The climate is changing, and so is the global regulatory environment. While many industries and companies have set voluntary emission-reduction targets, national governments and supranational bodies are increasingly seeking to accelerate the transition to a net-zero economy.
Between 2012 and 2022, the number of environmental regulations increased by 164 percent, and more than 70 countries have adopted more granular regulatory requirements and taxation mechanisms—for example, by requiring companies to report value-chain emissions at the product, rather than the organizational, level.
Carbon pricing mechanisms, which include carbon taxes and emissions trading schemes (such as the EU’s Emissions Trading System, or ETS)will play a major role in the regulatory response to climate change challenges. Currently, about 23 percent of global greenhouse gas (GHG) emissions are covered by these mechanisms, and this share is expected to grow.
Until carbon pricing becomes more universal, regions that operate these schemes face the risk that companies will respond by moving emissions-intensive activities to regions that do not. Exporting emissions in this way causes economic damage and undermines the goal of carbon pricing.
To address this problem, countries with carbon-pricing mechanisms are considering border taxes that aim to put a fair price on the emissions generated by the production of certain imported products. Many of these policies, including the US Clean Competition Act (CCA), remain the subject of ongoing government deliberations.
Last year, the EU became the first region in the world to implement such a policy. The EU’s Carbon Border Adjustment Mechanism (CBAM) will be phased in over a three-year period and will be fully effective in 2026. CBAM requires EU importers of certain carbon-intensive products to purchase certificates reflecting the carbon content of those products. The price of CBAM certificates will track the price of carbon in the bloc’s existing ETS scheme. Combined with the phasing out of free EU ETS allowances, one-off cap reductions, and accelerated benchmark reductions, the mechanism will have a significant impact on the cost of selected products sourced from global markets.
The financial impact of CBAM will vary by core product type. Initially, the regulation will target a select group of high-carbon-intensity products. Sectors covered in the first phase of the new regulation include cement, iron and steel, aluminum, fertilizers, electricity, and hydrogen. Users of these commodities will need to conduct a thorough analysis of the materials and components that are integral to their manufacturing processes to understand the impact of the new regime.
This impact is likely to be significant. Our modeling suggests that by 2030—assuming no changes to supply chains or production technology—CBAM could increase the cost of primary aluminum by 70 percent and the cost of steel by 40 percent (Exhibit 1).
For companies with significant exposure to these materials, a business-as-usual approach is likely to be costly. Top-down analysis of a typical European automotive company suggests that doing nothing could reduce profits by 20 to 40 percent over the rest of this decade. About half of these losses would come from the direct costs of complying—or not complying—with CBAM rules. The rest would come from reduced demand as customers increasingly switch to lower-emission products.
Unlocking opportunities
CBAM also creates significant opportunities. Companies that reduce emissions faster than their competitors won’t just spend less on carbon credits; they’ll also be well positioned to capture demand from higher-emitting competitors. The best of them will enjoy even more growth from price premiums for products with superior environmental performance and new green business models. Exhibit 2, which is based on analysis of a European automotive OEM, suggests that for this company such changes could actually boost EBIT by 15 to 50 percent by 2030.
The opportunities to mitigate the costs of carbon taxes arise across the organization’s value chain. Reducing the carbon footprint of the value chain through material substitution, waste-reduction initiatives, or process efficiency improvements delivers a twofold benefit: cutting both tax liability and the direct cost of energy, water, or waste materials. New kinds of business, such as circular models based on the lease or resale of refurbished or remanufactured products, can offer sources of repeat revenue with very low associated emissions. And superior environmental performance provides important nonfinancial benefits, too—for example, by improving employee engagement and retention.
In the short to medium term, the risks and opportunities created by CBAM will affect companies differently depending on their current supply chain footprint. EU-based companies with cross-border supply chains will feel the greatest impact, with many facing an urgent need to address potential input cost increases. Companies with supply chains that do not involve the EU may benefit from cost advantages versus EU-based competitors, since CBAM does not currently offer rebates for exporters. Non-EU players selling to EU customers will see additional business opportunities if their current carbon footprint is lower than the EU average. To take advantage of these opportunities, these companies will need to ensure that they have appropriate carbon-tracking and reporting processes in place. During the early phases of the scheme, suppliers of finished goods may also enjoy cost advantages over their EU competitors, since their products will not require CBAM certificates. In the longer term, we expect regional differences to narrow. For example, the current regulatory trajectory suggests that the US will adopt similar cross-border carbon regulations to the EU with a three- to five-year lag.
There is a wide range of actions companies should take to position themselves on the right side of the CBAM divide. They should ensure carbon transparency by implementing robust tracking mechanisms throughout the value chain to facilitate traceability. And they should prioritize cost-efficient carbon reduction by focusing on ecofriendly solutions that simultaneously lower emissions and costs. This focus on cost-effective decarbonization should be seamlessly integrated into all processes, making sustainability an inherent aspect of daily operations. Agile decision making and capital allocation are also vital, necessitating the implementation of frameworks that allow the swift capture of carbon-reduction opportunities. Collaboration across the supply chain is essential for reducing costs, and partnering with peers and suppliers can yield significant benefits in this regard. These approaches have already helped leading companies in a variety of sectors reduce their carbon emissions by 10 to 60 percent while cutting costs by 5 to 15 percent.
By acting proactively to implement cost-effective reduction strategies, organizations can thrive in a world that is increasingly focused on environmental responsibility and the goal of becoming net zero globally by 2050. Adopting a customized CBAM framework provides an opportunity to synchronize decarbonization efforts across borders and align interests and operations between suppliers and customers. McKinsey analysis shows that it is possible to achieve a win-win: successfully reducing costs and emissions simultaneously by as much as 60 percent.
The authors wish to thank Thomas Schmidt for his contributions to this blog post.