EU industry currently often pays for EU Emissions Trading System (EU ETS) carbon costs twice: Once for their direct installation emissions (the part not covered by free allocation), and a second time for the carbon costs that get passed through by electricity producers. While free allocation (FA) is a harmonized carbon leakage tool given to direct installation emissions, the EU ETS Directive’s Article 10 introduced indirect cost compensation (ICC) as a non-harmonised, voluntary carbon leakage measure to allow EU Member States to compensate heavy industries for indirect ETS costs.

In EU member states that apply ICC, the mechanism generally works in an effective, simple and predictable manner, reducing competitive disadvantages. That said, the current ICC system leads to three major issues:

1. Firstly, it is not harmonised across the EU, as only 14 out of 27 Member States decided to use it to varying degrees (some provide partial compensation, some full). This leads to competitive distortions between EU Member States and leaves industries in the 13 EU Member States without ICC exposed, basically penalising producers from these countries twice.
2. The ICC is granted based on total electricity consumption, including fossil-based power, meaning the current ICC partially serves as a fossil subsidy.
3. To prevent the risk of double protection under the WTO, the Carbon Border Adjustment Mechanism (CBAM) currently excludes the indirect emissions from most covered sectors because these sectors receive ICC. However, because ICC is not used by 13 EU member states, this double protection argument does not apply to industries in these countries.

To elaborate on the third issue, omitting indirect emissions from CBAM comes with two further issues:

1. If indirect emissions are not covered by CBAM, imported goods avoid full carbon pricing, which is concerning as electricity-related emissions account for a major share of the carbon footprint of these sectors in non-EU countries – up to 70% of total emissions for aluminium (IEA, 2023) and 95% for EAF steelmaking (JRC, 2022). The issue is worsened by the fact that the average grid emission intensity is significantly higher in non-EU countries than within the EU. This omission therefore distorts the level playing field, penalises EU cleantech manufacturing and undermines the CBAM’s climate credibility.
2. This exclusion of indirect emissions lowers incentives for third countries to invest in fossil-free energy, which goes against the CBAM’s goal to promote decarbonisation abroad.

At the same time, merely including indirect emissions in the CBAM scope is not sufficient for a level playing field. This is due to the EU’s marginal pricing mechanism on the short-term electricity market, where the market price is determined by the last and most expensive producer needed to meet demand, usually a fossil fuel plant. Power purchasing agreements (PPAs) are often pegged to the market spot price, so even if an industrial producer procures 100% fossil-free electricity through such a PPA, it continues to be exposed to an electricity price that includes a high carbon cost.

Therefore, EU industries often pay for a carbon cost embedded in the electricity price that is larger than the actual carbon intensity of the electricity production in the EU member state. This will put them at a competitive disadvantage vis-à-vis non-EU producers if they electrify production. Even as more renewables are integrated into the grid, neither household nor industrial electricity consumers stand to benefit any time soon, as the European Commission’s Joint Research Center (JRC, 2023) estimates that fossil fuels will still be setting the price 86% of the time in 2030.

Bringing ICC and indirect emissions together

The Business for CBAM Coalition believes there is a way to include indirect emissions under the CBAM while keeping part of the ICC. For this to happen, some are proposing to change the methodology of the ICC. In a nutshell:

• First, tailor the ICC methodology so that support should only be given to the share of fossil-free electricity that is exposed to carbon costs due to the EU’s electricity market design. Doing so allows indirect emissions to be phased into CBAM on the part of electricity that is produced with fossil fuels. It is also in line with the Polluter Pays Principle, where electricity producers and consumers should continue to bear the cost of emissions from fossil-based electricity. This would also improve the incentive to switch to fossil-free electricity.
• After revising the ICC methodology, aim to include indirect emissions for all sectors in the CBAM scope as of 2027. To prevent circumvention risks (e. an importer claiming indirect emissions originate from renewable rather than fossil-based electricity), the CBAM should continue to exclude the use of market-based specific emission factors such as Guarantees of Origin (GoOs) and Renewable Energy Certificates (RECs). These instruments allow non-EU producers to use fossil fuels but buy cheap GoOs and RECs on the global market, to then claim the energy source is fossil-free or renewable. Continuing to reject GoOs and RECs ensures a strong environmental integrity of CBAM by ensuring that only verifiable, plant-level emissions data is used to assess indirect emissions. If actual data is not provided, then punitive default values should be applied.
• At the same time, work to harmonise ICC across the EU through a targeted revision of the EU ETS State Aid Guidelines. Revising the ICC by making sure it is implemented in the same way across the EU would prevent intra-EU distortion This would enable industries in all Member States to equally benefit from this scheme and boosting industrial competitiveness across the EU.

These three things would be in line with the Commission’s assessment in the Steel and Metals Action Plan to work towards adequate post-2030 ICC measures, ensuring coherence with other means to address carbon leakage.

The Business for CBAM Coalition believes that while it is important to address the inclusion of indirect emissions and other outstanding CBAM issues, these discussions must not delay the implementation of CBAM’s financial obligations starting in 2026. A timely entry into force of the financial phase is essential to ensure predictability for industry and maintain credibility in the EU’s carbon market.

We continue to develop our thinking on significant CBAM issues, and stand ready to continue the discussion with the European Commission.

About the Business for CBAM Coalition

The Business for CBAM Coalition brings together businesses and business associations committed to upholding the ambitions of the Carbon Border Adjustment Mechanism (CBAM) and consequently of the EU Emissions Trading System (ETS). These policies are essential – not only for the EU’s path to cost-effective decarbonisation, but also for securing the long-term competitiveness of European industry in a rapidly evolving global economy.

Contact the secretariat via info@businessforcbam.eu

EU Transparency number: 666080999148-47