THE EU'S PROPOSED CARBON BORDER ADJUSTMENT TAX (PART 1)

Cost Challenges Ahead Signal Inflationary Pressures

The European Union (EU) may soon push forward with a carbon border adjustment mechanism (CBAM) if it can ensure compliance with the World Trade Organization (WTO).

The EU parliament backed the CBAM proposal in March, and the European Commission is set to make a formal legislative proposal for a CBAM shortly. We anticipate that Parliament and the Commission will begin negations in the second half of the year.

If implemented, a CBAM would levy tariffs on carbon-intensive imports such as aluminum, cement, and chemicals imported into the EU. The tariffs would be linked to the cost of emission allowances under the current EU carbon emission trading system (EU ETS), effectively imposing the EU ETS globally on select industries that export to the EU. In this way, the CBAM tackles two interrelated issues for EU member states: encouraging other nations to increase their carbon reduction and distributing the burden of carbon reduction in difficult to decarbonize sectors globally.

Thinking through the impact of a CBAM is tricky but essential. We do not yet know the scope or framework for implementation. That said, our impressions to date are as follows:

1. It is not evident that a CBAM would be effective in reducing carbon leakage.

2. There is a real risk of continued trade flow deviations rather than decarbonization for the aluminum sector in the EU. Despite a growing global demand for aluminum, Europe has lost more than 30% of its primary production capacity since 2008 due to the indirect costs related to the ETS [1]. Furthermore, while aluminum imports may be more economically competitive than domestic production, the cost of a carbon tax is punitive even for low carbon producers.

3. CO² prices may prove to be inflationary and could undermine energy transition policies in severe scenarios. Furthermore, technologies that many expect to deflate in cost (solar PV, for example) may re-inflate.

4. An active CBAM may have unintended feedback loops should it inflate the cost of new energy technologies.

The aluminum industry is an excellent backdrop with which to evaluate the implications of a CBAM. EU aluminum imports make up 40% of total domestic consumption. 40% is considerably higher than cement (3% of consumption), steel (4% of consumption), and nitrogen (17% of consumption). [2]

The largest aluminum exporters to Europe are Russia, Mozambique, Canada, South Africa, and the UAE, accounting for 80% of the EU's total imports [3]. Of the EU imports in 2020, 1.2 Mt (45% of the total) depended on either captive, non-renewable sources of generation or non-renewable grid power. [4]

It is not evident that a CBAM would be effective in reducing carbon leakage.

Should a CBAM capture both Scope 1+2 emissions, it would be cost-prohibitive for a substantial portion of European imports (at least 45%), assuming costs are not passed down to the consumer. In theory, this should stabilize or even encourage an increase in domestic production. However, it is not likely that European producers re-capture the lost import tonnage. Roughly 80% of European smelters rely on grid power, which has fossil generation in some form, putting them at a disadvantage to many Canadian and Russian producers that utilize hydropower.

The current average global level of direct and non-direct energy emissions of aluminum production is 12.3 tonnes of CO² per tonne of aluminum. RUSAL, a prominent Russian producer that attributes ~50% of gross revenue to European sales, had an emission intensity of 2.2 tonnes of CO² per tonne of aluminum in 2019. [5] An 82% difference in carbon intensity relative to global averages.

One of the only producers in the EU with a comparable carbon footprint is Norsk Hydro, which utilizes extensive hydropower resources for electricity production in Norway.

It is telling that Norsk Hydro has come out publicly against a CBAM, citing the inability to address production capacity continuing to leave Europe. While we agree, the firm is also keenly aware that their profitability is in trouble should their free allowances be removed at the expense of a carbon price being placed on imports. Industries' position that a CBAM is not an adequate replacement of free allowances is understandable. Scope 1+2 emissions across global producers can vary dramatically, principally due to the electricity source powering the aluminum smelters. However, even for low carbon producers that can utilize hydroelectric power, removing free allowances and implementing carbon prices is costly. [6]

There is a real risk ahead of continued trade flow deviations rather than decarbonization for the aluminum sector in the EU. While aluminum imports may be more economically competitive than domestic production, the costs of a carbon tax are not trivial, even for low carbon production.

