Introducing carbon pricing and EU CBAM mechanism application in the Energy Community

Author: Ljubo Maćić, special advisor, Economics Institute

By accepting decarbonization as an obligation through the Paris Agreement, the Contracting Parties of the Energy Community (EC) should prepare and start implementing carbon pricing. EU ETS integration, as a targeted solution, should enable a sufficiently long transition period with free emission allowances. If this is not possible, the contracting parties should consider other carbon pricing mechanisms until their EU accession. An attempt to introduce, uniformly, a heterogeneous region with a low GDP and a high coal share, within only a few years, into the EU zone of the highest international carbon pricing, cannot be successful, and certainly not into a separate regional ETS.

There can be no successful decarbonization if the European Union does not formalize and institutionalize continuous financial support until the EnC abandons coal.

Decarbonization inevitability

Under the Paris Agreement on climate change, Serbia, together with the Energy Community Treaty signatories, accepted that a response to the immediate threat of climate change is needed, similar to almost all countries of the world. Energy is the sector emitting about three-quarters of the greenhouse gases (GHGs), mainly carbon dioxide, causing global warming. Therefore, changes in energy, i.e. energy transition, will have the biggest and fastest contribution to hindering such processes.

The difference between the current and previous energy transitions is crucial. All the previous ones were based on the already achieved economic advantage of new resources and technological progress (from biomass and muscles towards coal, oil and gas). Knowing that life on the planet is threatened by irreversible climate change meant that this transition could not wait for its natural pathway – economic and technological maturity of new technologies.

Some technologies which are not quite certain are promoted and accelerated, without definitely knowing when they will be commercialized

Transition to carbon-free energy technologies had to be accelerated by regulatory incentives and public policies, still leaving advance financing to energy customers and states. Moreover, some technologies which are not quite certain are promoted and accelerated, without definitely knowing when they will be commercialized. Accordingly, policymakers assume great responsibility in each country for the pathways and success of such adopted policies and changes. This responsibility is particularly great in developing countries, whose resistance to failed policies and disruptions is lower.

It is natural that under the obviously complex and uncertain conditions, there are disagreements about how the transition will be managed and how it will be financed.

One of the key measures that should encourage reductions in the use of fossil fuels and high GHG emissions through additional economic coercion is carbon pricing introduction.

Carbon pricing mechanism application

Two dominant carbon pricing mechanisms are in use worldwide:

1. Emissions Trading System (ETS), applied in the EU and
2. Carbon taxes.

ETS operates on a cap-and-trade basis. Total emissions are limited, which are regulated, and gradually reduced. Emitters buy or receive emission allowances they can trade.

In the case of carbon taxes, carbon pricing (or emissions embedded in the fuel used) is determined in advance for some future period.

In general, ETS features include: the certainty of reaching the target emission reduction; the possibility of international cooperation; and economic efficiency, although insufficient and uncertain if the emission allowance market is small and not liquid, hence it could be potentially exposed to the influence of a dominant participant or volatile prices, which might be the case in small countries, such as Serbia; a longer implementation time is necessary until a complex system has been established and functioning, due to additional infrastructure and required administrative and professional capacities.

On the other hand, carbon taxes can be introduced quickly, relying on existing tax infrastructure, without new market infrastructure, providing price and revenue predictability and investment stability.

In total, in 2022, 23% of all GHG emissions globally, in 73 jurisdictions (not only countries but also parts of countries), including China, will be covered by various emission pricing mechanisms. Another important global indicator is that carbon pricing has been applied in highly developed countries and partly in medium-developed ones.

The EU adopted the Regulation on the CBAM, which protects EU producers of six goods

It is considered that the carbon pricing application will work effectively and encourage decarbonization if the price is set to over €50 per ton of CO2. However, now only about 5% of total global emissions are covered by prices above this limit, almost entirely under the EU ETS, but only in the past two years. On the other hand, the Chinese ETS price is around $10 per ton.

In May 2023, the EU adopted the Regulation on the Carbon Border Adjustment Mechanism (CBAM), which protects EU producers of six goods (electricity, iron and steel, cement, fertilizers, aluminum, and hydrogen) from import competition from countries not applying carbon pricing. From 2026, importers of these goods will have to pay to the budget of the importing country the difference between the EU ETS price and the emission price in the country of origin of the goods (currently 0 €/t in our country).

Third countries, whose electricity markets coupled with the EU market, can receive a time-limited exemption until 2030, provided that they accept the EU ETS carbon pricing, as well as all EU energy and climate regulations, including those that have so far not been covered by the Energy Community Treaty. CBAM application also imposes electricity market coupling conditions of the Energy Community Treaty parties with the EU market, and may even prevent it.

