How to address the Externalities of the EU’s Carbon Border Adjustment Mechanism in Serbia

By Elisabeth Friedrich

This essay is the First Prize winner of the Fall 2023 Chair’s Essay Competition on the topic of ‘Just Transition Policy’  

The European Union’s (EU) Emissions Trading System (ETS) is the first and most consolidated cap-and-trade carbon pricing scheme in the world and constitutes a central policy tool for the EU to transition to a green economy. The efficacy of this scheme is curtailed by carbon leakage, a highly politicised issue that entails companies moving production abroad to markets with more favourable (or no) carbon prices. In response, the EU recently implemented another policy innovation, the Carbon Border Adjustment Mechanism (CBAM), which essentially amounts to a tariff on carbon (for now only on specific sectors) and has wide-ranging impacts on trading partners. Understanding the distributional consequences of this measure as well as potential remedies for them is critical for ensuring the just transition to a green economy is fair for all workers and regions in Europe—and globally.

Accordingly, this essay explores (i) general findings in the academic literature about CBAM externalities, (ii) how the CBAM affects Serbia as one of the EU neighbours most vulnerable to the mechanism, and (iii) how a policy response could be designed to realign EU climate policy with the principles of the just transition.

Literature on the External Effects of CBAM

Branded by the European Commission as a necessary tool to reach net zero, CBAM has been fiercely criticised for its protectionist nature by trading partners from the Global South, where the Union has progressively outsourced production over the past decades (Brandi, 2021; Kurmayer, 2023). This claim is generally supported by the academic literature which, especially with respect to smaller low- and middle-income countries (LMICs), demonstrates the substantially negative, disproportionate impact the new EU carbon tariff has by imposing significant additional trade costs (Clark, 2021; Eike et al., 2021; Lim et al., 2021; Lowe, 2021; UNCTAD, 2021).

For the economies exporting CBAM goods to the EU, these trade costs translate to substantial welfare losses as employment and wage shares suffer from falling exports and fiscal revenues (Magacho et al., 2022). Here, the academic literature pinpoints several drivers that determine the strength and direction of CBAM effects in a given country. These factors include (i) the degree of dependency on EU exports (especially in CBAM goods), (ii) the carbon intensity of production in affected sectors which ultimately determines the amount of carbon tariffs raised and hence loss of competitiveness, (iii) the capacity to monitor and report carbon contents, and (iv) socio-economic aspects such as social protection coverage (Eike et al., 2021; Magacho et al., 2022; Perdana & Vielle, 2022). As all these factors are particularly pronounced in LMICs, CBAM is widely seen as exacerbating interregional inequalities and the EU externalising the economic cost of its climate transition as CBAM revenues are set to flow into the EU budget (Böhringer et al., 2012, 2018).

In order to design an effective policy response to this issue of climate justice, it is crucial to understand country-specific patterns of CBAM vulnerabilities, which so far is generally lacking in the literature. With Europe as this paper’s main area of interest, this aspect is explored using quantitative and qualitative data in the case of Serbia, one of the most CBAM-vulnerable EU neighbouring countries (Eike et al., 2021; UNCTAD, 2021).

CBAM Impacts in Serbia

Lacking export diversification clearly drives Serbia’s vulnerability to CBAM as exports to the EU accounted for 54% of total exports in 2022 (EU Delegation to the Republic of Serbia, n.d.). Even more importantly, the export of CBAM products to the EU made up 10.7% of total merchandise exports in 2022, with over 70% of Serbian CBAM goods going to the Union (Economics Institute & Chamber of Commerce and Industry of Serbia, 2023). Serbia is hence heavily dependent on exports to the EU market generally and in CBAM products (here mainly iron and steel, electricity, and in part also aluminium) specifically. Concretely, income losses in Serbia due to CBAM are estimated at 1-2 billion EUR annually, exposing almost 3% of employment and about 2.5% of wages (Magacho et al., 2022; UNCTAD, 2021), while only 39% of the population is covered by at least one social protection benefit (ILO, 2020).

