The revision of the Energy Taxation Directive could underpin a fair and green tax reform in Europe

Analysis

Tax systems across the EU are currently neither fair nor green. The burden of taxation has been steadily shifting in recent decades from corporate profits and personal wealth to labour income, especially of lower-income earners, helping to drive growing inequality across the EU. And with men disproportionately represented among the EU’s wealthiest citizens, the system helps underpin gender inequality too.

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Meanwhile just 6 percent of EU government revenues come from environmental taxes (mostly on energy), and tax breaks across the EU amount to some €35bn per year in fossil fuel subsidies, around four times the amount for wind and solar combined. IEEP estimates that just 44% of the external health and ecological costs of air pollution and greenhouse gas emissions are internalised in EU taxes. It is a clear injustice that too many EU polluters are not paying, while it is lower-income and marginalised communities that are disproportionately exposed to deadly climate and air pollution impacts.

Behind most of these fossil fuel subsidies lies the Energy Taxation Directive (ETD), and its revision as part of the Fit for 55 package is a key opportunity to spark a fair and green tax reform across the EU.

The current Energy Taxation Directive: neither fair nor green

The ETD dates from 2003, and sets minimum tax rates for energy products and electricity, aiming to preserve a level playing field in the single market. But those minimum rates, which are based on the volume of fuels sold, bear no relation to each fuels’ environmental performance. They were not indexed to inflation and so have declined markedly in real terms over the past 18 years, and worst of all they are subject to a patchwork of mandatory exemptions, optional reductions and nationally-specific derogations that create a series of perverse incentives and significant fragmentation in EU energy markets.

The ETD is the reason, for example, that coal, the most polluting fossil fuel, is taxed less for heating than fossil gas in many countries, while fossil gas is taxed less than electricity in every Member State except the Netherlands – a major obstacle to heating electrification that is essential to hitting the EU’s 2030 emissions target. While tax rate reductions are allowed for electricity from renewables, and used by some Member States, they are not required and are missing in many Member States.

In transport, the ETD is the reason that highly polluting diesel is taxed less than petrol across the EU, and – because the tax rates are based on the volume of fuels rather than their energy or carbon content – diesel and petrol are incentivised over biofuels. Given the directive dates from 2003, there is also no distinction in tax rates between so-called more and less sustainable forms of biofuel. Perhaps most egregiously, kerosene fuel for aircraft and bunker fuel for shipping are not allowed to be taxed all. That subsidy to the aviation industry alone amounts to some €8.2-13.9 billion per year.

But the ETD today does not just de facto favour fossil fuels, it also favours industry over households, and tends to favour higher income households over those on lower incomes and to some extent men over women. As Figure 1 shows, not only does fossil gas face lower prices and taxes than electricity, but EU households pay higher prices and taxes than industry, with sectors like agriculture and in particular energy intensive industries benefiting from various tax reductions. In transport, commercial use of diesel – including haulage trucks and company cars – enjoy the lowest rates too. Those tax breaks for company cars, linked to deadly air pollution in cities like Brussels, alongside the aviation exemption, likely benefit high income households and men in particular.

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Comparison of electricity and gas prices and share of prices from taxes for EU households and industry in 2020. Source: Eurostat.

 

The proposed revision to the Energy Taxation Directive

The proposed ETD revision is therefore a welcome opportunity for a course correction. At the heart of the proposal is a new structure for minimum tax rates, based on the energy content and environmental performance of fuels, reflected in a new four-part categorisation to reflect different fuels’ relative importance in the EU’s energy transition.

The highest tax rates are applied to coal, diesel and petrol, while fossil gas and hydrogen made with fossil fuels will initially be taxed at two-thirds of those rates, increasing over a 10-year period to the same level, to reflect their role as so-called ‘transition’ fuels. Lower rates are applied to so-called ‘sustainable’ biofuels, while the lowest rates are applied to so-called ‘advanced sustainable’ biofuels, hydrogen from renewables and electricity (whether it is generated from fossils or renewables, and whatever it is used for).

