CMKZ would like to thank André-Philippe Ouellet, CMKZ Collaborator, and Bernard Colas, for preparing this blog.

Canadian companies exporting goods should remain alert and be prepared to face an increased administrative burden when dealing with partners abroad. Most Western governments are currently working on border carbon adjustment mechanisms—often referred to as “carbon taxes”—to prevent carbon leakage (i.e., when a company offshores its production to take advantage of lower environmental standards). The second rationale underlying these mechanisms is to create a level playing field between firms regardless of whether or not they bear high production costs on account of environmental obligations. There are currently about sixty carbon pricing schemes in operation worldwide, most of which will eventually be completed with border carbon adjustment mechanisms.

Companies exporting to the European Union (EU) will be on the frontline; the EU being the first trading bloc to implement such an adjustment mechanism, the Carbon Border Adjustment Mechanism (CBAM). However, Canada, the United Kingdom and possibly the United States are next in line. The CBAM was initially supposed to come into force next January but will finally start producing effects from October 2023 on. The adjustment mechanisms of Canada’s trading partners will mainly affect Canadian firms exporting goods, while the upcoming Canadian mechanism will mostly affect firms relying on imports.

It should be noted that for the time being, the contemplated schemes will solely affect companies producing carbon-intensive goods such as steel, aluminium, chemicals, cement or fertilizers. Both the European and Canadian mechanisms in their current or anticipated design are limited to these sectors. Yet, businesses should have a plan, be prepared to meet new administrative obligations and face future customs duties since the list of targeted sectors is set to grow. According to trade experts, many governments are engaged in a “race to the top” as most of them have an incentive to “tax” foreign production that oft benefits from much lower environmental standards.

European Union

EU institutions have been working on the development of the CBAM since 2021. This adjustment mechanism is part of the EU’s “fit for 55” plan which aims to significantly reduce the Union’s carbon emissions, including indirect emissions attributable to imports. The plan is designed to implement the EU’s climate law, according to which the EU must reduce its emissions by 55% from 1990 levels before 2030.

The European Commission, the European Parliament and the Council reached a provisional agreement mid-December 2022 following inter-institutional negotiations, the trilogues. Final details will be available once the agreement is sealed, but the European authorities have confirmed on the basis of this “political” agreement that the CBAM should be implemented from October 2023. The CBAM goes hand in hand with and complements the EU Emissions Trading Scheme (ETS), which is yet to be finalized.

The European Commission submitted its plan in July 2021, the Council in March 2022 and the European Parliament in June 2022. Interestingly, the European Parliament went beyond what the Commission and the Council had planned by adding new sectors to the list and by factoring in some products’ indirect emissions, i.e., the emissions attributable to the type of energy used to produce it. The new CBAM version does not go as far as proposed by the EU Parliament, but the list of covered products will grow in the years to come. For the time being, the European mechanism will apply to iron, steel, aluminium, some “simple” metal by-products such as screws and bolts, cement, fertilizers, electricity, some chemicals and hydrogen.

Canadian companies will be affected as, under the latest agreement, no exemptions have been granted to the EU’s trading partners. A mutual recognition mechanism could, in theory, be negotiated since the European Parliament does not wish to penalize states with the same climate change mitigation “ambition” as the EU. For the time being, the only possible exemption would concern shipments worth less than 150 euros and those from countries where the carbon pricing would be the same as in the EU. Canadian producers will still have to pay the difference between the price of CO2 emissions in Canada and in the EU, where carbon is taxed more heavily.

From October 1, 2023 on, the first burden on affected businesses will consist of an administrative one, as businesses will need to file a report containing the estimated direct carbon density of the affected products (in addition to indirect emissions for certain goods). This calculation can be complex for companies and problematic in relation to products from states where the information is not available for technical or political reasons. Companies will have to provide this information on a quarterly basis and the price paid under their national scheme. The reports will be subject to audits.

Then, in 2027, the European Commission will re-evaluate the mechanism, which will then come into full effect for covered products and tariffs will be payable. At this stage, companies should still benefit from accommodations, as the CBAM is not expected to be fully functional before 2035. Thus, thanks to “free” allowances, in 2027, companies would pay only 7% of the bill, 16% in 2028, 31% in 2029, 50% in 2030, until reaching 100% in 2035. Free allowances for importers will have to be consonant with those allocated to European firms. The adjustment fee will vary on a weekly basis, depending on the European carbon market. This will thus become fundamental data for companies to factor in.

Currently, the price of carbon in the EU is about $125/tonne, while in other countries, the paid price is higher (e.g., $75/tonne in the UK) or much lower than in Canada (about $2/tonne in China). In Canada, the price per tonne of carbon is $50, and in Quebec only $35, the adjustment could thus be painful. As an illustration, the adjustment should be about $75 per ton, depending on the price of carbon in the EU in a given week. The European countries importing higher proportions of affected goods are Bulgaria, Ireland, Spain and Greece.