Carbon pricing application in the EU

The ETS has been in use in the EU since 2005. The EU ETS covers some 10,000 stationary installations in energy and industry, as well as air traffic within the EU. The ETS now applies to around 38% of total GHG emissions in the EU. The ETS is expanding to other sectors in order to reach ambitions set by the European Green Deal and Fit for 55, i.e. reducing emissions by at least 55% by 2030 compared to 1990.

After three phases of EU ETS application (2005-2007, 2008-2012, 2013-2020), the fourth is underway, which will last from 2021 to 2030. Until 2018, in most of the previous period, the EU ETS price was below €10/tCO2, while from early 2021 it exceeded €30, even reaching €90/tCO2. EU members thus had a period of some 15 years of relatively low carbon prices, allowing companies to prepare and adapt to carbon pricing applications.

Expectations are that the EU ETS price will rise, up to 140 €/tCO2 by 2030, and over 300 €/tCO2 by the middle of the century.

Another important factor supporting the adaptation of EU companies to ETS implementation is the long period in which free emission allowances were issued, especially to EU members with the lowest GDP per capita.

Until 2012, 90% of emission allowances were free

Until 2012, 90% of emission allowances were free. By 2020, there were 57% of free allowances, while they were not allowed to electricity companies, except optionally for the 10 member countries with the lowest GDP. Things are similar in the fourth phase until 2030. No announcements have been made that free allowances will be issued after 2030, except for industrial goods until 2033, however not for electricity.

On the other hand, an equally important issue for carbon pricing implementation is the use of collected revenue. The EU directive stipulates that at least 50% of auction proceeds must be used for climate energy purposes, to support decarbonization, and to remediate decarbonization effects. In 2021, considerably more was spent on such purposes, 76% of the revenue, while it was similar in previous years, and in some member states even 100%. This should also serve as guidance for finance ministries of the regional countries when carbon pricing application kicks off.

Carbon pricing application initiatives in the Energy Community Treaty parties

The Treaty establishing the Energy Community does not cover climate change, except that it calls on the Contracting Parties to seek to join the Kyoto Protocol, which they have done.

The countries of our region are signatories to the Sofia Declaration on the Green Agenda for the Western Balkans; however, it is not legally binding in the sense that it determines the dynamics, quantifications and deadlines for changes. With this declaration, the signatories agreed to work towards reaching climate neutrality by 2050 and, inter alia, to harmonize with the EU ETS, as well as to work on introducing other carbon pricing instruments.

In November 2021, the EC Ministerial Council adopted the Decarbonization Roadmap, which includes regulations on monitoring, reporting, and verification of GHG emissions and their implementation, which are a prerequisite to implementing any emission pricing mechanism. The road map envisages the implementation of regulations to prepare for EU ETS integration (emissions monitoring, reporting, and verification), though without the established ETS implementation deadlines.

At the informal meeting of the Ministerial Council in late June 2023, proposals were made, without any previous comparative analysis, to implement the regional ETS

In December 2022, the EC Ministerial Council in its conclusions called for carbon pricing system conceptualization and preparation of a discussion proposal at the next Ministerial Council (end of 2023). At the informal meeting of the Ministerial Council in late June 2023, proposals were made, without any previous comparative analysis, to implement the regional ETS in the EC area.

However, the implementation of such a separate Regional ETS goes beyond the scope of the adopted Roadmap, because it only mentions EU ETS integration. The need to introduce the ETS was placed in the context of the adopted CBAM implementation, in order to protect the EC contracting parties against the external implementation costs.

If the Regional ETS were to be applied, it is unclear, inter alia, how the emission pricing inside the Regional ETS would be formed and how price equivalence would be achieved in the EU ETS and the regional ETS, which exempts EC from applying the CBAM. It is also unclear whether the free emission allowances scheme could be applied in the Regional ETS from 2030, not currently covered by the EU regulations (while the Commission currently does not have the mandate to accept it), and which would enable the EC contracting parties to enjoy a transitional regime for a longer period, similar to the one EU members enjoyed for a long time.

A preliminary analysis shows that, until EU accession, it would be more convenient, at least for some contracting parties, to introduce carbon taxes

The implementation of a highly complex mechanism, such as emission pricing introduction or more specifically the Regional ETS in a politically non-integrated region with numerous controversies, requires a thorough prior analysis of options, conditions, possible outcomes, impacts, and effects. If impact assessment is a mandatory practice in the EU for every new significant regulation or new policy, the European Commission must ensure that this is also done for the EC before any decision is made.

Each country, especially those with a high share of coal, should do the same internally at greater length, considering possible mechanisms and looking for the ones that are most suitable for the period until they become part of the EU when EU ETS application will be mandatory.