Under the proposal, Member States would remain free, as currently, to set their own rates above these new minima, but would be required to respect this relative ranking. In absolute terms, the top minimum rates are nonetheless barely increased compared to today – meaning revenues based on these rates would still fall far short of the external health and ecological costs of burning the fuels – but this time the rates would be indexed to inflation, meaning a gradual increase in the years ahead. This gradualist approach is, it must be said, in line with what is widely considered best practice in reforming environmental taxes.

But just as important, the proposal also broadens the tax base by removing swathes of the current loopholes. Most notably, the mandatory exemption for aviation and shipping fuels is ended, although kerosene is afforded a lengthy ten-year transition period during which rates would be increased towards the highest rate. Given its higher risk of carbon leakage from ships bunkering outside the EU, a reduced rate is applied to shipping.

Significantly, the proposal removes the distinction between fuels used for commercial and non-commercial purposes, which would see a welcome end, for example, to tax breaks for company cars. That said, lower taxes could nonetheless still be applied to fuels used in agriculture, aquaculture and forestry – still acting as incentives for intensive agro-food business models. And the proposal still leaves the option of reduced rates to preserve the competitiveness of energy intensive industries, although some more stringent conditions for applying these are introduced.

Any energy tax increases will have regressive first order social impacts, as energy taxes represent a higher share of the income of lower income households. The proposal seeks to address this by allowing for a ten-year period of tax exemptions for the most vulnerable households, and a ten-year transitional phase-in period of the new rates for all other households. But as the Commission notes, ultimately energy tax reforms can be progressive depending on how Member State governments use their revenues. 

Returning revenues as equal lump-sum payments to households, for example, would entail a redistribution from those on higher to lower incomes. Alternatively, Member States could invest in energy efficiency measures in lower-income households, or reduce labour taxes and social security contributions to help boost employment (and if employers responded by reducing working hours, that would have substantial gender-equalising benefits too).

Is consensus possible?

Ultimately though, because the power to control tax policy rests with the Member States, the biggest question about this proposed revision remains whether a consensus on it can be reached in the Council of the EU. The Commission can bring the Member States’ horse to the water of progressive environmental tax reform, but it cannot make it drink.

A previous attempt at reform from 2011 to 2015 was blocked by an unholy alliance of vested industry interests – from diesel auto-makers to coal miners and shipping magnates – and their Member State backers, while civil society activists were notably absent from the public debate. This time around many opponents of reform will no doubt invoke the ‘gilets jaunes’ protests as another reason to maintain the status quo. From the UK to Switzerland, many (far) right-wing opponents of climate action are using apparently ‘pro-poor’ arguments to block and delay new policy measures.

Champions of climate justice should be wary of such arguments. They should remember that the current system is far from fair, benefiting industrial and high-income polluters most of all. What is more, artificially lowering energy prices for deadly fossil fuels is at best a very limited approach to supporting people on lower incomes. Any serious attempt at addressing spiralling inequality in Europe should be more concerned with the fight for adequate minimum wages, decent universal public services and wider progressive tax reforms, alongside an accelerated effort to address the climate crisis, to which lower income communities everywhere are most vulnerable.

That’s why it is vital to see the ETD revision as part of a broader package of fiscal policy measures that can serve to both cut emissions and reduce inequality in Europe. Based on IEEP’s forthcoming analysis of the National Recovery and Resilience Plans, some governments seem to have grasped that. We can expect governments like those in Spain or Belgium, for example, to emerge as stronger champions for ETD reform this time around, alongside long-standing environmental tax reform proponents like Sweden and Finland.

As for the others, one of the Commission’s strongest arguments for reform may this time be persuasive. Under the status quo, government revenues from energy taxes are projected to take a big hit in the coming years – falling by nearly a third by 2035 – as the transition to electric vehicles gathers pace. Reforming the ETD is vital to sustain those revenues over the next decade. Finance ministers, even in the most recalcitrant of Member States, may well conclude this time around that doing nothing on energy taxes is no longer an option.

The proposed ETD reform is careful and cautious, and the need for compromise and horse-trading between Member States’ priorities across the Fit for 55 package may offer it a better chance of success than during the earlier attempted revision. But the unanimity principle nonetheless means adoption will be far from easy. The challenge for progressives across the continent will be to make the case for this reform as one essential element of building the fairer and greener tax system Europe needs.