IMF | Climate Change Mitigation and Policy Spillovers in the EU’s Immediate Neighborhood

The EU has been a global pioneer in the transition to decarbonize its economy and its immediate neighbors (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. More immediately, the question whether the EU’s carbon border adjustment (CBAM)—an import tax on carbon intensive imports—will affect its neighbors has been attracting increasing attention.

The paper assesses the performance of the EUN countries to date on emissions mitigation, their policies on that front, the extent to which they have experienced inward  spillovers of tightening EU emission mitigation policies, and how further stringency in decarbonization policies in the EU in future is likely to affect them. We also study the consequences of the EUN countries trying to keep pace with the EU’s carbon transition through a unilateral and upfront adoption of economywide decarbonization policies.

EUN countries have lagged the EU significantly in emissions mitigation. Their emission problem arises, mainly, from carbon-heavy power generation and industrial sectors. The high natural endowment of coal, the highest carbon emitting fossil fuel, has been a major source of cheap locally available energy. While these countries benefited from being reliant on coal during the recent energy crisis, a more sustainable way to achieving energy security will be relying more on renewables, converging to EU standards, and eventually through EU accession, directly benefiting from EU-wide policies that also help with energy security.

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 unfavorably 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. Our  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.

An important question we consider is how much impact CBAM will have on EUN countries in the coming years as it becomes fully operational, as well as in the more distant future when the policy is expected to be tightened further by expanding it to a wider set of the Union’s imports. We find that output effects of the CBAM, once its currently proposed form is fully operationalized in 2026, would be limited, however, exports of EUN countries’ emissions-intensive industries could be directly impacted, particularly metals and energy industries, and North Macedonia and Serbia are heavily exposed in this regard. Over the next decade, the EU ETS emissions cap for power and industry is set to converge to zero by 2040 and an ETS on emissions for buildings and transport is envisioned; these future developments could have spillover effects for EUN countries, though these countries have less of a catch up to do in the latter sectors. In addition, over the long run, further tightening of the CBA could also affect the competitiveness of EUN countries given their trade integration with the EU, necessitating the tightening of emission mitigation policies.

Putting a price on carbon is the most economically efficient and equitable policy response to the emerging challenge of decarbonization in EUN. We find that the fear that a tax on carbon will adversely affect output by hitting firms and reduce household welfare, particularly for the poorer ones, is overdone. At the same time, policymakers need to be mindful of the industries that could be hit hard by a decarbonization policy and provide social assistance and safety nets, where needed. Our analysis indicates significant fiscal impact particularly when an effective recycling mechanism is in place. Under a $75 carbon tax and relative to a business-as-usual scenario, fiscal revenues from the tax would amount to about 3 percentage points of GDP on average, and it would result in an about 25 percent reduction of CO2 emissions by 2030.

Given the strong economic integration of EUN and EU, it would be in the interest of the former to keep pace with the speed of emission mitigation in the latter in future. Most of the EUN countries are at different stages on the path to EU accession and hence adhering to EU standards in this area will likely be required under the accession process. Broadly, the EU accession process would bring a host of long-term benefits, including a reorientation of the economy to achieve higher growth and living standards. Realigning the economy with EU’s climate goals and its standards on emissions would also be a key part of the accession process. An up-front adoption of a comprehensive  decarbonization strategy, such as through the introduction of an economywide carbon tax, would be of greater benefit to these countries than postponing action for later.

You can read the full working paper here.

Compliments of the IMF.