Effects of introducing a carbon tax in the Eurasian Economic Union

_ Yuri Kofner, research assistant, International Institute for Applied Systems Analysis (IIASA); non-residential research fellow, Skolkovo Institute for Emerging Market Studies; editor-in-chief analytical media “Eurasian Studies”. Munich, 8 August 2020.*

EAEU needs to react to EU climate policy

In order to curb “carbon leakage”[1], but also to finance the massive EUR 2.1 trillion Recovery Fund and EU budget for 2021-2027, the EU is currently debating the introduction of a carbon border tax (also called carbon border adjustment, CBA) to levy an additional toll on foreign goods imports based on greenhouse gas (GHG) emissions levels caused during their production.

The implementation of such a tariff would have substantial adverse effects on the carbon-intensive economies of the Eurasian Economic Union (EAEU)[2], which in 2019 sold 38 percent of their abroad goods exports to the European market. For instance, KPMG assessed that if the EU in 2025 introduces the CBA based on direct carbon emissions in production, Russian exporters alone will have to bill an additional tariff of EUR 3.4 billion annually between 2025-2030. Moreover, Eurasian exports might lose some of their competitiveness on other markets as well, since other countries might soon follow the EU’s example of cross-border carbon taxation and sustainable development standards.

The only way for the EAEU member states to avoid this likely new tariff burden is to autonomously adopt policies, which will reduce the carbon footprint of their economies and force their industries to cap greenhouse gas emissions by modernizing and using more renewable energy sources.

Leading economic researchers in this field hold the best policy measures to achieve this change to be fuel taxes, emission trading schemes (ETS)[3] and, foremost – the carbon tax (CO2 tax).

The aim of this paper is to analyse some of the effects of a potential implementation of a carbon tax in the EAEU member states in regards to CO2 reduction, government revenue, domestic welfare costs and benefits.

Carbon taxation

A carbon tax is a tax imposed on CO2 releases emitted largely through the combustion of carbon-based fossil fuels. Administratively, the easiest way to implement the tax is through taxing the supply of fossil fuels – coal, oil, and natural gas – in proportion to their carbon content.

Carbon footprint of the EAEU in 2030

The International Monetary Fund (IMF) estimates that without additional climate mitigation policies (hereinafter called the “business as usual” scenario) in 2030 the EAEU trade bloc will account for 4.3 percent of global greenhouse gas emissions. It should be noted that due to the ongoing  improvement in energy efficiency, to the gradual increase of renewables in electricity and heat generation, to electrification of transport systems, but also  to structural shifts from industrial production towards services, net CO2 emissions of the EAEU are set to decrease by 9 percent between 2017 and 2030 (Tab. 1).

Tab. 1. Paris mitigation pledges and CO2 emissions in 2030 (business as usual)

Paris mitigation contribution Share of
global CO2 (in percent)
Tonnes
CO2 per USD 1000
real GDP
Tonnes
CO2 per
capita
Net change in CO2 emissions, 2017-2030 (in percent)
ARM GHGs to not exceed 5.4 tonnes per capita for the period 2015-2030 0.02 0.41 2.4 24
BLR Reduce GHGs 28 percent below 1990 by 2030 0.14 0.90 6.4 -6
KAZ Reduce GHGs 15 percent (25 percent) below 1990 by 2030 0.68 0.96 12.0 12
KGZ Reduce GHGs 11.49-13.75 percent (29-30.89 percent) below BAU in 2030 0.02 0.90 1.1 -7
RUS Reduce GHGs 25-30 percent below 1990 by 2030 3.40 0.88 9.5 -13
EAEUa 4.26 0.89 9.6 -9

Source: (IMF 2019) and author’s calculations. aWeighted using expected GDP shares of the EAEU member states in total EAEU GDP in 2030 based on estimates by (Kofner 2020).