Both the US and China compete for aluminum from Canada and Russia, respectively. As a result, the EU ingot premium may need to substantially increase to divert flows away from the US and China to meet European aluminum demand.

A carbon tax on imports becomes a consumption tax on the consumer in a scenario in which carbon abatement is either not possible or excessively costly.

Below is a chart that maps the carbon intensity per tonne of aluminum, by producer, from 2015 - 2020. The dotted lines indicate the planned carbon reduction roadmap for producers that have made their targets public. The shaded blue area represents the 2015 Paris pledges, testing the alignment of company emission targets against the UN Paris Agreement goals. [7]

Figure 1: Carbon Intensity of Major Aluminum Producers

Should a Scope 1+2 import tax be implemented, RUSAL is in a comparatively strong position. EBIT margins for RUSAL over the last three years are ~6%. However, should the carbon price on imports be roughly equivalent to the EU ETS carbon price today, average EBIT margins would drop to -8.3%. At a $100 per tonne CO² price and zero-carbon abatement, margins drop to -22% unless costs are passed through to the consumer. This is an unsustainable cost profile for a major producer.

We should note that if EU ETS allowances are scaled back faster under an active CBAM, then the auction clearing price for carbon is likely only to increase, not decrease. A $100 per tonne price on carbon is very much in reach.

For producers that do not have access to hydropower, the prognosis under an active CBAM is grim. For example, Hillside Aluminum in South Africa (100% owned by South32) has roughly 6x the carbon intensity of RUSAL. Using the same scenarios as RUSAL, margins are unsustainable for prices less than $50 per tonne.

Interestingly, Hillside Aluminum has a slightly superior 3-year average EBIT margin compared to RUSAL when a carbon price is not applied. Over a more extended period, one could say that the two businesses have similar earnings margins. Hillside's carbon intensity, though, is 6.3x that of RUSAL. As a result, once a carbon price is applied, the similarities in the two businesses ' earnings power evaporates and the availability of free cash flow to invest back in the business changes dramatically.

If the less carbon-intensive capacity is not profitable and most domestic production is even less profitable, we find it unlikely that the EU can wind down domestic allowances. Should the EU choose to accelerate the removal of domestic allowances with a CBAM in place, EU aluminum prices will be forced to appreciate substantially. The price of aluminum may increase by ~40% under a $100 per tonne carbon price scenario. [8] If they appreciate to an equilibrium that compensates the average EU producer, it will likely attract export production back into the member states at the expense of the domestic output. In short, there is a significant quantity of non-EU aluminum production that is less carbon-intensive than domestic production. Any attempt to price carbon makes the EU less competitive than global producers all else equal.

Stay tuned for next week’s release that explores our final two conclusions on the inflationary impacts of CO² prices and the potential reinflation of new energy technology costs.

[1] Morgan Stanley, “EU Carbon Border Adjustment: A “Notional ETS”?”, May 2021

[2] Ibid.

[3] Eurostat.

[4] Captive, non-renewable sources of generation could include thermal coal while non-renewable grid power could include natural gas, by way of example.

[5] RUSAL Annual Report, 2020.

[6] To-date, the EU has attempted to prevent leakage by allocating free allowances to sectors at risk. While the EU views a CBAM as an opportunity to reform allowance allocation (a potential acceleration of the drawdown of free allowances), industry almost uniformly views the CBAM as a necessary addition to free allocation, not a replacement.

[7] The Transition Pathway Initiative uses the Sectoral Decarbonization Approach (SDA) which was created by CDP, WWF & WRI in 2015 and is also used by the Science Based Targets Initiative. For more information on SDA, please refer to “A method for setting corporate emission reduction targets in line with climate science”, May 2015.

[8] A base case price of $2,400 per ton, with ~ 9.7 kg of CO²per kg of Aluminum, raises the price to $3,370: a 40% increase.