Carbon Border Adjustment Mechanism (CBAM) aims to mitigate carbon leakage and level the playing field from a cost of carbon perspective. It is designed to deter carbon-intensive processes and promote greener practices.

The legislative process started covering value chains that the EU considers to be at the greatest risk of carbon leakage based on carbon and trade intensity with potential expansion of the scope of CBAM to include organic chemicals and plastics. The chemical industry is much more complex than industries already covered by CBAM hence the ability to implement, manage and operate a mechanism for the chemical industry requires multifaceted considerations.

In this article, we will showcase the fertilizer industry as one of the sectors that stand prominently at the intersection of CBAM and global trade, with urea taking a central role. The question is how does CBAM impact producers outside the EU and does it represent a threat or an opportunity for the GCC.

What is CBAM?

The Carbon Border Adjustment Mechanism (CBAM) is a European Union (EU) policy designed to combat carbon-intensive practices and promote environmentally friendly methods. Its primary purpose is to prevent “carbon leakage” by applying a carbon cost to carbon-intensive goods on import on the emissions released during production. Industries in the EU are subjected to regulations and measures to reduce their carbon emissions. As a result, industries could relocate their operations to countries with less stringent or no emissions reduction measures, where they can produce goods more cost-effectively but potentially with higher emissions and EU products get replaced by more carbon-intensive imports, resulting in carbon leakage.

CBAM will initially be implemented on value chains that the EU considers to be at the greatest risk of carbon leakage. These encompass the sectors iron and steel, cement, fertilizers, aluminium, electricity, and hydrogen. These specific sectors have been singled out due to their substantial greenhouse gas emissions and their significant role as import sources into the EU. As CBAM’s scope expands, it will likely encompass additional industries that exhibit similar characteristics and risks of carbon leakage.

The CBAM taxation will start in 2026, following a phased approach that kicks off with a transition period which started in October 2023. During this transitional phase, importers will be required to report emissions linked to their imports to give them time to become accustomed to the policy.

CBAM has been designed to mirror the existing EU Emissions Trading System (EU ETS), maintaining consistency in carbon pricing and free allocations. This alignment is crucial to ensure compliance with World Trade Organization (WTO) regulations. Importers subject to CBAM will need to purchase emission certificates, akin to participants in the EU ETS, as part of their compliance obligations.

CBAM and Fertiliser Industry

The fertiliser industry, with urea taking a central role, stands prominently at the intersection of CBAM and global trade. In this article, we will focus on urea, given the Gulf Cooperation Council’s (GCC’s) substantial export volume of over 17 million tons annually, and Europe’s significant imports of up to 4 million tons each year, as depicted in the accompanying figure. Europe’s growing dependence on urea imports to meet its nitrogen demand underscores its magnitude in the context of CBAM. Urea emerges as the most likely fertiliser to be exported from the GCC to the European Union and be affected by CBAM. Consequently, it serves as a logical choice for a case study, allowing us to delve into the intricate dynamics of carbon pricing, trade, and environmental policy in this context.

Examining the competitive terrain in the European market, the dominant importers into the EU are North African nations, primarily Egypt and Algeria, as well as Eastern Europe, with Russia playing a significant role. At present, GCC is not a major exporter to Europe with generally higher netbacks on offer in Asia Pacific, but this could change in the future. In the urea case study, we have evaluated CBAM’s effects on the European Union, GCC, North Africa, and China. China has been included as its coal-based capacity which adds another complexion to the study.

EU-ETS and CBAM Development

It is important to understand the emission trading scheme and how it will develop as CBAM is the superseding carbon leakage mechanism. Free allocations are being phased out with CBAM phase-in.

EU ETS is a cap-and-trade system for GHG emissions allowances that can be traded between entities covered under the ETS. Under EU ETS, large industrial assets must hold the necessary European Union Allowances (EUAs) for its emissions. Assets operating in the EU are allocated a number of Free Allowances (FA) by the government and the remaining have to be purchased at auction or on the secondary market. One European Union Allowance (EUA) unit gives the holder the right to emit one ton of CO₂ or the equivalent. Number of allowances within EU ETS are capped and decrease every year to ensure total emissions fall. In most cases, free allowances are determined by a product-based benchmark. In the case of urea, it is defined by the ammonia benchmark, which is based on the average GHG intensities of the top 10 percent lowest emitters.

The EU-ETS emissions cap, the total number of available allowances, is set to dramatically decrease, effectively halving by 2030 in alignment with the EU’s “Fit for 55” emissions targets. This shift implies that the reduction in total emissions will now drive a reduction in free allowances, overriding the influence of the benchmark-based allocation.