Paris pledges of the EAEU member states

In 2015, 190 parties signed the Paris Agreement for meaningful action to begin slowing atmospheric accumulation of heat-trapping gases. The centrepiece of the agreement are commitments by signatory parties to reduce greenhouse gas emissions, as specified in their “nationally determined contributions” (NDCs). These commitments include objectives for both mitigation (reducing emissions) and adaptation (building resilience to climate change).

It should be noted that these contributions are not consistent with containing mean projected warming to 2oC. For some developing countries they are partially dependent on external finance. And they are not legally binding. Yet countries are expected to report progress on meeting their NDCs every two years starting from 2018 and to submit updated NDCs every five years.

All five member states of the Eurasian Economic Union signed the 2015 Paris Agreement, with their pledges varying from not exceeding certain CO2 per capita thresholds to reducing greenhouse gases by up to 30 percent below 1990 emission levels (Tab 1).

Climate policies in the EAEU

So far, the EAEU member states gave only fringe attention to climate mitigation issues. Only Kazakhstan has implemented a nation-wide policy measure to curb carbon release. In 2013 it introduced an emissions trading system covering 129 companies in the power sector, centralized heating, extractive industries and manufacturing (oil and gas mining, metallurgy, chemical and processing industry, production of building materials). In 2019 the carbon price was USD 1-2 per tonne of CO2 and covered 50 percent of all greenhouse gases emitted in the republic. For comparison, the EU’s ETS was implemented in 2005 and by now covers 45 percent of GHG emissions and almost 11 thousand companies in power generation, industrial production and even aviation. Currently, at USD 27 per tonne of CO2 the carbon allowance price in the EU ETS is almost 14 times higher than in Kazakhstan.

To date, matters such as environmental protection, combating climate change or facilitating the transition to a green economy (including renewable energy sources) are not adressed by the EAEU Treaty and are not assigned to the competence of the supranational body of the union – the Eurasian Economic Commission (EEC). However, at present, the EEC and related expert circles are working on the “EAEU Development Strategy until 2025”, which is likely to include issues of research, technical and industrial cooperation in the field of renewable energy, green economy and environmental protection. The strategy may be adopted at the 2020 autumn summit.

Again, both to mitigate climate change and to avoid likely income losses on the European export market due to foreseeable EU CO2 import barriers, the EAEU member states should pre-emptively consider introducing their own carbon reduction measures, e.g. carbon taxes. Here it would be important for them to coordinate their actions among themselves in order to prevent, in advance, potential intra-EAEU competitive distortions and possible trade disputes. Already, sections XVII  and XVIII of the EAEU Treaty provides for such coordination.

Simulation methodology and scenarios

Using the results of a 2019 simulation by the fiscal affairs department of the International Monetary Fund, the author summed up some of the effects for the EAEU and its member states of a potential implementation in 2030 of a carbon tax , either union-wide or by the member states at national level. The research results include effects on CO2 reduction, government revenue, domestic welfare costs and benefits.

The simulation is a spreadsheet model, which distinguishes five fossil fuels, namely coal, natural gas, gasoline, road diesel, and other oil products (used in power generation, petrochemicals, home heating, non-road vehicles, etc.). The model projects, out to 2030, annual use of fossil and non-fossil fuel use in three sectors –  power generation, road transport, and an ‘other energy’ sector, where the latter represents an aggregation of direct energy use by households, firms, and non-road transport.

The carbon tax is modelled by incorporating into the fuel tax a charge of a uniform tax on CO2 emissions. Two counterfactual scenarios are simulated: the introduction of a USD 35 tax per tonne of CO2 and a more ambitious USD 70 per tonne carbon price.

Simulation results

Reduction of CO2 emissions

According to the estimation results, the introduction of a USD 35 carbon tax throughout the EAEU will reduce union-wide CO2 emissions by 12 percent below the “business as usual” baseline. A USD 70 carbon tax would curb greenhouse gas emissions union-wide by 19 percent below the baseline. In relative terms, CO2 emissions would be reduced the most in Kazakhstan – between 17 and 24 percent depending on the carbon price tag (Tab. 2).

