The UK plans to introduce a Carbon Border Adjustment Mechanism (CBAM) tax in 2027, imposing tariffs on high carbon imports. It will be similar to the EU’s CBAM, but comes a year later.

Once the tax is in place, the government says it will raise UK emissions costs. While the border tax protects domestic markets, exports could suffer. The European Union is planning to widen the Emissions Trading System (ETS) to include sectors like housing and transport and the UK is likely to follow suit.

To speed up decarbonisation, customers must move from emitting energy sources to cleaner options. The EU and UK have attempted to encourage such a move by establishing ETSs, imposing explicit carbon costs on the largest emitters.

From that fairly simple idea, a complicated plan to impose tariffs on imported goods has emerged. The aim is to protect domestic sectors that have to pay for carbon, via an ETS, while also competing with foreign goods.

Free allowances mean ETS costs are minimal in energy-intensive sectors outside power generation, largely due to international competition. But that is likely to change once the border tax is in place.

Carbon costs

UK carbon prices are low, with the December 24 contract around £37 per tonne of CO2e in early October. This is down from a peak of around £70 per tonne of CO2e in 2021, shortly after it split from the EU ETS.

In early October, bearish sentiment grew after the government proposed extending its current system of free allowances by one year. This would align with the planned border tax introduction.

The UK ETS was generally higher than the EU ETS from its launch until mid-2022. Since that point, European levels have been higher. On October 17, the EU ETS prices were just over 63 euros (£52) per tonne of CO2e. The UK also has a carbon price support mechanism, which closes the gap with the EU price.

While the ETS has helped the UK reduce coal use in power generation, the low UK price for wider industry (including free allowances) reflects more of a carrot than stick policy. The previous Conservative administration, led by Rishi Sunak, continued this approach and Prime Minister Keir Starmer has shown few signs of diverging on the ETS.

This contrasts with the strict government approach to upstream oil and gas. This could risk supporting demand on the one hand, while domestic supply falls.

Cutting handouts

Once the border tax is in place, the government plans to cut free certificates and reduce their overall number. This will pressure industry to reduce GHG emissions. Sectors will be protected from cheap higher carbon imports by the border tax.

“Currently, the UK ETS price is not putting many UK businesses at a disadvantage compared to imports,” said Chimdi Obienu, senior research consultant in carbon markets at EcoAct.

“The exact share of allowances received for free is based on the emissions performance of the facility against industry-specific benchmarks, but many installations have limited ETS costs beyond those required for emissions monitoring, reporting and verification,” he said.

Power generators do not get free allocations because they are not competing globally. “Therefore, the UK ETS price is mainly determined by what electricity producers are willing to pay for allowances.”

For the time being, the government has made clear that free allowances will continue.

Obienu added that UK ETS costs were limited by a surplus of emissions allowances. The ETS authority is addressing this to help “increase its effectiveness as a decarbonisation tool”. ETS allowances will reduce by 45% between 2023 and 2027, in line with the UK’s net zero ambitions.

UK CBAM

The government plans to implement a UK border tax or CBAM by 2027. The price will be based on the GHG emissions intensity of the imported good and the gap between the carbon prices in the country of origin (if any) and the UK. CBAM liability will lie with the importer.

It will affect emissions-intensive industrial goods imported to the UK from the aluminium, cement, ceramics, fertiliser, glass, hydrogen, iron and steel sectors. The tax will apply to Scope 1 and 2 emissions and ensure comparable coverage with the UK ETS, which will be lower than the headline UK ETS price to reflect domestic free allowances.

Obienu said the border tax would “allow the UK ETS to function more effectively by reducing the risk of carbon leakage, thereby enabling regulators to phase out the provision of free allocation to domestic entities.”

Eventually, all sectors under the ETS will pay for all their emissions. The UK CBAM will protect domestic industry from cheaper imports with higher GHG emissions.

*Announced in 2023, the Yara Eyde will be the world’s first container ship to use clean ammonia as fuel.*

International disadvantage?

A UK CBAM does not solve all the problems for domestic industry.

“While a carbon border tax would price the emissions from the production of goods imported into the UK, those same emissions will not necessarily be priced when UK goods are sold in other markets,” noted Obienu. UK goods may still face lower cost, higher GHG goods.

“The EU is facing this issue – carbon border taxes supporting domestic firms at home but not internationally,” as it implements its CBAM, he added.

The only solution is for other countries to adopt carbon pricing and compatibility.

The EU CBAM covers cement, iron and steel, aluminium, fertilisers, electricity and other industries. The group will phase it in gradually.

A transitional period began on October 1, 2023. During this time, importers must report emissions data but not yet pay the adjustment fees. Full implementation will begin in 2026. Other sectors being considered include glass, chemicals, pulp, paper and textiles.

Industry groups and analysts suggest the EU may need to consider additional mechanisms, like export rebates, to ensure CBAM addresses carbon leakage effectively.

But Obienu said this must comply with WTO rules. “The UK will eventually face the same questions as it develops its own carbon border tax system.”

