In our previous insight published in 2023, we confirmed that EU steel production faced a significant competitive disadvantage due to the unilateral carbon cost imposed by the EU ETS, which raised their marginal costs (MC) while marginal revenues (MR) remained constrained by global market prices. With the Carbon Border Adjustment Mechanism (CBAM) entering its definitive phase in 2026, a critical question emerges – when will this instrument truly level the playing field for EU producers?
Carbon cost squeeze: How the carbon price has cut EU mill production potential
The chart below reveals the structural shift in the Europe steel market’s competitiveness as carbon prices have lifted. In 2023, with the EU carbon price consistently exceeding $60 /tCO₂, the resulting increase in marginal production costs led to a contraction of ~25% in the maximum production potential of EU steel mills.
The more recent surge in the EU carbon price to above $80 /tCO₂ has further eroded the sector’s competitiveness, ultimately contracting its maximum production potential by ~29% from pre-2018 levels (n.b. notice the intercept of the best fit lines for each carbon price level drop from 24.1 Mt, pre-2018, to 16.4 Mt currently, reflecting this reduction in production potential).
The marginal imperative: Why incremental cost and revenues now dictate survival
A steel mill will determine its maximum production potential where the marginal revenue (MR) of its last tonne equals marginal cost (MC). For a mill acting as a price-taker in the competitive global steel market, MR is primarily set by the world price and, for Europe, reflected in the cost of imports. Conversely, MC represents the incremental cost of producing an additional tonne of steel, encompassing inputs such as raw materials, energy and labour, but also, for EU mills, the cost of carbon.
For EU steel production, the transition to CBAM and a reformed Emissions Trading System (ETS) demands a decisive shift in financial focus from average to marginal cost. While free allowances lower average compliance costs, they do not lower the marginal cost of production.
The left-hand chart below shows a typical average cost curve for a steel mill (i.e. the dark blue line) with the carbon price set to zero. As production volume increases, costs fall as fixed costs are spread across larger volumes and yields and energy efficiency improve. This is why steel mills suffer when they are forced to operate at low capacity utilisations – average costs rise rapidly, and profitability falls.
The introduction of carbon price, at $100 /tCO₂, as in the right-hand chart, fundamentally changes this cost structure. The average cost curve effectively pivots around the free allocation threshold. Below the free allocation threshold (i.e. typically ~85% of historical output), average costs fall as surplus allowances can be sold. (n.b. there are rules regarding the allocation of free allowances at low production levels that would limit the benefit that can be gained in practice).
However, at production levels above the free allocation threshold, average costs rise as additional allowances need to be purchased at $100 /tCO2. However, the marginal cost curve reacts differently, rising sharply. At a historical output of 5.5 Mt/y, a $100 /tCO₂ increases average costs by ~$180 /t steel per tonne of steel. $100 carbon price adds ~$180 to marginal cost but only $25 to average costs.
Crucially, free allowances under the EU ETS do not reduce marginal cost as they do average cost. The reason is opportunity cost – using a free allowance to cover an emission means forgoing its market value. Therefore, whether a mill uses a free permit or buys one, the marginal cost of emitting, and hence of producing an extra tonne of steel, increases by the full carbon cost right (i.e. emissions intensity multiplied by the carbon price so, in this case, ~1.8 tCO2/t steel multiplied by $100 /tCO2 gives a marginal cost increase of $180 /t steel across the full production range). This is important as EU mills compete with imports based on marginal cost and they have lost competitiveness on this measure as carbon prices have lifted.
Under EU ETS, focusing on average cost is like looking in the rear-view mirror. It reflects a past of subsidies and distortions. Marginal cost is the windshield. It shows the true, incremental cost of the road ahead.
Further, EU CBAM requirements will raise import costs, increasing steel mills' marginal revenue by lifting market prices. This creates a dual impact, whereby profitability is now determined by the new marginal cost and revenue curves. A mill focusing on average cost will overproduce and lose money. To thrive, it must use the intersection of marginal cost and revenue to set production, pricing and investment strategy. We explain the impact of this interplay below.
CBAM will align EU steel output with pre-ETS optimal output only by 2032
In the absence of a carbon price – largely reflecting the pre-2018 period when carbon prices were very low – the marginal cost curve of an EU steel mill, taken from above, intersects the marginal revenue curve at a particular point. The first chart below illustrates this relationship for a ‘representative’ EU steel plant and shows a maximum production potential of ~5.4 Mt; this will also be the profit maximising point (n.b. notice, average costs are irrelevant to this discussion).
The introduction of the EU ETS alters this equilibrium by imposing a cost on carbon emissions. At the carbon price of ~$95 /tCO₂, the marginal cost of production for an EU mill increases significantly and similarly across the production range, as the carbon cost is added wholly to the conventional input costs.
While the MR remains dictated by the global steel market, the elevated MC curve now intersects it at a lower output of ~3.7 Mt, despite the allocation of free allowances. This shift illustrates how the carbon price directly reduces the profit-maximising production capacity of EU mills, impairing their output, lifting average costs and lowering profitability. This illustrative example reflects the situation today, as shown in the first chart of this insight.
CBAM seeks to address the resultant loss of competitiveness by levelling the playing field within the EU internal market. It achieves this by imposing a carbon cost on imported steel equivalent to that borne by EU producers under the ETS, raising the marginal cost of importing but, importantly, only by the average cost to EU mills.
This mechanism effectively raises the relative price of imported steel within the EU. Consequently, the effective marginal revenue for EU mills for sales within the EU increases, as they face less price-elastic competition from foreign producers whose previously lower carbon costs no longer confer a decisive advantage.
This coordinated mechanism ensures a predictable transition – as free ETS allowances for EU producers are phased down to zero by 2034, the CBAM charge on imports is simultaneously phased up. This parallel adjustment progressively narrows the carbon cost gap between EU-made and imported steel, levelling the EU market.
By 2032, with free allowances reduced to 26.5%, and assuming price-setting importing mills still have higher emission intensities than EU mills, the CBAM charge will have risen sufficiently to theoretically offset the remaining cost disadvantage for EU producers. At this point, modelling suggests that the profit-maximising output for sales within the EU market could return to the pre-ETS level. This creates a genuine ‘level playing field’ for competition within the EU internal market by the time the transition concludes.
However, the rebalancing applies only within the EU market. CBAM cannot create a level playing field beyond Europe’s borders. In export markets, EU mills will continue to face a structural cost disadvantage that intensifies with every rise in the carbon price. Consequently, while EU-focused capacity may recover, a significant share of historically export-oriented production will stay uncompetitive, preventing a full return to pre-ETS output levels.
If you are interested in understanding how CBAM will influence import trade and steel pricing in the EU or how CRU’s Steel Cost Model and CBAM module can help you, please get in touch, we’ll be happy to talk.
