Introduction
In the previous parts of our series on carbon markets, we delved into the complexities of carbon capture, utilization, and storage ("CCUS"), and the intricacies of carbon markets and pricing policies. In this installment, we explore the emerging field of Carbon Border Adjustment Mechanisms ("CBAMs") (also known as Border Carbon Adjustments ("BCAs")) and examine their potential impact on the Canadian energy industry.
CBAMs are being implemented and studied by various governments around the world, including Canada, as a potential response to a growing climate policy concern – carbon leakage. Carbon leakage occurs when producers and emitters of carbon dioxide ("CO2") transfer their production to a jurisdiction outside of the regulated jurisdiction and often to a jurisdiction with lower or non-existent emissions policies. The net result is that emissions in the regulated jurisdiction may decrease but the overall global emissions remain the same or may even increase – the emission sources just transfer from one place to another. Another instance of carbon leakage occurs when activities which generate large emissions are moved to another jurisdiction with little or no emissions policies, and the resulting goods or services are then imported back into the regulated jurisdiction. The movement of such goods and services across borders effectively negates the purpose of the carbon policies and undermine their effectiveness. CBAMs aim to address these concerns.
Perhaps a convenient consequence of the implementation of CBAMs is that local production of selected products (which is subject to emissions targets and penalties) can be protected from global competition from jurisdictions without emissions targets and penalties. Practically, additional costs of production, including carbon taxes, will be passed on to the consumer through higher prices. A producer who is not subject to emissions targets and penalties will have a lower cost of production and therefore be able to sell their products at a lower price in comparison to a competitor subject to such measure. This can have a profound impact on a business's ability to compete. Traditionally, such cost of production imbalances have been addressed through trade agreements, treaties, litigation, and trade wars. By imposing a carbon cost on selected imported carbon-intensive products, CBAMs can be implemented with a view to leveling the playing field for domestic producers under the guise of preventing carbon leakage.
Whether intended or unintended, CBAMs may have the effect of protecting selected industries and producers from foreign competition.
This article will examine the development of CBAM policies, how they address policy concerns and the potential consequences of such policies on the energy industry in Canada.
Background
The United Nations Framework Convention on Climate Change ("UNFCCC") aims to stabilize greenhouse gas emissions to prevent harmful interference with the climate system. Under the Paris Agreement, countries are required to set increasingly ambitious climate targets. Canada has committed to a 40-45% reduction in emissions below 2005 levels by 2030 and achieving net-zero emissions by 2050. This commitment is supported by a plan of the Government of Canada, "A Healthy Environment and a Healthy Economy," which includes carbon pricing as a central pillar. Canada's carbon price is currently $80 per tonne of CO2 and is set to increase to $170 per tonne by 2030. The implementation of emissions charges based on set carbon pricing models, such as Canada's, has raised other issues including: competitiveness with products from jurisdictions that have not adopted carbon policies or jurisdictions which have adopted carbon policies but which are not implemented in the same way, to the same extent or calculated in a similar fashion; and the possibility of moving high-carbon intensity production to locations outside of the jurisdiction; and/or purchasing carbon credits from outside jurisdictions (all referred herein to carbon leakage). Carbon leakage is a significant concern to policy makers as it undermines the intent and purpose of the legislation, which is to reduce CO2 emissions in the atmosphere. It is also a significant issue to industry as it can cause significant competitive disadvantages due to the increased costs imposed on production. Policy makers are now exploring ways to prevent carbon leakage.
Introduction to CBAM's
Variations in climate policies across jurisdictions pose many challenges to climate policy goals. Inconsistencies in calculating emissions, emissions credits, intensity of CO2, taxes and incentives, have been leading to carbon leakage and altered global supply chains. CBAMs are purportedly designed to address these concerns and equalize carbon costs across borders thereby preventing carbon leakage and ensuring fair competition for local businesses. A country cannot legislate matters in a manner that impacts on the sovereignty of a foreign jurisdiction, but it can try to influence the behaviour of producers in that jurisdiction by imposing restrictions on imports and exports through duties and sanctions. This is ultimately what CBAMs do.
Initially introduced by the European Union, CBAMs aim to level the carbon market playing field by imposing a tariff or duty on carbon-intensive products imported from regions with less stringent or no carbon pricing mechanisms. This ensures that the carbon price of imports is equivalent to the carbon price of domestic production, thereby supporting the EU's climate objectives without undermining its competitiveness.
In the EU, CBAMs will apply to selected products and industries. As such CBAMs can be directed at products and industries in a subjective way. The selection criteria can (will?) be used to favour local producers or certain "clubs" of countries. For example, a nation may view certain energy production practices negatively and implement a major duty on nations that export that form of energy. This may impose a domino effect, with countries imposing retaliatory tariffs based on how their exports are treated by nations using CBAMs.
The EU's CBAM is set to begin in 2026 and will cover sectors such as cement, iron and steel, aluminum, fertilizers, electricity, and hydrogen. During its transitional phase (2023-2025), importers must report greenhouse gas emissions embedded in their imports, gradually adjusting to the new system before certificates will have to be purchased and surrendered annually.
Other than the EU's CBAM, to date, no other country has enacted CBAM legislation. There is, however, significant interest from governments to study the issue. CBAMs can take various forms, such as import charges or requirements for emission allowances. They can also include export rebates to ensure domestic goods compete fairly in foreign markets.
