Europe’s Energy Taxation

On April 23, 2011, the European Commission announced it would revise the EU’s rules on energy taxation. This comes at a crucial moment for Member States, who are slowly edging out of the financial crisis, and will need to help meet the Union’s 2020 targets. The revision of existing energy taxation rules is expected to introduce many financial benefits while simultaneously support sustainable growth.

Currently, taxation of energy products is harmonized only to a certain extent at EU level. The 2003 Energy Taxation Directive set minimum rates for taxes on energy products, such as motor and heating fuels. By now however these rules are considered outdated and inconsistent with the Union’s evolving goals. Revision of the Directive is aimed at addressing the EU’s goals in energy and climate policies, in particular to increase energy efficiency by 20% by 2020, to stimulate the consumption of environmentally friendly fuel such as biodiesel, and to remove competitive distortions within the internal market.

The Economic-Environmental-Energy Chain

A fair and transparent energy taxation is needed to reach our energy and climate targets. Our common goal is a more resource-efficient, greener and more competitive EU economy.

- Algirdas Semeta, EU Commissioner for Taxation, Customs Union, Audit and Anti-Fraud.

Innovations in the EU energy market are generally governed by economic principles. However, environmental concerns are playing an increasingly important role. Since the effects of the economic crisis are wearing off in most Member States, and a new challenge is arising in the face of higher oil prices, the financial incentive to decrease the use of fossil fuels seems apparent. Also, the EU’s aims of obtaining 20% of its energy from renewable sources, achieving a 20% increase in energy efficiency, and decreasing greenhouse gas emissions by 20% before 2020 (the 20-20-20 Strategy), play an important role in revising the Energy Taxation Directive.

From an economic point of view, the EU’s current taxation rules for energy fuels set a minimum rate above which Member States are allowed to place their own rates. This has created obstacles and distortions in the internal market because (i) current minimum rates are based on volume (EUR/1000l) and are set according to historical rates in each state, and (ii) because different levels of taxation among fuel types in each state have led to market price signals not fulfilling their role. The first factor creates unfair competition between fuel sources and allows tax benefits for some fuel types without justification. For example, coal is currently the least taxed fuel source, and biodiesel is taxed at the same rate as conventional diesel. The second factor resulted in artificial differences among fuel prices. For example, prior to taxation, diesel is more expensive than petrol. In most Member States, a lower tax is levied on the former than on the latter, resulting in what is charged at the pump to not reflect the original price.

From an environmental point of view, the EU’s current system of taxation does not address the issue of CO2 emission reduction in a comprehensive way. In fact, as stated above, some cleaner fuels are taxed at the same rate, or even more heavily, than the polluting fuels they are expected to replace. However, four Member States (Denmark, Ireland, Finland, Sweden) have introduced a so-called ‘carbon tax’ to address this issue by making consumers pay for pollution. Still, these states each apply a different price-tag on carbon, which are not synchronized with rules under the EU Emissions Trading Scheme (ETS). This also contributes to distortions in the internal market.

De-carbonization through Taxation

The aim of the new Energy Taxation Directive is to steer the Union in the direction of a low-carbon and more energy efficient economy. The values which drive the revision are the need to contribute to sustainable growth, promote resource efficiency, and create a greener and more competitive economy. It comes after calls by the March 2008 European Council, and echoes the 2010 UNFCCC COP 16 in Cancun, Mexico.

The Commission’s answer is a comprehensive solution to a modern day problem. The current minimum tax rate is to be split in two parts. One is to be based on CO2 emissions of the specific energy product and to have a price fixed at 20EUR per tonne of CO2. The other concerns the fuel’s energy content and will reflect how much actual energy is generated in Gigajoules (GJ). The minimum tax rate is to be set at 9.6 EUR per GJ for motor fuels and 0.15EUR per GJ for heating fuels.

The single minimum rate for CO2 emissions would harmonize pollution taxation in the entire Union. To complement the ETS, it will apply only to sectors not covered by the scheme through the introduction of a ‘carbon tax’ on sectors such as households, transport, smaller businesses, and agriculture. Under the new rules, biofuels for example – which are currently taxed at the same rate as conventional fuels (as a result of the ‘per volume’ rule) – would be subject to an exemption due to their better CO2 emissions. Logically, renewable energy sources are equally exempt from the CO2 element, since they do not produce pollution during energy generation. At the same time, the most polluting fuel – coal – will become the most heavily taxed.