Michael Barlow, partner at UK law firm Burges Salmon, welcomed a UK CBAM by 2027.

“However, by introducing the UK CBAM a year later than the EU this could potentially lead to an influx of high-emission products in the UK market, if producers in regions like Asia and the Middle East seek to avoid the EU’s CBAM.” To mitigate this, some industry leaders suggest advancing the UK CBAM to 2026.

Following expansion

This year, the EU expansion starts with maritime emissions under the Effort Sharing Regulations (ESR) for large ships operating within the EU and those docking at EU ports. Emissions from road transport and buildings will also be managed under the ESR, starting in 2025 or 2026.

From 2026, the EU, like the UK in 2027, plans to phase out free allowances for certain sectors. The ETS will tighten to help achieve the group’s 55% emissions reduction target by 2030. Beyond that, the EU aims to have a comprehensive carbon pricing system for all major sectors by 2050.

The UK is likely to follow suit. “As of now, the UK government is actively reviewing the UK ETS to enhance its effectiveness and potentially expand its coverage, including maritime transport and road transport and buildings,” it has said. “Similar to the EU, there are considerations to develop a separate mechanism for these sectors.”

Barlow said expanding the scope from power generation, industry and domestic aviation to include housing and transport “is arguably becoming necessary if the UK is to achieve its legally binding target of net zero by 2050.”

However, he noted that implementing an explicit carbon price in these sectors is politically challenging. “Balancing carbon pricing with other policies and regulations will be crucial to ensure equitable and effective decarbonisation.”

Businesses should “integrate the development of the UK CBAM and ETS into their future plans. This involves assessing the impact on their supply chains, engaging with suppliers to reduce emissions, investing in low-carbon technologies, and incorporating potential costs into financial planning,” he said.

Government support

As prices rise, the use of hydrocarbons will become more expensive, forcing companies to shift to alternatives.

“This level of decarbonisation among regulated industries will require further government support to promote innovation and bring emerging green technologies to scale,” Obienu said. “For example, airlines urgently need more affordable and practical Sustainable Aviation Fuel (SAF) to reduce their emissions.”

This would help companies reduce emissions, decreasing demand for UK ETS allowances and moderating the carbon price.

“As regulated entities often pass their carbon costs through to consumers, government support for the innovation and deployment of low-carbon technologies can help keep product prices down for buyers further along the value chain, including households,” noted Obienu.

As a result, government will face choices around how to share the burden between private industry, consumers and the state.

Greater state support for low carbon options would benefit Britain’s long-term economy, according to Oliver Chapman, founder and CEO of OCI Group.

“If the government applies policy, which supports the move to Net Zero, then it is in effect helping to create a supply chain – or UK orientated ecosystem – which could provide the UK with a significant competitive edge,” he said.

However, “there may be a short-term cost to these policies … but many of the savvier businesses, which have a long-term plan, are in any case adopting the policies the UK government is trying to encourage.”

Barlow said that as ETS carbon prices rise, government support will be necessary to mitigate the impact on electricity prices and prevent carbon leakage.

“The government continues to support industry decarbonisation through various funds and investments, such as the Industrial Energy Transformation Fund and the Net Zero Innovation Portfolio,” he added.

Effective and encouraging

The ETS has significantly reduced power sector emissions over the past decade. This should extend to other industries with border taxes and the removal of free allowances.

“The EU and UK ETS schemes are widely considered the most effective market-based instruments to push industrial decarbonisation at the scale and speed required to fight climate change effectively,” said Obienu.

In addition, they are encouraging the adoption of carbon pricing elsewhere. “Another facet of carbon border taxes is that goods imported from countries with their own carbon pricing mechanisms in place will face lower costs than goods imported from countries where emissions are not priced at all.” This will encourage other countries to set up their own carbon pricing mechanisms.

“Evidence suggests the EU CBAM has already been effective in accelerating discussions on the implementation of carbon prices in countries like Turkey, for which the EU is a major export market for emissions-intensive goods,” said Obienu.

CBAMs of the world unite

Barlow said the UK and EU ETS schemes, along with carbon border taxes, certainly created financial incentives for businesses to adopt sustainable technologies.

“However, the success of these schemes will depend on their design, implementation and international co-operation,” the Burges Salmon partner said. “Ensuring comprehensive coverage, robust enforcement and balancing environmental and economic goals will be key to their effectiveness.”

A UK CBAM will help align the country with the EU. Matching the sector-by-sector approach should keep this trading relationship in line and focused on the grander target of net zero emissions by 2050.

Adapting to these plans, and the timing slip between the UK and EU, will pose challenges to companies.

But it is the direction that the world is heading. The UK and EU are driving forwards CBAM plans, but others are following. Canada has talked of one and this was a topic of discussion in 2023 amid energy exchanges. There are also various plans for a CBAM in the US, despite a domestic carbon price.

A CBAM is an effective tool for government planners to drive change. Global alignment on such a carbon mechanism could help tackle the big problems, but also drive innovation and provide new revenue sources for governments to support decarbonised energy plans.

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