A carbon tax constitutes a fiscal mechanism designed to regulate and reduce greenhouse gas emissions by imposing a levy on such emissions. This policy measure incentivizes businesses and individuals to adopt environmentally sustainable production methods and lifestyle practices. Its primary objective is to mitigate the adverse effects of climate change while advancing the principles of sustainable development. By integrating environmental stewardship with economic imperatives, the carbon tax framework seeks to reduce greenhouse gas emissions and facilitate a transition toward environmentally responsible and sustainable economic activities.

Since the 1990s, carbon taxation has emerged as a key legislative tool for combating climate change, with Nordic countries like Finland and Denmark pioneering its implementation to reduce fossil fuel consumption and promote sustainable development. The European Union (“EU”) advanced these efforts in 2005 by launching the EU Emissions Trading System (“EU ETS”), establishing a framework for trading carbon emission allowances. Subsequently, countries such as Japan, Australia, and Mexico enacted carbon tax legislation to address emissions. The global consensus on climate change mitigation has led to the widespread adoption of carbon tax policies, with nations like Singapore and South Africa introducing such measures in 2019.

In 2021, the European Commission launched the 'Fit for 55' package to align the EU's climate, energy, transport, and taxation policies with its climate goals, aiming to cut net greenhouse gas emissions by 55% by 2030 and achieve climate neutrality by 2050. On May 17, 2023, the European Parliament approved key elements of the package, including reforms to the EU ETS and the introduction of the Carbon Border Adjustment Mechanism (“CBAM”).

Framework of EU CBAM

The EU CBAM regulation imposes a levy on imports from carbon-intensive sectors, such as iron and steel, cement, fertilizer, aluminum, electricity, and hydrogen products, originating from jurisdictions that do not implement equivalent carbon pricing mechanisms. The regulation is aimed at addressing the risk of carbon leakage, which occurs when production is relocated to countries with less stringent carbon policies or when imports of carbon-intensive goods displace domestically produced goods.

The implementation of the EU CBAM is structured into two distinct phases:

1. Transitional Period (October 1, 2023 to December 31, 2025): During this phase, importers are afforded enhanced flexibility in fulfilling their reporting obligations concerning the direct and indirect greenhouse gas emissions embedded in their imports. Notably, there is no requirement for such reports to be verified by an independent and accredited verifier. Furthermore, importers are permitted to submit emission data based on estimations and are exempt from any financial payments or adjustments during this period.
2. Fully Operational Period (commencing January 1, 2026): From this date, only importers authorized under the CBAM framework will be permitted to import regulated goods into the European Union. Such importers will be obligated to purchase CBAM certificates. Furthermore, this phase marks the gradual phasing out of allowances previously available under the EU ETS, thereby significantly increasing CBAM-related costs in subsequent years.

The EU is expected to broaden the scope of CBAM to encompass additional downstream products and categories currently regulated under the EU ETS, such as ammonia, refinery products, organic chemicals, base organic chemicals, and polymers.

Impact of Carbon Taxes on Cross-border Imports

As the CBAM is applied based on emissions generated during the manufacturing of goods outside the EU, upon their export to the EU, Indian businesses may face a risk of diminished competitiveness due to the increased costs associated with this levy. Consequently, supply chains may need to be re-evaluated and adapted. To maintain competitiveness, companies must prioritize the rapid decarbonization of their operations and ensure they have access to accurate data in order to comply with the expanding CBAM emission reporting requirements.

The imposition of a carbon taxes by the importing countries could lead to a fundamental shift in supply chain management. Companies may need to reconsider their sources of raw materials, manufacturing processes, and transportation methods to reduce their carbon footprints. Moreover, businesses will have to invest in new technologies, data management systems, and emissions tracking mechanisms to ensure compliance with CBAM and other regulatory frameworks.

Importantly, the impact of these changes will be felt across the entire supply chain, from raw material suppliers to manufacturers to distributors. Each entity will need to adapt to the new requirements, which may involve rethinking long-established practices, sourcing decisions, and even market strategies. While these disruptions may present challenges in the short term, they also create significant opportunities for innovation, efficiency improvements, and enhanced sustainability practices.

In the long run, the CBAM and similar regulations are likely to shape the future of global trade by rewarding companies that can demonstrate environmental responsibility and penalizing those that do not align with sustainability goals. As such, businesses must be proactive in understanding the implications of these regulations and in developing strategies to navigate the challenges while capitalizing on emerging opportunities.

Implications for Indian Exporters

To import goods covered by the CBAM into the EU, importers are obligated to purchase CBAM certificates from the designated authorities in the member state where they are authorized to import. The CBAM certificates must correspond to the total embedded emissions associated with the imported goods. The price of these certificates is based on the average closing prices of EU ETS allowances, which are calculated weekly in accordance with EU ETS procedures on the common auction platform. This pricing mechanism effectively ensures that importers bear the equivalent carbon cost that would be applicable if the goods were produced within the EU.

