Levelling the Playing Field for Carbon Emissions

If your country of operation has strict limits or severe costs associated with carbon emissions, why not manufacture your carbon intensive commodity in a different jurisdiction and ship it over? It might mean even higher emissions once transport is factored in, but it might also mean higher margins.

It’s simple economics, but companies that continue to produce in countries imposing domestic sanctions on high carbon emissions understandably find it less than amusing. The proposed solution by the European Union is the Carbon Border Adjustment Mechanism (CBAM), an instrument designed to level the playing field, ensuring that there is no cost advantage, from a carbon perspective, for European companies to import from outside of the EU versus buying domestically.

Our latest white paper, Levelling the Playing Field for Carbon Emissions, provides an introduction to the CBAM and EU carbon policy background, as well as case studies of three aluminium manufacturing companies based both inside and outside the EU. It also explores the potential unintended outcomes of CBAM in relation to policy avoidance, and social, political and geopolitical impacts.

CBAM was created, in part, to prevent what is known as ‘carbon leakage’, which is the concept of companies moving high-emitting facilities out of the EU to avoid being captured by the EU Emission Trading Scheme (EU ETS). The EU ETS is a market for high-emitting sectors to buy and trade carbon emissions allowances within the European Union and has become a cornerstone of the union’s decarbonisation strategies under the European Green Deal.  To mitigate the risk of carbon leakage, the EU has historically provided free carbon allowances to certain high-emitting industries.  However, with the adoption of the ‘Fit for 55’ package, the EU aims to phase out free allocation of allowances, potentially increasing the risk of carbon leakage.

To address this risk and encourage global adoption of similar carbon policies, the European Commission launched the CBAM. The CBAM aims to put a fair price on the carbon emitted during the production of carbon-intensive goods that are bought within the EU for high emitting sectors. There are six sectors captured in the first phase, notably cement, iron & steel, aluminium, fertilisers, electricity and hydrogen. Exporters to the EU will be required to report their carbon emissions, and EU importers will purchase carbon certificates based on this information. The price of these certificates will be determined by the weekly average EU ETS price. The CBAM, which will be phased in at the same pace as the EU ETS free allowance phase out, will mean that there is no longer a price advantage for exporters into the EU versus domestic producers that must pay carbon costs resulting from the EU ETS.

Our paper provides case studies of three aluminium manufacturing companies: Hydro ASA, South32 and Rio Tinto.  These case studies demonstrate how different companies in the same industry are uniquely positioned to respond to the CBAM.  Factors such as geographic and materials exposure, business model, carbon intensity, and preparedness for the climate transition determine whether the CBAM presents a risk or opportunity to these companies.

The paper also explores potential unintended outcomes at the systems level such as policy avoidance and social, political and geopolitical consequences. More specifically it discusses potential relocation of facilities, rerouting of trade flows, exploitation of ‘loopholes’, rising social and political tensions with knock on impacts for climate policy, and global trade retaliation, limiting climate progress.

By attaching a price to the negative environmental costs of carbon emissions, we see potential for the CBAM to be a catalyst for a global decarbonisation. While the pathway is expected to be bumpy, this could provide an important signal to companies and countries to accelerate their transition to a low carbon economy.

Professional investors only.

The report has been co-authored by the investment team at J O Hambro Capital Management Limited (“JOHCML”), which is authorised and regulated by the Financial Conduct Authority and is registered as an investment adviser with the SEC. Registered office: Level 3, 1 St James’s Market, London SW1Y 4AH. Issued in the European Union by Perpetual Investment Services Europe Limited (“PISEL”) which is authorised by the Central Bank of Ireland. Registered office: 24 Fitzwilliam Place, Dublin 2, Ireland D02 T296. Issued in the United States by JOHCM (USA) Inc. (“JOHCMU”).  References to “JOHCM” below are to either JOHCML or PISEL as the context requires. Perpetual Group is a trading name of JOHCML and PISEL.

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