Other jurisdictions, including the UK and Canada, are exploring CBAMs. The UK plans to implement a CBAM by 2027, and Canada is actively studying them. This global trend towards CBAMs indicates a significant shift in how countries manage carbon emissions, with profound implications for international trade and the global energy industry.
It remains to be seen what effect the EU's CBAM will have on the EU's trading partners and what their response will be. Further, the application of CBAMs to products and locations which are protected under international trade treaties and laws will need to be examined.
Interplay with Carbon Transportation
As we explored in Part 3, carbon transportation is a critical component of the carbon market infrastructure. CBAMs introduce a new layer of complexity to this landscape, potentially affecting the competitiveness of carbon-intensive products in international markets. For Canadian energy companies, the imposition of CBAMs by major trading partners like the EU and the UK could negatively affect Canada's ability to export certain energy and related products. On one hand, Canada's stringent carbon policies may position its exports favorably against those from less regulated regions. On the other hand, the additional costs imposed by CBAMs could make Canadian products less competitive if not adequately matched by domestic policy support. The EU's CBAM may be used as a protectionist policy to promote domestic production over foreign exports. Nations like Canada could be faced with the decision of implementing domestic supports for the affected industries, or implementing their own duties and taxes to protect Canadian competitiveness.
An analogy may be made to the wood pulp and paper industry. Canada had attempted to support its pulp and paper industry through various domestic tax benefits and duties on American wood products. While these policies had the intention of protecting an important Canadian industry, they resulted in a trade war with the United States.1 The U.S. imposed retaliatory duties on softwood lumbar imported from Canada and this led to decades of trade litigation between the two nations.2 It is unclear if CBAM policies could lead to similar trade wars and litigation. Will the EU's CBAM aid Canada in protecting the competitiveness of Canada's vital industries or will it result in barriers to and increased costs for Canadian products?
Summary of "Exploring Border Carbon Adjustments for Canada"
Currently, Canada mitigates carbon emissions through domestic pricing systems and financial support for emission reducing technologies.3 However, as carbon prices rise, additional measures like CBAMs may be considered.
How the international community views the imposition of CBAMs will be an important indication of whether such policies will help or hinder local industries. Nations with similar carbon-neutral ambitions may create their own policies to collaborate and support like-minded nations. Other nations will adopt different approaches based on their own self-interest and react with their own tariffs and duties. It remains to be seen how the global energy industry will react to different CBAM proposals as they develop.
The Government of Canada is engaging with international partners to explore the potential of CBAMs and the alignment of climate policies. In the face of the adoption of the EU's CBAM, Canada is collaborating with the EU and the U.S. in an effort to address the impacts that climate policy disparities can have on trade.4 The Government of Canada is also consulting more broadly with stakeholders in both Canada and abroad with the view to assessing the environmental, economic, and trade implications of CBAMs.
As countries implement ambitious climate measures, it remains to be seen what role CBAMs will play in preventing carbon leakage and supporting competitive and effective climate policies. As well, the ability of CBAMs to achieve their intended objectives in a global marketplace remains to be seen. The Government of Canada is committed to exploring CBAMs as part of its broader strategy to achieve its climate targets and maintain international competitiveness.
Effect on Carbon-Intensive Imports and Exports
CBAMs could also impact the competitiveness of imported carbon-intensive products in Canada. For instance, crude oil imports from the Middle East and Venezuela might become less attractive due to additional costs imposed by CBAMs; however, domestic consumers may pay the price for more expensive products due to lack of available options for replacement products.
In addition, Canadian exporters of energy may face challenges under CBAMs. The EU did not implement a proposed system of exporter credits whereby EU-based exporters of carbon-intensive industries would have received financial credits when exporting to nations that do not have intensive carbon policies. The EU determined that such a policy would negate their intention of fighting carbon leakage. Canadian energy exporters may face a situation where they pay duties on energy exported to nations with CBAMs, while finding their prices uncompetitive in non-CBAM nations due to the increased costs of production and exportation to areas with CBAMs.
Conclusion
The introduction of CBAMs will undoubtedly complicate the energy industry's strategic landscape. Companies must now consider the carbon intensity of the components of their products and their supply chains, not only for domestic compliance but also for international competitiveness.
CBAMs are being developed as part of a next wave of global carbon policy developments, aiming to control carbon markets, prevent carbon leakage and enforce climate commitments worldwide. For the energy sector, this means navigating new complexities and opportunities in both exports and imports. As countries like the EU, UK, and Canada move forward with these mechanisms, energy companies must stay informed and agile, adapting to the changing regulatory environment to maintain competitiveness and support global climate goals.
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Footnotes
1. "The Canada – United States Softwood Lumber Dispute" (May 2003) online (pdf): Canadian Institute of Forestry .
2. Canada, Global Affairs Canada, Softwood lumber (Ottawa: Global Affairs Canada, 2024) online: Softwood lumber.
3. Government of Canada, Exploring Border Carbon Adjustments for Canada (Ottawa: Government of Canada, 2023), online: Government of Canada.
4. Ibid.
The foregoing provides only an overview and does not constitute legal advice. Readers are cautioned against making any decisions based on this material alone. Rather, specific legal advice should be obtained.
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