A preliminary analysis shows that, until EU accession, it would be more convenient, at least for some contracting parties, to introduce carbon taxes. However, one should consider the effect of postponed electricity market coupling with the EU market and find a solution to this very important problem.

Financial support for decarbonization

Decarbonization is a highly expensive, investment-intensive process. Financing capital-intensive investments such as those required by RES, eliminating the effects of energy structure changes in coal-dependent regions affected by the transition and protecting poor customers and competitiveness of the economy is a complex undertaking for every country, especially for less developed ones.

It is certain that each country will have to secure most of the funds for its own transformations and transition. However, bearing in mind the Energy Community Treaty (regardless of the fact that that Treaty does not include climate change), followed by the respective EU accession stages of the contracting parties, as well as the role and obligations of the EU, energy transition at a speed that follows the EU’s energy-climate ambitions is not possible, without EU’s financial support. Significant support now provided by the EU in all areas is far from what is needed for a several decades-long transition process.

Energy transition at a speed that follows the EU’s energy-climate ambitions is not possible, without EU’s financial support

EU documents do not indicate that it is ready to establish and financially support a separate dedicated source of funding for EC, symmetrical to the one applied through special mechanisms in the EU in order to adequately support decarbonization goals and mechanisms.

The Just Transition Mechanism (JTM) has been established in the EU, currently for the 2021-2027 EU budgetary period. It finances activities from the Just Transition Fund, together with a special scheme under the InvestEU and combined with a credit line for the public sector with the EIB (up to EUR 100 billion has been announced). This support accelerates the transition and mitigates its socio-economic impact, and is implemented under joint management, as part of the cohesion policy, which is the EU’s main policy for reducing regional differences and for solving structural changes in the EU.

For example, as part of such a policy, the European Commission adopted one such program in December 2022 – for Poland, valued at EUR 3.85 billion, under the 2021-2027 EU budgetary period intended for five coal regions.

If Germany needs about EUR 40 billion in direct costs to exit coal and remediate its exit effects, Serbia would need about EUR 6 billion in proportion.

If Germany, as determined by the State Coal Commission, needs about EUR 40 billion in direct costs to exit coal (primarily lignite) and remediate its exit effects, Serbia would need about EUR 6 billion in proportion. If the eastern part of Germany does not accept to abandon the use of lignite before 2038, it is neither feasible nor does it have any real justification, given the current conditions and the state of energy technologies, to demand that Serbia do so before 2050. After all, Poland has not accepted yet to shut down its lignite power plants before 2049.

As the European Commission claims, calling for solidarity, that “no one will be left behind” in the EU decarbonization, we cannot be left behind either. After all, the historical responsibility of the developed countries for carbonization generated through cumulative emissions in the industrial era, whose wealth was contributed by carbonization, requires them to help others, if they want to drag them into costly decarbonization. The Paris Agreement also establishes principles of differentiated responsibility and respective climate change capabilities.

The EU should be asked, in line with the EU practice, to formalize and institutionalize joint or bilateral financial support for the decarbonization of the EC

Therefore, the EU should be asked, in line with the EU practice, to formalize and institutionalize joint or bilateral financial support for the decarbonization of the EC, until coal exit, adjusted to the level of GDP per capita and coal share. Such support should be proportionate to the goals and efforts of the EC parties and monitored by the EU.

These funds, as in the EU, would support economic diversification, worker retraining and assist regions exiting coal, investments in small and medium-sized enterprises, the opening of new companies, research and innovation, environmental rehabilitation of coal regions, growth of clean energy generation and transformation towards low-carbon technologies.

Funds collected through these mechanisms would be combined with existing sources of funds generated by the EU and IFIs. Nevertheless, each country would have to finance decarbonization largely from its own sources. A large part of the funds should be secured from the carbon pricing mechanism revenue.

The fact that no funds for EC transition have been earmarked in the 2021-2027 EU budget cannot serve as justification for the EU today

At the same time, the fact that no funds for EC transition have been earmarked in the 2021-2027 EU budget cannot serve as justification for the EU today. The European Commission certainly knew in 2020, as written in the Sofia Declaration, that the EC contracting parties would be required to adopt and implement energy-climate goals for 2030 and accept climate neutrality in 2050.

Similarly, the Energy Community Treaty, signed in 2005, does include any provisions on the solidarity of the contracting parties. The Treaty was a higher and earlier step in integrating EU’s energy sector compared to other sectors.

