CBAM could increase the cost of delivered steel to the EU by about 56% and 49% for India and China, respectively, by 2034Climate change as an unusual externality demands collective, global action. Hence, when the global community fails to act collectively, taking meaningful action individually can put a country or region at a significant economic disadvantage through carbon leakage. Specifically, businesses from countries with no or lax emission constraints, all other things being equal, may benefit from trading internationally at lower costs in comparison to those from countries or blocs taking meaningful action on reducing emissions, such as the EU. The EU’s Carbon Border Adjustment Mechanism (CBAM) is the EU’s response to this challenge. It is a policy tool designed to address carbon leakage by imposing a carbon price on imports from countries with climate policies less stringent than those of the EU. It combines both regulatory and market-based elements to level the playing field for EU businesses that must comply with EU-ETS regulations while encouraging global adoption of more ambitious climate measures. CBAM started in 2023 with a transitional phase focusing on reporting requirements. Implementation, including financial penalties, is expected by 2026 and full implementation by 2034.153 The revenue generated from CBAM, which will be based on EU-ETS prices, could be substantial, with potential uses for funding both mitigation and adaptation efforts within and outside the EU.154 Specifically, these revenues could be allocated to support the transition to low-carbon technologies, fund climate resilience projects or contribute to global climate finance, particularly aiding developing countries under the principle of CBDR-RC.155 The implementation of the CBAM faces several critiques and challenges, both within the EU and internationally. One of the primary concerns for European producers is the potential increase in production costs due to the need to account for the carbon content of imports.156 This could, perversely, put some European producers at a competitive disadvantage relative to producers in countries with more lenient carbon regulations. Additionally, the administrative complexities associated with CBAM – such as the precise calculation of the carbon content in imported goods and navigating intricate reporting requirements – could impose further financial and logistical burdens on businesses.157,158 Internationally, the CBAM has been criticised for its potential to exacerbate trade tensions, particularly with countries that view the mechanism as a form of protectionism. Critics argue that CBAM could be perceived as a unilateral EU measure and lead to retaliatory trade measures from other countries.159 Additionally, there are concerns about the compatibility of CBAM with World Trade Organization (WTO) rules, particularly regarding non-discrimination principles.160,161 The mechanism could be seen as a violation of WTO agreements if it is perceived to unfairly target imports from specific countries or disrupts free trade. Wood Mackenzie, a data analytics company, estimates that CBAM could increase the cost of delivered steel to the EU by about 56% and 49% for India and China, respectively, by 2034.162 CBAM also raises various sectoral concerns, especially for industries that are heavily reliant on carbon-intensive processes. Key sectors targeted by CBAM, including steel, aluminium, cement and fertilizers, are particularly anxious about the increased costs associated with compliance.163 These industries already face MRV challenges under the EU-ETS, and the additional burden of the CBAM could further strain their competitiveness in global markets. For instance, CBAM will increase production costs in the steel and aluminium sectors, potentially making them less competitive against producers from countries with more lax environmental regulations when trading with a third country.164 Moreover, the cement industry has raised concerns regarding the accuracy and fairness of carbon content calculations, which are crucial for determining the carbon price on imports.165 There is also apprehension about how CBAM will interact with existing measures such as the EU-ETS, which already imposes non- negligible costs on these sectors.166 The sector lobbies argue that without adequate protection or compensation, such as free allowances or rebates, CBAM could inadvertently lead to more carbon leakage, where production shifts to countries with less stringent climate policies, undermining the EU’s environmental goals. While these concerns are valid, there is also the potential that the sheer size of the EU’s single market will lead to the bloc’s emergence as the principal climate policy-maker through the implementation of CBAM. Carbon content will become a vital component of international trade, forcing producers to reflect the abatement costs of GHG emissions in their prices. As the cost grows, higher-emitting producers will find the EU a less economically attractive trading destination,167 thus providing an opportunity for low-emitting producers to capitalize and compete for market share. In the long run, as EU demand for low-emitting products rises, high emitters will be incentivized to decarbonize their products. CBAM thus holds some promise as an instrument for addressing the unusual externality that is the core driver of the climate finance gap.3.3 Carbon Border Adjustment Mechanism (CBAM) Bridging the Gap: How to Finance the Net-Zero Transition 24

Bridging the Gap How to Finance the Net Zero Transition 2025