This is an extract from a recent working paper “Climate Change Mitigation and Policy  Spillovers in the EU’s Immediate Neighborhood” by the International Monetary Fund.

The EU has been a global pioneer in the transition to decarbonize its economy and its immediate neighbours (EUN), namely, Albania, Bosnia and Herzegovina, Kosovo, Moldova, Montenegro, North Macedonia, Serbia, and Türkiye, which are heavily integrated with and reliant on the bloc through economic, financial and FDI and technology channels are likely to be significantly affected by such a transition. The EU has been a leader in introducing sophisticated policy instruments that help with decarbonization in an economically efficient manner. The evolution of its emissions trading system, ETS, applied uniformly among all member states, is perhaps an example of the biggest experiment, globally, with a decarbonization policy. The EU’s partner countries, that are deeply integrated in economic relations with it, are expected to be affected by its rapid decarbonization towards net zero by 2050.

More immediately, the question whether the EU’s carbon border adjustment (CBAM)—an import tax on carbon intensive imports—will affect its neighbours has been attracting increasing attention. 

The EUN countries have significantly lagged the EU in implementing emission mitigation policies and while the CBAM may not have a sizable immediate impact on overall output, it could have significant effects on energy-intensive sectors and overall export competitiveness over the long run. EUN countries have made some progress in introducing emission mitigation policies over the past two decades, though they have increasingly lagged EU members, especially in the use of market-based policy instruments. They have heavy trade integration with EU, and the CBAM could have major impacts on exports of power, metals and commodities sectors. In addition, over the long run, the CBAM could also affect the competitiveness of EUN countries given their trade integration with the EU, necessitating the tightening of emission mitigation policies

EUN countries’ emissions mitigation policy efforts have been generally weak. They have significantly lagged EU members and have been moving only gradually towards market-based instruments since 2000. They still have substantial fossil fuel subsidies in place, and as a group, they compare unfavourably in terms of implicit subsidies, i.e., the cost of fossil fuel externalities not covered by consumer prices.

The EU’s heavy push to decarbonize its own economy over the past two decades appears to have spilled over and influenced emissions mitigation in EUN countries. The empirical findings suggest that as the EU has increased the stringency of its climate policies, the EUN countries have lowered their emissions, more so than other countries. Over the 2000-20 period, a near doubling of EU environmental policy stringency was associated with a potential reduction in emissions in EUN countries by as much as 10 to 20 percent, after controlling for other factors. Putting a price on carbon is the most economically efficient and equitable policy response to the emerging challenge of decarbonization in EUN.

Nature of Climate Issues in EU Neighborhood

Economic growth has been a key driver of rising GHG emissions, but improvements in energy efficiency have helped. The quantum of emissions in EUN countries is small in global context. Since 2000, the carbon footprint of EUN countries has risen steadily, as growing economic activity and improving living standards boosted demand for energy. Energy efficiency has been the key to moderating the growth of carbon emissions—the EUN countries where emissions per capita increased the least were also those where improvements in energy intensity have been the greatest. The economic output of EUN countries is highly emission intensive, but these countries may also be at a point of transition. 

The power sector is the main source of GHG emissions in EUN countries while the carbon footprint of the other sectors is small and not much different from that in EU countries. Heat and electricity generation accounts for the largest share of GHG emissions and explains most of the variation among countries. Power plants in EUN countries produce significantly more GHG, both per capita and per unit of energy than in the more developed European countries.

The fuel mix is to blame for the high emissions intensity of electricity generation in most EUN countries. Coal remains the backbone of energy systems as many of the EUN countries are endowed with deposits of lignite—the most CO2-intensive grade of coal. For example, in Kosovo, Serbia and Bosnia and Herzegovina, lignite accounts for more than 60 percent of electricity generation.

EUN countries have the highest levels of air pollution in Europe today. While a carbon tax does not directly target air pollution, it would play a crucial role in facilitating phase-out of coal, thereby mitigating its adverse impact on air quality. 

Policies and Spillovers

EUN countries have made some progress in introducing emission reduction policies since 2000, but they lag EU members in this regard. EUN countries have been moving only gradually towards market-based instruments. From a theoretical standpoint, while market instruments such as carbon taxes offer a comprehensive way of reorienting the economy away from carbon, other instruments may not be substantially inferior. 

Further, some market instruments like an explicit carbon tax are less acceptable to the public than “hidden” measures such as targets, regulations and standards. There is also some evidence that the likelihood of adopting market-based instruments rises with country income, and given their lower incomes compared to richer countries, EMDEs are more likely to use non-market instruments. Not surprisingly, EUN countries mainly rely on regulatory measures, policy support, and targets as policy instruments though there has been a gradual increase, over time, in the adoption of economic instruments

The EUN economies are integrated with the EU, mainly through trade, which is a potential channel for emission mitigation policy spillover from the latter. The EU-EUN trade integration is underpinned by various agreements and partnerships, including the European Neighborhood Policy and the Eastern Partnership.

EU Policy Spillovers: Carbon Border Adjustment Mechanism

The EU’s CBAM is a significant step in the evolution of its climate mitigation policy to drive a collective effort towards a sustainable and low-carbon global economy. The EU has been at the global forefront in tackling climate change by introducing increasingly ambitious and sophisticated policies, including EU ETS, Effort Sharing Regulation, transport and land legislation, all aimed at achieving carbon neutrality by 2050. To safeguard business competitiveness and reduce carbon policy leakage, the sectors exposed to high leakage currently receive a greater share of free allowances under the ETS. 