Tab. 2. Reduction in CO2 emissions from carbon taxes in 2030 (in percent below “business as usual”)

USD 35 carbon tax USD 70 carbon tax
ARM 9 16
BLR 8 15
KAZ 17 26
KGZ 15 24
RUS 11 18
EAEUa 12 19

Source: (IMF 2019) and author’s calculations. aWeighted using expected GDP shares of the EAEU member states in total EAEU GDP in 2030 based on estimates by (Kofner 2020).

Impact on energy prices

A carbon tax would significantly increase energy prices in the Eurasian Economic Union. Coal prices would be affected most dramatically, increasing by 80 percent on average above business as usual prices in 2030 for a USD 35 CO2 price. Impacts on other energy prices are more moderate but still significant – on average 24 percent for natural gas, 16 percent for electricity and 7 percent for gasoline. Electricity prices would be affected less in Russia (13 percent increase), Armenia (5 percent increase) and Kyrgyzstan (due 1 percent) due to a larger share of nuclear and hydro energy in electricity generation.

Tab 3. Impact of USD 35 carbon tax on energy prices in 2030 (percent of price increase)

Coal Natural gas Electricity Gasoline
ARM 0 25 5 8
BLR 111 7,3 18 10
KAZ 95 25 38 14
KGZ 105 24 1 14
RUS 77 24 13 6
EAEUa 80 24 16 7

Source: (IMF 2019) and author’s calculations. aWeighted using expected GDP shares of the EAEU member states in total EAEU GDP in 2030 based on estimates by (Kofner 2020).

Impact on government revenue

Comprehensive carbon taxation in the EAEU would mobilize substantial new government revenues. A tax of USD 35 per CO2 tonne would, union-wide on average, raise estimated total government revenues by 2 percent of GDP in excess of total “business as usual” government revenues. A USD 70 carbon tax would increase total state revenues by 3.2 percent of GDP in excess of the “business as usual” scenario. Again, due to relative carbon emission intensity of its industry and transport sector, Kazakhstan’s government could expect the largest revenue increase between 2.8 and almost 5 percent of GDP in excess of “business as usual” revenues (Tab 3.).

Tab 3. Government revenue from carbon taxes in 2030 (in percent of 2030 GDP, in excess of “business as usual”)

USD 35 carbon tax USD 70 carbon tax
ARM 1.3 2.4
BLR 2.8 5.3
KAZ 2.8 4.9
KGZ 2.6 4.7
RUS 1.8 2.9
EAEUa 2.0 3.2

Source: (IMF 2019) and author’s calculations. aWeighted using expected GDP shares of the EAEU member states in total EAEU GDP in 2030 based on estimates by (Kofner 2020).

It should be noted that higher energy costs due to the carbon tax would tend to reduce employment and investment at the economy-wide level, which will lower revenues from broader taxes, for example on labour and capital. Therefore, the carbon tax revenues should be used efficiently by either reducing the broader (e.g., income) tax burden or to fund public investments into areas, which are deemed to be crucial for sustainable economic growth – education, health, research and development, digitization and infrastructure.

Welfare effects

Surprisingly, since the Eurasian economies are well known to be very carbon-intensive, the simulation results show that the introduction of a union-wide USD 70 carbon tax would create a substantial positive net welfare effect and increase the EAEU‘s GDP by of 3.4 percent on average in comparison to the “business as usual” trajectory (Tab. 4).

Tab 4. Welfare gains and economic costs from a USD 70 carbon tax in 2030 (in percent of GDP)

Welfare gains Economic costs Net welfare effect
ARM 0.2 0.2 0.0
BLR 1.8 0.5 1.3
KAZ 2.1 0.9 1.2
KGZ 0.1 0.8 -0.7
RUS 4.5 0.6 3.9
EAEUa 4.0 0.6 3.4

Source: (IMF 2019) and author’s calculations. aWeighted using expected GDP shares of the EAEU member states in total EAEU GDP in 2030 based on estimates by (Kofner 2020).