Under the regulation, CBAM will gradually be phased in over an 8-year period until 2034, which means that free allocations must phase out across the same period for the covered sectors. The CBAM phase-in rate is defined by the regulation and can be combined with the EU ETS free allocations phase out to approximate a combined free allocation phase out profile in the fertilizer value chain. By 2030, it is anticipated that over 60 percent of free allocation allowances will effectively vanish, with the complete elimination of free allocations expected by 2034. This rapid change in the free allocation will result in significant changes to the cost environment in the EU with particular implications for the downstream agricultural sector.

For the average EU fertiliser producer, these reductions in free allocation result in significant cost increases. Assuming a constant carbon price of US$100 per ton and no improvements in emissions intensity, the tax burden on the average EU producer is set to increase from approximately US$ 30 per ton of urea to US$ 80 per ton by 2030 and over US$ 120 per ton by the end of 2034. This translates to an astounding tax increase of over 300 percent, as depicted in the figure below.

In reality, carbon prices are also expected to rise, amplifying the cost of fertilizer in the EU even further. The inevitable outcome is that European fertilizer prices will likely diverge from global counterparts, creating a scenario where EU farmers face increased expenses.

The Opportunity for GCC

The European fertiliser market is on the brink of a transformation into a high-cost environment as free allowances are phased out, and CBAM is introduced, so how can the GCC take advantage. The GCC plant displayed in the figures below has been modelled as a “best in class” unit with a carbon intensity aligned to the best 25th percentile in the European Union. The figure illustrates the average cash cost[i] of urea production plus carbon tax for the EU, GCC, North Africa (NA) and China under three distinct CBAM scenarios including a present scenario which represents the current position in the market (US$ 100 / ton of CO2 eq), a theoretical scenario where free allocations have bene phased out but CBAM hasn’t been introduced (US$ 200 / ton of CO2 eq) and finally a scenario which represents the future where CBAM has been fully implemented (US$ 200 / ton of CO2 eq).

CBAM’s introduction levels the playing field in the European market when compared to the theoretical scenario where CBAM isn’t introduced. CBAM does not improve the competitiveness of EU assets; consequently, previously uncompetitive assets continue to face challenges in this new landscape.

The phase-out of free allowances, coupled with increased carbon prices is expected to give best in class GCC assets with competitive advantage in Europe rather than a disadvantage. The advantage for GCC producers is rooted in their modern, energy-efficient production facilities which can produce lower carbon intensity fertiliser which will pay lower carbon taxes compared to the older assets in Europe.

[i] Cash cost (of production) includes raw material, utilities and fixed costs on

Conversely, Chinese coal-based urea capacity emerges as significantly uncompetitive in the European market under CBAM. These Chinese assets would be burdened with carbon taxes three times higher than their European counterparts. In essence, CBAM serves as a formidable barrier, effectively preventing high carbon intensity coal-based fertilizers from entering the EU market.

The phase-out of free allowances in the European Union indeed poses a significant challenge to the competitiveness of EU exports, particularly in the field of nitrogen fertilizer production. Currently, the EU exports approximately 13 percent of its commodity nitrogen fertilizer production, and it plays a dominant role in the calcium ammonium nitrate (CAN) market, accounting for 60 percent of international trade in this fertilizer.

Analyzing the competitive landscape in the context of CBAM implementation and free allocation phase-out reveals intriguing insights. The figure below illustrates the average export competitiveness of EU capacity and the GCC currently and following the complete phase-out of free allocations.

What becomes evident is that CBAM, in its current form, does not offer protection for EU fertilizer exports. Instead, the phase-out of free allocations is expected to result in a substantial loss of export competitiveness for EU players. GCC players have a unique opportunity to explore and potentially invest in markets such as CAN, where Europe holds a major production hub and influences global prices. Investing in CAN markets could yield favourable netbacks compared to other fertilizers, offering a strategic advantage. Moreover, GCC players are poised to enjoy a significant competitive edge over EU counterparts in these markets, even before considering the feedstock advantage.

For European capacity and the EU as a whole, the situation presents a dilemma. To maintain competitiveness in export markets, a rebate-type mechanism for exports running in parallel with CBAM would be advantageous. However, as of now, there have been no official announcements regarding the introduction of such a mechanism as the EU wary it might be classified as an export subsidy in contravention of WTO rules.