However, pursuing export diversification is not viable in response to this, not only due to Serbia being surrounded by the EU geographically, but also because in the long-term, Serbia is aiming to join the EU, making it unlikely overall for trade to be rerouted. This dynamic aligns with the findings of existing literature stating that CBAM weights more heavily on smaller countries as their internal markets are not as strong and EU trade is of higher relative importance, rending their negotiating position weak compared to bigger players like China or India (Eike et al., 2021; Magacho et al., 2022).

Accordingly, based on the expert interviews conducted for this study, strengthening monitoring and reporting capacity as well as the uptake of renewable energy are the most promising policy options to alleviate the unequal distributional consequences of CBAM on Serbia. With CBAM reporting obligations already in place since 1 October 2023, one of the country’s leading legal experts on CBAM implementation in Serbia, Branko Gabrić, sees affected Serbian companies already struggle deeply: “[They] face difficulties in accurately measuring and reporting their carbon emissions due to a lack of established systems and expertise in this area. Serbia has yet to adopt MRV [monitoring, reporting and verification] legislation, and companies are generally not accustomed to preparing detailed environmental reports. This could lead to potential non- compliance with CBAM requirements and associated penalties.” (personal communication, December 1, 2023).

In the long-term, experts also stress the heavy dependence of Serbia on GHG-intensive energy sources, with over 70% of its energy grid depending on fossil fuels (mostly coal) (IEA, 2022). Under CBAM, this makes it likely for the export of electricity to the EU to become unprofitable, says economics professor Slavica Manić from the University of Belgrade (personal communication, November 16, 2023). Similar effects are expected in the iron and steel as well as aluminium sectors, further underlining the deeply negative impact CBAM (already) has on the Serbian economy (B. Gabrić, personal communication, December 1, 2023; Magacho et al., 2022).

Policy Response to CBAM Impacts in Serbia

Having gained an in-depth understanding of the negative effects of CBAM in Serbia as well as the factors that dive them, the Serbian government would be well-advised to support domestic industry as much as possible (e.g., through the introduction of MRV legislation) to adapt to CBAM-induced bureaucratic burdens and hence remain compliant, as well as making critical investments in green energy and putting in place a carbon pricing system on its own. This, however, amounts to a heavy strain on Serbia, only adding to pre-existing development challenges.

For the EU to leave Serbia to the far-reaching distributional consequences of its CBAM regulation would not be aligned with the principles of a fair transition to a green economy in Europe nor with the EU’s own interests regarding the accession candidate state. Additionally, the Union’s historical responsibility for causing the climate crisis and the substantial negative economic and environmental impacts of CBAM on LMICs globally led to recent turmoil over the EU CBAM at COP28 (Kurmayer, 2023). This further underlines the need for sweeping CBAM-complementing policy action to restore international acceptability of the mechanism as well as, ultimately, ensure its effectiveness as a climate policy which depends on equitable burden sharing as a precondition (IPCC, 2014, p. 291).

In the context of Serbia specifically, acknowledging that substantial export diversification is highly unrealistic, recommendations to the EU for CBAM-complementary policy measures include that

1. in the short-term, the Union should support Serbia to fully integrate to the EU’s energy grid, enabling the country to be excluded from CBAM at least in this sector. Given that electricity will make up the largest share of EU carbon revenues stemming from Serbia (Magacho et al., 2021), this would already lift a sizable burden off the Serbian economy.
2. Further, exemption from punitive fines in the transition period should be considered to allow proper monitoring and reporting capacity to be established.
3. In the long-term, the EU should mobilise additional climate finance, potentially using parts of the revenues generated by CBAM (Brandi, 2021), directly promoting the uptake of renewable energy in CBAM sectors in Serbia. This aligns with the findings of Perdana and Vielle (2022) that CBAM complementing measures should focus on the promotion of energy efficiency and renewable energy sources to improve countries’ the adaptability to the incentives to decarbonise set by CBAM.

In line with the principle of ‘Common but Differentiated Responsibilities and Respective Capabilities’, these policies would tackle Serbia’s specific vulnerabilities to CBAM and hence help to alleviate its negative externalities, ensuring that the transition to a green economy championed by the EU as a self-proclaimed global climate leader is fair for all workers and regions in Europe.

References

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Böhringer, C., Carbone, J. C., & Rutherford, T. F. (2018). Embodied Carbon Tariffs. Scandinavian Journal of Economics, 120(1), 183–210. https://doi.org/10.1111/sjoe.12211

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