It should be noted that the CBAM is not only applicable to CO2 emissions but also to other pollutants such as nitrous oxide and perfluorocarbons, although these emissions are counted in tons of CO2 equivalent. On a positive note, exporters should only have to deal with a central authority established by the European Commission rather than with the national authorities of each member state.

United States

Canadian companies should also closely monitor the situation in the US. Proposals for such a carbon adjustment mechanism sporadically show up on the table. The latest proposal, the US Clean Competition Act, was introduced by Democratic Senator Whitehouse in June, around the same time as the European Parliament’s position paper. This is the second proposal of its kind; another bill was introduced in the US House of Representatives last July, the FAIR Transition and Competition Act, but is unlikely to go forward. However, Senator Whitehouse’s bill is worth reflecting on as it represents a significant trend in the US. This trend could eventually become reality when Democrats and Republicans manage to strike a deal. At present, only a few Republicans support the bill, but the protective effect on US companies could change the game. Indeed, avoiding carbon leakage presumably leads to more equity among companies, as firms from developed states often face a high environmental regulatory and financial burden, a burden which is not matched in most states (e.g., China).

However, the mainstream approach in the United States differs from that in Europe. While the EU places great emphasis on carbon pricing in the state of origin of goods, Americans are more interested in the regulatory pricing of carbon (intrinsic carbon pricing), as there is no federal carbon pricing in the US. The price to be paid under such a scheme would therefore be the difference between its real production costs attributable to environmental obligations and the average regulatory cost in the corresponding US industry branch. For example, if $100 out of the production cost of a tonne of steel is attributable to environmental costs in Canada but the average costs $150 in the US, the producer would have to pay the $50 differential at the border. A producer would then have two choices to avoid the tax. First, ensuring that its emissions are equal to or less than the average in the US industry. Second, paying more in carbon credits (assuming that this is possible) to match the average burden of US producers.

On its face, such a system would be fairer as it would take into account indirect environmental costs. Nevertheless, the administrative burden on the targeted firms could be even greater than under the European CBAM, as the monetary value of environmental obligations is much more complex to calculate than that of a formal pricing scheme. A possible border carbon adjustment system would, of course, consider the explicit cost per tonne of carbon in Canada.

The US will not likely implement carbon pricing or a carbon adjustment mechanism in the very near term. However, it is plausible that the US do so in the next few years, at least as a response to the CBAM. An American adjustment mechanism would also likely enter into force progressively.

In addition, steel and aluminium companies should keep an eye on the Green Steel Deal negotiations that are ongoing between the EU and the US. This agreement could add a layer of administrative complexity to the steel and aluminium sectors. Canada is expected to join such an agreement, which would safeguard Canadian companies against additional tariffs, but the game is far from over, given the sensitivity of those industries.

Canada

The Canadian government is likewise still working on a carbon adjustment mechanism that would prevent carbon leakage in Canada as well. The mechanism—still under consideration—that Canada will implement will first have an effect on Canadian companies importing carbon-intensive goods from abroad (raw materials, tools or consumer goods). The price of these goods could rise on account of tariffs on products from countries with lower CO2 emissions standards than Canada.

For the time being, Canada has indicated that products from jurisdictions that have a higher or equivalent carbon tariff should not be affected by its mechanism. This could encourage the EU and possibly the US to harmonize their systems with Canada or to offer recognition certificates. The implementation of such a system will also increase Canada’s leeway in negotiations with other trading blocs and should ultimately increase the competitiveness of Canadian firms.

Resistence from Developing Countries in Sight

The measures at stake will likely face a backlash from developing countries such as China and India, and even from the US and Canada if a recognition agreement—at least partial—is not reached between countries with adjustment schemes.

The EU claims that its measure is compatible with its commitments under the WTO Covered Agreements, but the measure is likely to end up before the WTO’s judicial bodies. In particular, the fact that credits or subsidies are granted to low-polluting companies could constitute a form of export subsidy, which is prohibited.

The fact that regulatory costs not arising from carbon pricing per se are not taken into account could also be considered discriminatory and thus in potential violation of the WTO Covered Agreements. The Canadian mechanism would also probably face legal challenges from the countries mentioned above.

CMKZ Advice

In this context, it is recommended that Canadian companies operating abroad :

• Verify if any of the goods they export or import are on the list of goods covered by the European CBAM;
• Assess their supply chains to see if any inputs could be affected by carbon adjustment measures in the EU, Canada and elsewhere;
• Assess the carbon content of their products exported to the EU according to the relevant methodology, including that of the suppliers involved;
• Assess the financial impact and establish a financial reserve before the scheme’s effective implementation (tariffs) in 2027;
• List and prepare all other information subject to reporting obligations and the periodicity of transmission to the relevant authority;
• Implement a plan to reduce the carbon footprint of their products, especially if their export markets are concentrated in Europe and the US;
• Establish an input substitution and rationalization strategy if your company imports materials or products with a high carbon footprint;
• Expect some uncertainty and less predictability in the trading system due to legal challenges that are likely to surface, particularly from developing countries.

For information on international trade regulations, please do not hesitate to contact Bernard Colas or one of our other CMKZ lawyers specializing in international trade law.