Nonetheless, if the integration focus is shifting from grid energies to the investment-intensive, complex and uncertain energy transition, it is rather justified that the principle of solidarity between the EU and the contracting parties and among the contracting parties should somehow be incorporated into the Treaty. This would help to establish the symmetry between rights and obligations and make it more effective, while reflecting the relations within the EU, which is the meaning of integration.

EU ETS and EU CBAM implementation challenges

There are two key indicators of the size of the challenges to which they will be exposed and the capacities of the EC contracting parties in the decarbonization process, including carbon pricing implementation:

1. Coal share in electricity generation, the most important indicator of decarbonization challenges and costs, equalling to some 65% in Serbia. However, when the EU was entering the transition it had an average of about 30%. In the EU, only Poland currently has a higher (about 70%) and the Czech Republic a comparable (about 44%) share of coal. The regional countries (Serbia, B&H, North Macedonia and Montenegro) have about 40 to 65% share of coal.
2. Gross domestic product (GDP) per capita, the most important indicator of the capacity to implement and accept the decarbonization effects, measured by the purchasing power of Serbia is 44% compared to the 2021 EU27 average, which is significantly lower than Bulgaria, whose GDP (57% of the EU average) is the lowest in the EU. Other Western Balkan countries have between 32 and 48% of the EU average.

ETS and EU CBAM application effects in Serbia and the Western Balkans

There are no expectations that Serbia will be an electricity exporter in the future, except in relatively small quantities, in periods of reduced electricity consumption and favorable hydrological conditions. If some 1.5 TWh of electricity is exported to the EU annually, the cost of CBAM (representing future EU revenue) would in 2030 be lower than €100 million (if calculated on the basis of Serbia’s average expected energy mix, with increased RES share). Introduction and gradual emission pricing growth would reduce this cost.

The cost of CBAM can be avoided if carbon pricing equal to EU ETS pricing is applied in Serbia. However, the annual cost of applying a possible EU ETS price of about €100/tCO2 would be some €2,200 million in Serbia (for a total emission of 22 million tons of CO2, which is significantly less than the current one). The cost of EPS would increase by this much, which would largely be passed onto all energy customers and increase their wholesale prices by approximately €70/MWh.

The cost of ETS would be some 20 times higher than the cost of CBAM

Customers in Serbia cannot accept this. The cost of ETS would be some 20 times higher than the cost of CBAM. With such cost relations, it is less important that CBAM cost is becoming EU revenue, while the ETS revenue becomes Serbia’s revenue.

Carbon pricing application effects are also different. The biggest impact, measured by costs per produced MWh, is on Serbia, because it has the largest share of coal in electricity generation.

CBAM application impact on the power companies of the EC contracting parties and the Western Balkans region is decidedly different. Bosnia and Herzegovina will suffer the hardest hit, as a large exporter and due to its high coal share in generation.

However, in any case, the export of electricity from coal-fired thermal power plants to the EU will practically become unprofitable from January 2030 if CBAM exemption is obtained (when EU ETS price is applied), while already from January 2026 if an exemption is not obtained (possible by applying the CBAM Regulation), because the additional carbon emission costs in the production costs of about 100 €/MWh will make it so.

Conclusion

The EC contracting parties should prepare and start implementing carbon pricing. EU ETS integration, as the final solution, would have to enable a sufficiently long transitional period with free emission allowances. If this is not possible, the contracting parties should consider other carbon pricing mechanisms (e.g. carbon tax) until their EU accession.

A successful attempt at quick and uniform introduction into the EU regime, a zone of the world’s highest carbon pricing of the most underdeveloped European region, heterogeneous both in terms of energy and politics, where capital is not available under favorable conditions, is not possible. The regional ETS would first have to resolve numerous open and still unresolved national and international, legal, economic, fiscal and other issues, to facilitate its establishment and to become functional. I am convinced that this is not possible.

There can be no successful decarbonization if the European Union does not formalize, institutionalize, and implement continuous financial support until EC exits coal

There can be no successful decarbonization if the European Union does not formalize, institutionalize, and implement continuous financial support until EC exits coal. The EU cohesion policy in energy must therefore be expanded to include the EC. If the EU wishes to mobilize the entire world to get behind fossil fuel phase-out at COP28, it must show that it is doing so in a sustainable way in a small neighborhood where it exercises institutionalized influence.

In the latest EU slogan “let’s buy European” under the global redistribution of influence in energy technologies and businesses, a commensurate place must be found for Balkan energy knowledge and energy equipment and services, allowing us not to continue to be mere technology buyers.

The contracting parties must show more enthusiasm and reach a national consensus to adopt a decarbonization policy and introduce carbon pricing, which will ensure long-term security of supply and energy availability, through reasoned, persuasive, and clear communication aimed at public opinion, above all at energy customers.