Challenges and opportunities for carbon pricing in the Western Balkans

For the Western Balkan countries, aspirations to accede to the European Union (EU) mean there is urgency to align with the bloc’s climate and environmental policy acquis. All six Western Balkan countries (the WB6)—Albania, Bosnia and Herzegovina, Kosovo, Montenegro, North Macedonia, and Serbia—endorsed the Sofia Declaration in 2020 and thereby committed to a shared Green Agenda in alignment with the EU Green Deal, including the implementation of a carbon pricing instrument.

Progress on carbon pricing since then has been limited, but the topic appears high on government agendas as analyzed in the latest edition of the Western Balkans Regular Economic Report. The Sofia Declaration was followed by the Decarbonization Roadmap under the Energy Community in 2021, which included carbon pricing, as well as a roadmap for implementation of the Green Agenda. Most of the WB6 have since set up monitoring, reporting and verification (MRV) frameworks for greenhouse gas emissions, a necessary foundation of future carbon pricing systems.  To date, Montenegro has made the most progress on carbon pricing, with an emissions trading system in operation since 2020 covering the power and industrial sectors (Table 1).

Table 1. Carbon pricing and MRV developments in the Western Balkans

Can the Carbon Border Adjustment Mechanism incentivize decarbonization? 

With the EU's proposed Carbon Border Adjustment Mechanism (CBAM) on the horizon, the EU is changing the equation for trading partners, suggesting countries introduce carbon pricing before 2026 or their exports to the EU will be taxed for untaxed carbon content in its country of origin. Given the proposed slow phase-in of the mechanism, a suggested temporary exemption of linked power markets (see Article 2(7) of the latest available text of the draft CBAM Regulation) and limited sectoral scope, the EU CBAM is not designed to harm trading partners, but rather intends to offer a common timeline and sectoral coverage for implementing carbon pricing and broader climate action in trading partner countries.

One technical hurdle to implementing carbon pricing in the WB6 is linked to characteristics of their power markets. While significant progress has been made toward improving regional connectivity among the Western Balkan partners (including through the Trans-Balkan Corridor), a regional energy market is yet to be accomplished. With a fully integrated energy market across the WB6, these countries could better access cheaper and greener energy alternatives, balance resources, and better diversify their power mix. Partially monopolistic markets (with the largest supplier ranging from 37% of market share in Albania to 100% in Kosovo) furthermore make it hard to create a level playing field for renewables by deterring new entrants and limiting competition. Wind and solar technologies, currently accounting for only 3% of total energy supply in the region, could especially benefit from improved market conditions.

The WB6 also face mixed near-term impacts from carbon pricing and CBAM, and first movers in domestic carbon pricing may fear being worse off. CBAM as proposed in December 2022 would cover between 1% and 10% of total exports by country (based on 2018–2022 data), averaging 4% across all WB6 (Figure 1). Modeling done for Serbia shows that the macroeconomic impact of CBAM is expected to be small, as declining exports would be partially balanced out by reallocation of labor and capital to growing low-carbon sectors. However, there are more targeted impacts on carbon intensive sectors like ferrous metals, chemicals, nonmetallic minerals, power supply, and coal mining.

On carbon pricing, results tell a similar story: macroeconomic impacts could remain minimal when tax revenues are spent productively (studies suggest impacts of EU-aligned carbon pricing in the WB6 could range from -1.7% to +0.6% of GDP), but additional policies will be needed to manage the impact on emissions-intensive sectors.

Regionally coordinated action is needed to better price fossil fuels

Carbon pricing will have significant benefits extending beyond EU alignment for the WB6 and will be even greater under joint or coordinated implementation in the region.  A regionally coordinated carbon pricing approach can take many forms. Coordinated price levels will help address carbon leakage concerns and moving forward as a group would allow the WB6 countries to build capacity faster and share knowledge on common carbon pricing building blocks. However, for carbon pricing to be effective, counteracting pricing instruments will need to be phased out. This includes a refocusing of fossil fuel subsidies and reform of electricity tariffs. In addition, supporting measures are needed to further enhance availability and affordability of low-carbon technologies.

Aligning excise taxes with the EU acquis can be an easy first step towards improved pricing signals. Recently, some WB6 countries introduced temporary fossil fuel excise duty reductions in response to high energy prices and inflation. However, going forward, better reflecting the environmental cost of fuels by, for example, aligning excise rates with the proposed revised EU Energy Tax Directive (ETD), would move the WB6 towards further EU alignment and would be a first step towards a stronger carbon pricing signal while MRV and other institutional capacity for direct carbon pricing are being built up.