However, cross-country effects vary widely, with a net welfare surplus of almost 4 percent for Russia and a net welfare loss of 0.7 percent for Kyrgyzstan. This shows the necessity for the EAEU member states to negotiate either exemptions / transition periods (lower carbon prices) or to agree on an inter-country carbon reduction subsidy mechanism. Countries incurring relatively higher net costs from carbon taxation, i.e. Kyrgyzstan, could be compensated by members with relatively larger net benefits – mainly Russia and Kazakhstan. An potentiallz viable alternative to carbon taxation would be to introduce a comprehensive emissions trading scheme in the Eurasian Economic Union.

The creation of an integrated electricity market and transmission system in the EAEU, enabling easier cross-border electricity transfer from renewable generation sources, e.g. hydropower plants, to industrial and household end-users, would be another important task on the regional integration agenda.

The annualized costs of carbon taxation, measured by the economic value of the foregone fossil fuel consumption, i.e. the losses in consumer surplus from higher fuel prices and less state, are estimated to make up 0.6 percent of union GDP on average. Admittedly, the estimates do not account for potential terms of trade impacts and changes in global fossil fuel demand. For example, (Liu et al. 2019), using a G-Cubed multicountry, multi-sector intertemporal general equilibrium model, estimated significant net welfare losses to Russia of -1.7 percent of GDP, mainly due to a decline in international energy prices and international demand for petrol and natural gas, resulting from global action to meet Paris mitigation pledges.

However, the above-mentioned higher domestic fuel costs are counteracted in all and offset in four out of five EAEU member states by the domestic environmental co-benefits from reduced fossil fuel use, particularly reductions in air pollution health damages, but also reductions in motor vehicle traffic congestion and accident externalities, as shown by (Parry et al. 2015). The highest relative domestic environmental co-benefits would be experienced in Belarus (1.8 percent of GDP), Kazakhstan (2.1 percent) and Russia (4.5 percent), which is especially logical for the latter two, due to the unusually high air pollution damages in Russian and Kazakhstani cities. Relatively speaking, Kyrgyzstan would experience the least co-benefits from a carbon tax – only 0.1 percent of GDP –  potentially due to the fact that high air pollution levels in Bishkek and other Kyrgyz cities are caused not only by traffic and centralized power/heat generation, but also by a unusually high volume of wood burning for households heating purposes during the winter months.

According to another study by (Parry et al. 2018), the domestic net welfare effects for Russia were estimated at 3.7 percent of GDP, which is similar to the results presented above.

It should be noted that none of the mentioned studies account for climate-economic effects of reduced carbon emissions, both from the deceleration of global warming, i.e. a lesser likelihood of flooding, droughts, forest fires, as well as a lesser likelihood of oil spills, which are all prominent problems in Russia, Kazakhstan and the other EAEU member states.

Conclusion and policy recommendations

Both to socio-economic and structural reasons, the EAEU member states, except for Kazakhstan, have so far payed not much more than lip service to climate mitigation issues, which were very low on the national policy agendas and, as so far, not even part of Eurasian integration project.

However, what foreign and domestic experts have warned about for several years already, e.g. (Makarov et al. 2017) from the Higher School of Economics, is becoming reality: the introduction of tariff and non-tariff barriers by one of the EAEU’s leading trade partners against its goods exports based on embodied carbon dioxide content.

The Eurasian Economic Union member states are forced to react now. And since it is likely that other trading partners of the EAEU will soon introduce similar carbon border taxes and sustainable development standards, there are not many policy options. The bottom line is that in order to remain competitive in the carbon-free global market of the future, the Eurasian member states need to independently take measures to decarbonize their industrial production and transport systems.

Leading economic researchers in this field hold the best policy measures to achieve this to be fuel taxes, emission trading schemes and, foremost – the carbon tax.

According to simulation results presented in this paper, the introduction of a union-wide USD 70 per tonne carbon tax would have substantial positive outcomes in comparison to the 2030 “business as usual” baseline: a reduction of greenhouse gas emissions by 19 percent, an increase of government revenues by 3.2 percent of GDP and a domestic net welfare surplus of 3.4 percent of GDP, mainly due to less air pollution and a healthier population.