However, to further align its climate policies with global competitiveness and remove incentives for carbon leakage, the EU has put into force CBAM in 2023, which, when operational, would amount to an import tax on embodied carbon of certain carbon intensive goods from non-EU countries. The Mechanism aims to preserve a level playing field for EU producers and promotes explicit or implicit pricing of carbon in other countries, while attempting to remove the disparate incentives between domestic and foreign producers. By incentivizing carbon mitigation overseas and encouraging trading partners to adopt domestic carbon pricing, the EU aspires to achieve efficient carbon emission reduction within a fairer and more sustainable trading system. 

Based on analysis, EUN countries will face varying degrees of foregone revenues subject to CBAM. The destination of the revenues the EU will collect under the CBAM is yet to be determined.

Carbon Tax and its Implications

The future course of EU’s emissions mitigation policies is likely to be increasingly stringent and one where it redoubles efforts to preserve its economic competitiveness by aligning incentives of foreign producers who export to the bloc. The CBAM, in its current form which would be fully operational by 2026, is limited to select industries and would be phased in over the next few years and is thus not expected to have immediate impacts on EU’s partner countries.

From an economic standpoint, unilaterally using an economy wide carbon price is perhaps the most effective incentive to alter the behavior of firms and consumers to decarbonize. By imposing a tax on CO2 emissions today that raises the price of carbon, the EUN countries could raise the price of carbon and thus transmit a powerful signal through their economies—a signal that would make carbon-intensive goods and services dearer, and therefore would help rebalance consumption and production toward low-carbon options.

Despite its obvious pros, carbon tax comes with many real and perceived cons. First, is an overarching fear that there is a tradeoff between carbon taxation and output and employment—that a higher price of carbon will result in deindustrialization as many existing industries will not be able to adapt, resulting in worker layoffs.

Second, policymakers fear that the change in pricing in the economy brought about by the carbon tax would hit consumers, particularly poorer ones. Third, there are real economic costs associated with economywide decarbonization in general, undertaken through measures such as carbon tax—these depend on the costs, availability, and implementation of alternative green technologies. 

Last, energy-related decarbonization also entails risks of stranded assets and relatively large employment transitions for specific activities and/or regions. These risks and transition costs also imply political economy concerns that can make carbon pricing politically unfeasible. A carbon tax is thus often perceived as an efficient instrument that is infeasible—i.e., it is difficult to sell as a viable policy option.

Macroeconomic Effects and Sectoral Distribution

By using carbon taxation as a pricing instrument, the CPAT approach can assess country-level effects on several economic variables namely, energy demand, prices, emissions, fiscal revenues, GDP—as well as distributional consequences for household consumption.

However, it should be noted that the CPAT is a partial-equilibrium tool to assess domestic effects of a carbon tax without accounting for international spillovers (e.g., carbon leakage) or household income effects. Accordingly, other scenarios in which each EUN country acts alone or in a broader coalition can significantly affect the overall results.

A unilateral carbon tax imposed in EUN countries would not result in much negative macroeconomic implications by 2030, but would yield considerable dampening of emissions relative to the business-as-usual (BAU) baseline.

The direct impact of the carbon tax on energy costs will depend on the carbon content of the fuels used to generate energy and the burden will be greater on firms that use coal-fired power than for those that rely on cleaner fuels. Figure below provides a sector-by-sector summary of how a $75 per ton carbon tax will affect the direct cost of energy inputs in the five most affected industries. The increase in such input costs would be particularly high, by about 15 percent or more, in chemicals, non-metallic minerals (Serbia and Albania) and basic metals (Albania). 

The carbon tax will also affect firms indirectly as higher energy prices push up upstream costs of inputs.

Policy Lessons and Implications

The emission problem in the EUN countries arises, in large part, from their carbon-intense power generation and industrial sectors. The high natural endowment of coal in EUN countries may have been a major source of locally available energy in the past, and it may have served these countries well during the energy price shocks emanating from the Russian invasion of Ukraine, but in a world that is increasingly likely to internalize carbon costs, coal will quickly become a “costly” fuel. 

EUN countries’ record on emissions mitigation policies is generally weak. Despite making some progress in introducing emission reduction policies since 2000, they have significantly lagged EU members in this regard. EUN countries have been moving only gradually towards market-based instruments over this period. The increasing stringency of climate policies in the EU over the past two decades appear to have spilled over considerably. 

Putting a price on carbon is the most economically efficient and equitable policy response to the emerging challenge of decarbonization in EUN. By reflecting the cost of emissions in the prices of fuels, electricity, and goods, carbon pricing would promote a full range of behavioral responses across households, firms, and sectors for reducing energy use and shifting toward cleaner energy sources.

Market instruments other than a carbon tax and non-market instruments can also be viable policy options. Putting a price on carbon through the introduction of carbon tax is a first best policy, but it has also been a reform that has elicited concerns and has been unacceptable, not least in middle income countries where it is viewed by the public as an unnecessary price to pay for the past pollution of developed countries.

The EUN countries are at different stages on the path to EU accession and alignment with EU climate policy is inevitable. Ultimate entry into the EU would require realigning the economy with the EU’s climate goals and its standards on emissions—a direct channel of spillover of EU policies. In this regard, policymakers in these countries face a choice: whether to wait to transition their economies away from carbon later when it is necessary to do so for EU accessions reasons, or to do so as soon as possible. 

Access the complete paper here.