embedded emissions. However, CBAM has also raised concerns about potential protectionism and impacts on developing countries, leading to trade tensions and diplomatic efforts to address these concerns. The EU is engaging in dialogue and considering assistance to help trading partners adapt.

Looking ahead, both the EU ETS and CBAM are poised to evolve. The ETS will continue to strengthen with tighter emissions caps, expanded sector coverage, and potential international linking. CBAM’s scope is expected to broaden over time, covering more sectors and refining emissions accounting. The EU’s move on CBAM is already influencing climate policy beyond Europe, prompting other countries to consider their own carbon pricing mechanisms. Over time, this could lead to a more harmonized international carbon pricing regime. However, challenges remain, including avoiding economic disruptions, addressing trade tensions, and ensuring global participation. The long-term vision is a global carbon pricing system that internalizes the cost of carbon, making CBAM potentially redundant. Until then, the EU ETS combined with CBAM represents an ambitious attempt to drive down emissions and catalyze broader change through global trade rules.