Next Steps for GCC Players

The implementation of CBAM undoubtedly grants best-in-class Gulf producers a competitive edge within the European Union and European policies will create demand for green and blue fertilizers but does this advantage translate into higher net profits for GCC players, and how should this factor into their future investment decisions?  Firstly, GCC players will have to consider how forecasting prices will change in the EU.

The figure provided illustrates a European asset classified as a laggard and a best-in-class GCC plant. It traces the trajectory of their EU-ETS and CBAM taxes, commencing at a carbon price of US$100 per ton of CO2 and steadily increasing to US$ 200 per ton by 2034.

Currently, marginal price setters in Europe are typically smaller plants that rely on higher-cost natural gas. At this stage, the EU-ETS tax represents a relatively minor component of production costs. However as free allocations phase out and carbon prices increase EU-ETS tax is poised to surpass the combined costs of natural gas and fixed expenses for EU producers, thus becoming a pivotal factor in forecasting prices and netbacks in the EU market.

Despite the introduction of a net tax for GCC imports, the cash cost advantage for best-in-class GCC plants compared to the marginal price’s setter increases through the forecast, which translates into higher netbacks leading importers. This advantage could outweigh the increased logistics costs associated with placing material in the European market and drive a change in marketing strategy. However, to gain a comprehensive understanding of how their netbacks will evolve, GCC producers must meticulously assess the emissions intensity of their assets and compare it to that of the laggard European player with time.

It is vital to acknowledge that EU-ETS and CBAM considerations should be integrated into the competitive analysis of GCC producers. While North African countries currently dominate imports into the EU due to their geographical proximity, a comprehensive assessment of North African urea emissions intensity in comparison to that of the GCC is essential for a thorough competitiveness evaluation.

In addition to its role in shaping marketing strategies, CBAM should be a central consideration in investment decisions, particularly when evaluating blue or green fertilizer projects. The implementation of CBAM, coupled with the phased-out free allocations, promises a guaranteed netback premium for projects based on its emissions intensity, illustrated in the figure below.

As previously discussed, the price of fertilizer within the European Union is expected to rise due to the imposition of higher carbon taxes on conventional “grey” producers. However, green and blue fertilizer imports will only attract very small amounts of CBAM tax or none at all. This advantage translates into significantly higher netbacks for green and blue fertilizer investments, unlike their grey fertilizer counterparts. Once the sustainability credentials are considered and high demand for green/blue fertiliser in Europe, additional premiums are also expected.

In essence, gaining a profound understanding of CBAM and its evolving dynamics is paramount when determining the strategic positioning of GCC plants and future investments, especially in anticipation of the potential implementation of similar schemes in other regions. These factors will play a pivotal role in shaping the future of GCC fertilizer exports to the EU and beyond and need to be accurately forecast:

• Emissions Intensity Estimation: A precise estimation of the emissions intensity of the proposed project is necessary to determine the potential CBAM liability and calculate the netback premium that the project might gain.

• EU ETS Carbon Price Forecast: This should be based on emissions cap policies, as discussed earlier, and consider forecasts of emissions in Europe.
• Free Allocations Phase-Out Profile: An in-depth understanding of the phase-out profile, as outlined in legislation, is crucial.
• EU Capacity Forecast: Accurate capacity forecasts for the EU and insights into the emissions intensity of marginal assets are essential.

Conclusion

In light of the significant reductions for available EU ETS allowances and Free Allocation, business as usual is not an option. CBAM’s primary objective is to safeguard the European Union against “carbon leakage” by imposing carbon border tariffs. CBAM does not improve the competitiveness of European assets. Its introduction is expected to deter carbon intensive imports, but it also presents an opportunity for best-in-class GCC assets. The phase in of CBAM and accompanying phase out of EU ETS free allowances is set to bring about a rapid transformation in the European fertiliser market significantly increasing the cost environment.

Best-in-class Gulf assets can capture the increase in costs as higher netback, however, to fully grasp the economic opportunities, Gulf producers must comprehend concepts that deviate from norm including European policy, carbon pricing and free allocations. The improvement in netbacks could outweigh higher logistics cost associated with placing material in Europe and drive a change in marketing strategy for GCC players. Low emissions intensity fertilizer can take advantage of the high-cost environment whilst paying no or minimal CBAM tax. This can be used to inform investment decisions in a market where there is not yet publicly reported premium for green products.

Lessons will be learnt from the first phase of CBAM, but the convoluted nature of polymer and chemical value chains will introduce new complexities that will need to be considered. A fact-based approach is required to allow GCC to strategically position themselves ahead of future announcements.