Consequently, EU importers are required to obtain data on the embedded emissions of the imported goods. If the importer or an affiliated entity operates the facility producing the goods, the information on embedded emissions may be directly available. In the absence of such direct access, the importer must procure the data from a third-party registered operator or facility located in a non-EU member state. Should the third-party operators or facilities be registered with the relevant CBAM authorities, information on the embedded emissions may be obtained through a centralized database.

While the CBAM primarily governs the importation of goods and imposes compliance obligations on EU importers, its implications are anticipated to extend significantly to Indian businesses, given the substantial trade volumes between India and the EU. The degree of impact is expected to vary across industries and sectors, with certain products being more vulnerable to CBAM due to their inherent characteristics and the manufacturing processes utilized. Beyond the associated financial and regulatory challenges, CBAM could incentivize Indian businesses to adopt more sustainable practices in line with global environmental standards. Furthermore, it may serve as a precursor to the potential introduction of domestic carbon taxation policies in India.

Steps for Transitioning to Carbon Tax Regime

Against the complex and evolving framework of carbon pricing, energy taxes, and related regulations, it is crucial for businesses - such as manufacturers, traders, importers, and exporters of goods subjected to the carbon tax - to promptly prepare for their impact. To effectively navigate the evolving carbon tax landscape and its potential impact, we recommend the following future-focused actions:

1. Continuous Monitoring and Evaluation: Organizations should regularly assess whether their goods or raw materials fall under carbon tax regulations by reviewing customs data, purchase invoices, bills of entry, business models, and logistics flows. It is essential to keep internal controls and forecasting systems up to date to reflect potential changes in the carbon tax regime, including new products and jurisdictions. Continuous monitoring will help businesses remain agile and respond quickly to any regulatory changes.
2. Forecasting Financial Impacts: Companies should integrate potential costs related to CBAM certificates into their financial planning. This includes modelling different scenarios for future carbon pricing under the ETS. By forecasting these costs, organizations will be better prepared for the financial impact of CBAM.
3. Enhancing Supply Chain Efficiency: Given the potential financial burden of CBAM and other carbon taxes, businesses should seek opportunities to improve supply chain efficiency while aligning with decarbonization goals. This may include adjusting sourcing strategies or collaborating with suppliers who have lower carbon footprints. Organizations should also evaluate how CBAM-related costs might affect customer pricing and adjust procurement strategies accordingly. Special attention should be paid to carbon intensity in sourcing and ensuring suppliers can provide accurate data for CBAM compliance.
4. Ensuring Data Accuracy: It is crucial to ensure the completeness and accuracy of the data provided by suppliers. Implementing a comprehensive data validation process will help demonstrate due diligence and support internal controls. Additionally, organizations may need to conduct vendor due diligence and other verification measures to ensure the reliability of CBAM-related data.
5. Managing Carbon Pricing Information: If the country of origin of CBAM goods has a carbon pricing system in place, businesses should implement processes to gather the required data for CBAM declarations. This will help prevent the risk of paying carbon costs twice and ensure compliance with CBAM regulations.
6. Assigning Responsibility for CBAM Certificate Management: A designated team or department should be responsible for the ongoing purchase and annual surrender of CBAM certificates, as required by EU regulations starting in 2026.
7. Establishing CBAM Governance Framework: As CBAM involves multiple stakeholders from different business functions, it should be incorporated into the broader corporate risk management framework. This includes defining roles, responsibilities, processes, and internal governance structures. Proper documentation will demonstrate that the business is diligently managing CBAM compliance.

Conclusion

The global drive for climate action is anticipated to result in the implementation of similar policies across other regions. The United Kingdom is poised to introduce the world’s second CBAM regime, following the EU, thereby contributing to a more interconnected and sustainable global economy.

The message to Indian entities intending to maintain exports to the EU or other jurisdictions implementing CBAM is unequivocal: they must promptly assess whether they possess the requisite emissions data, including, where applicable, emissions data for their upstream supply chain, as required by their customers in CBAM jurisdictions. In the absence of such data, immediate measures must be taken to establish a more comprehensive data collection process than is currently in place. With the obligation to report actual embedded emissions data, it is imperative that these actions be undertaken without delay.

In several instances, this will necessitate modifications to purchase contracts to ensure that suppliers are legally required to provide the necessary emissions data. Additionally, exporters must invest in the education and upskilling of their downstream partners to ensure compliance with emissions calculation and data-sharing requirements. Special consideration should be given to entities operating in sectors impacted by competition law, as such regulations may impose restrictions on the sharing of information.

The collection and provision of the requisite data to EU customers for inclusion in their quarterly CBAM reports represents an initial obligation. This is not a one-off duty but an ongoing requirement. It necessitates the establishment and maintenance of a robust, repeatable data collection and reporting process, which will have significant implications for supply chain management, third-party contracts, and internal governance structures.

This insight has been authored by Ajinkya Gunjan Mishra and Avani Tewari from S&R Associates. They can be reached at [email protected] and [email protected], respectively, for any questions. This insight is intended only as a general discussion of issues and is not intended for any solicitation of work. It should not be regarded as legal advice and no legal or business decision should be based on its content.