Admittedly, carbon taxation would lead to a significant rise in fossil-based energy prices, especially in coal production. This suggests the expediency of speedily adopting policies to support an increased share of nuclear, hydro, wind and solar energy in electricity generation, as well as to accelerate the transition to alternative mobility technologies based on electrification, hydrogen and, potentially even, less carbon-intensive natural gas engines.

Another and related important task for the Eurasian Economic Commission and the national governments to mitigate the costs due to a potential rise in carbon-intensive energy prices is the creation of an integrated electricity market and transmission system in the EAEU, which is planned to be achieved by 2025.

Concerning the shortcomings of this study, it did not take into account such significant issues as the effect of carbon pricing, both within the EAEU and abroad, on the international competitiveness of the Eurasian economies, both due to their relatively high production costs and due to the expected lower global demand for fossil fuels. In order to correctly estimate the trade and welfare effects of domestic and foreign carbon policies, this aspect needs to be evaluated in further studies, which would be especially relevant for policy makers in Russia and Kazakhstan.

Further studies would also need to estimate the potential carbon leakage due to carbon reducing policies, i.e. from “exporting” emission-intensive production to non-EAEU neighbouring countries in order to evade costs. This matter has been given much research attention in the EU and has ultimately led to the EU carbon border tax debate.

In order to avoid advantage asymmetries between member states in intra-EAEU trade, but also to due to the public good nature of climate mitigation, it would make sense for the EAEU member stats to act together by either introducing a union-wide carbon tax, or, at least to coordinate their national carbon policies. At the same time, differences in the net effects of carbon taxation, as shown in this paper, point to the necessity for the EAEU member states to negotiate either exemptions / phasing periods (lower carbon prices) or to agree on an intercountry carbon reduction subsidy mechanism.

Finally, the welfare costs and benefits of introducing a union-wide emissions trading scheme in the EAEU, as a potentially viable alternative policy option, should be analysed in greater detail. The study presented in this paper only shows that a union-wide ETS would lead to a reduction of CO2 emissions between 3 and 10 percentage points lower than what could be achieved by a carbon tax (Tab 5.).

Tab 5. Reduction in CO2 emissions from ETS and carbon tax in 2030 (in percent below “business as usual”)

ETS USD 35 carbon tax USD 70 carbon tax
ARM 5 9 16
BLR 6 8 15
KAZ 15 17 26
KGZ 8 15 24
RUS 8 11 18
EAEUa 9 12 19

Source: (IMF 2019) and author’s calculations. aWeighted using expected GDP shares of the EAEU member states in total EAEU GDP in 2030 based on estimates by (Kofner 2020).

Notes:

[1] Carbon leakage is a possible increase in emissions in other regions in response to a policy mandated emissions reduction in one country or region. Leakage could result from the relocation of economic activity, for example, the migration of energy-intensive firms away from countries whose energy prices have increased by climate policy. Alternatively, it could result from increased demand for fossil fuels in other countries as world fuel prices fall in response to reduced fuel demand in countries taking mitigation actions.

[2] The Eurasian Economic Union is a supranational trade and integration bloc made up of five post-Soviet states – Armenia, Belarus, Kazakhstan, Kyrgyzstan and Russia – with the aim of creating a common internal market based on the free movement of goods and services, labour, capital and enterprise. In 2019, its GDP by PPP was USD 4.7 trillion with a population of 184 million.

[3] An emissions trading system or scheme is market-based policy to reduce emissions (sometimes referred to as cap-and-trade). Covered sources are required to hold allowances for each tonne of their emissions or (in an upstream program) embodied emissions content in fuels. The total quantity of allowances is fixed, and market trading of allowances establishes a market price for emissions. Auctioning the allowances provides a valuable source of government revenue.


*Disclaimer: Views expressed in the article belong solely to the author and not necessarily represent that of the author’s employers or organizations.

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