The implications of fiscal measures to address climate change

Prepared by Steffen Osterloh

Published as part of the ECB Economic Bulletin, Issue 2/2020.

This box assesses the impact of fiscal measures to reduce greenhouse gas emissions on growth and inflation over the March 2020 ECB staff projection horizon. Current EU-wide emission reduction targets and policy objectives for the period 2021-30 are based on the 2030 climate and energy framework, which was adopted by the European Council in 2014. The framework sets binding targets for cutting greenhouse gas emissions to below 1990 levels, namely a reduction in emissions of 20% by 2020 and at least 40% by 2030. Policies to reduce carbon emissions in the European Union comprise: (a) the EU Emissions Trading System (ETS), which covers around 45% of the EU’s greenhouse gas emissions and limits emissions from, in particular, sectors with heavy energy use within the European Union plus Iceland, Liechtenstein and Norway, such as power stations, energy-intensive industries and flights between airports located in the European Economic Area (EEA); and (b) national measures in sectors that are not covered by the ETS, such as transport, heating and agriculture.

The EU ETS provides certainty about annual emission reduction in the sectors covered but leaves uncertainty concerning the development of allowance prices. The EU ETS works on the “cap and trade” principle, setting a cap on the total amount of certain greenhouse gases that can be emitted by installations covered by the system and allowing firms to trade their emission allowances. The cap is reduced over time so that total emissions fall. The share of auctioned allowances, i.e. allowances that are not given away for free to companies, has been increased over time, rising to 57% in the trading period 2013-20. The price which companies have to pay for the auctioned share of the allowances has an effect similar to a tax on the carbon content of a company’s inputs, as it immediately increases their production costs. The empirical literature shows that cost increases due to previous ETS allowance price rises were, to a large extent, passed through to consumer prices.^[1]

The development of allowance prices in the EU ETS over the past two years has possibly generated some limited inflationary pressures, but markets expect, at most, further moderate increases over the projection horizon. Having been relatively stable at low levels of, on average, around €6 per tonne of CO2 between 2012 and 2017, the ETS price rose significantly in 2018 and 2019, ending 2019 at around €25 per tonne. This increase also translated into a surge in public revenues from the auctioned allowances and additional costs for companies. This implies a positive impact on euro area inflation in 2018 and 2019 and a negative but very small impact on GDP growth. However, despite the ongoing rationing of emission allowances, ETS futures currently do not point to a further surge in prices, which suggests that no major impact on consumer prices is expected in the coming years. Nevertheless, volatile allowance prices continue to represent a risk factor for the HICP.

The reduction in emissions in the remaining (non-ETS) sectors is enshrined in the Effort Sharing Regulation. This legislation establishes binding annual greenhouse gas emission targets for EU Member States for the periods 2013-20 and 2021-30. Overall, compared with 2005 levels, the national targets aim to collectively deliver a reduction of around 10% by 2020 and 30% by 2030. In contrast to ETS sectors, Member States are responsible for designing policies to achieve national targets for non-ETS sectors.

A national carbon pricing system for sectors not covered by the EU ETS, which is expected to have positive effects on inflation, was recently agreed in Germany. As part of the “climate package” agreed in December 2019, a national carbon pricing system for the transport and building heating sectors will be introduced in 2021. As the carbon pricing system will start with a fixed price that will gradually increase until 2025, it initially resembles a carbon tax. The December 2019 projections reflected the initial coalition agreement of a starting price of €10 per tonne of CO2 for 2021. A positive effect on HICP between 2021 and 2022 was forecast, while the effect on GDP was expected to be small.^[2] The impact on prices and GDP is expected to be muted as a large share of the revenue from the sale of allowances will be used to compensate industry and consumers, particularly via lower electricity prices resulting from a reduction in the levy imposed by the German Renewable Energy Act (Erneuerbare-Energien-Gesetz – EEG) in line with increasing CO2 prices. Moreover, climate-related spending will be increased. The March 2020 projection incorporates the revised package, which envisages a much higher price of €25 per tonne of CO2 in 2021, rising to €55 per tonne by 2025. However, the macroeconomic implications of this revision are expected to be small since the effects of the higher CO2 price will be lessened, reflecting the announcement that the additional revenue will be fully used to further lower electricity prices by reducing the EEG levy.

Few increases in carbon taxes are expected in the next years. Together with carbon cap and trade schemes, carbon taxes, which are levied on the carbon content of fuels, are regarded as the most cost-effective instrument to reduce carbon emissions. An automatic gradual increase in carbon prices to reach national emission reduction targets would allow households and firms to adapt, but none of the eight euro area countries with a carbon tax currently has such an automatic mechanism in place. Ireland has passed legislation for an increase in carbon taxes for 2020 with very minor fiscal implications for the euro area as a whole and the government has stated its intention to introduce linear increases in the tax until 2030. In Portugal, a mechanism links the carbon tax rate to the price of EU ETS allowances in the preceding year, which has recently led to some increases. The remaining countries currently do not foresee an increase in their carbon tax rates.

Several countries are planning increases in environmental taxes over the projection horizon, but their overall size is limited at the euro area level. More than half of euro area countries plan to increase environmental taxes other than carbon taxes over the next two years. These increases mostly relate to excise taxes on energy and fuels, but also concern taxes on vehicles and airline tickets. The biggest increase in such taxes is foreseen in the Netherlands, although the macroeconomic effects will be largely offset by compensatory cuts to energy taxes. In the other countries, these measures are typically small (in almost every case the annual increase is below 0.1% of GDP) and for the euro area as a whole their size is marginal. Moreover, in some cases, indirect tax measures with an expansionary effect will be implemented, such as tax cuts to incentivise the use of public transport, e-mobility or LPG. Finally, there is very little use of direct tax measures to support the green transition.

Overall, the impact of climate measures on euro area GDP and prices in 2020-22 is expected to be low, but in the medium term the tightening of emission reduction targets could pose an upside risk to the inflation outlook. While some effect on euro area inflation is expected for 2021 and 2022 from the German package, no other large Member State currently has concrete plans for a similar carbon pricing system. Moreover, no substantial effects are expected in other countries that already have carbon taxes in place. Several Member States are planning increases in environmental taxes but the implications for growth and prices over the projection horizon are projected to be small for the euro area as a whole. However, in the medium term the impact of climate measures on prices could increase owing to a possible further tightening of emission reduction targets as part of the European Green Deal which was announced by the European Commission in December 2019. More ambitious targets may have a positive effect on EU ETS emission allowance prices and could entail the implementation of new national measures with a positive effect on the general price level, such as a national ETS or carbon taxes.