The second element is more complex and has to do with how efficient the fuel source actually is. When it comes to energy consumption, the efficiency of the source matters more than its volume and it would create a level playing field for all fuel types. For example, under the current system, diesel is taxed at lower rates than petrol in all Member States (except the UK) despite the fact that more energy is generated per liter. This has led to the price of diesel being lower at the pump than petrol, which in turn created an artificially high demand for the product, in spite of supply shortages in the Union. Under the new rules, a neutral taxation method is applied, resulting in a more realistic final price. In essence, this will contribute to the removal of these, and other, distortions in the market.

A combination of the above two elements will be used to determine the final tax. The EU will still set the minimum for each product and Member States would remain free to set their own rates above this minimum. This approach has been dominant since 1993 because of a compromise solution which gives Member States some flexibility due to their different budgetary needs.

Where is the Catch?

The changes to the Energy Taxation Directive will apply to all fuels at the point of consumption. Essentially, when a person fills up his or her car at a gas station, both components of the new tax system will apply. However, neither component will apply to electricity, since no CO2 is produced at the point of consumption (when switching on the light for example). That being said, it neglects the fact that oil, gas and coal are used to produce the electric power, all of which generate greenhouse gasses. However, the electricity sector is subject to the ETS’ rules. Similarly, when it comes to nuclear power, the new rules do not apply due to the same logic. Yet, small-scale electric installations that fall outside the ETS’s purview (such as household diesel generators) would be taxed under the revised rules which should help promote the development of domestic renewable energy installations that do not emit CO2.

However, the environmental component of the revisions is set to impact household budgets. Currently, 10% of CO2 emissions come from the residential sector because of fuel used for heating etc. The new rules recognize that the family budget will come under attack, and propose that there should be solid safety nets and accompanying social measures, especially for low-income households. At the moment, only the UK has defined the concept of ‘energy poverty’ as occurring when a family spends more than 10% of their income on energy (Source: Friends of the Earth). Yet, no such definition has been accepted at EU level, and the regulation of this aspect is left to each individual Member State. The Commission proposed the revenue from the new tax could be ‘recycled’ to compensate households through lump-sum social payments, as is already the case in the Member States who have introduced a CO2 tax. How effective this will be remains to be seen. It is clear that heating will remain the main problem, since each state depends on different fuel sources for warming its residential areas (gas, wood, coal etc.) and the variation between fuel types will result in different tax rates. Certainly, individuals would have to reconsider the way they keep warm during winter.

Furthermore, the new Directive includes a long transition period for Member States to adapt to the new rules. Most notably, nine states (Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia) will have until 2020 to implement the CO2 component of the new tax rules, due to their generally lower GDP per capita. The basis of this idea remains vague, since fuel prices are already considered too high in these countries and the current EU rules on minimum levels of taxation have come under scrutiny from national governments for placing their economies at a disadvantage. For example, Bulgaria’s petrol and diesel prices have been criticized recently for being extremely high compared to the population’s average income, even though the country has one of the lowest rates in the EU (see table).

Considering alternative fuels, the current rules tend to favor liquefied petroleum gas (LPG) and compressed natural gas (CNG) due to their fairly new position in the market. As such, a transition period of 12 years is given to these fuel types, during which they can continue to enjoy beneficial treatment and allow them to reach a level of equal competition with traditional fuels. Whether such preferential treatments will cause distortions in the market is a question left unanswered. Yet, with oil prices rising, these alternative fuel types are looking increasingly more attractive to the consumer, even without the new taxation rules.

Two other sectors will also continue to benefit from the revised Directive. The tax rates related to agriculture will remain lower, although they will depend on the environmental objectives that are supposed to ensure this sector’s contribution to saving energy. Less convincingly, the new proposal will not apply to aviation and maritime transport because of existing international obligations and the risk of competitive distortions. It should be pointed out however that aviation is set to enter into the ETS in 2012,  requiring all airlines flying to Europe to buy permits for each tonne of CO2 emitted. This intent  caused great consternation among foreign airliners, notably US and Chinese operators, on grounds of unacceptable cost increases. In response, Union officials have argued this to be a necessary step to break the deadlock on this topic at the United Nations (Source: EurActiv). The issue of maritime transport however remains shrouded in mystery.

From Principle to Reality

For now, the new proposal revises the rules for fuel taxation as the Commission sees fit. It is up to the Council of the EU and the European Parliament to discuss and amend as they wish. Expectations are such that the Directive will be accepted and put into force from 2013. The Commission sees this as ideal, since it would coincide with the ETS’s third working phase (2013-2020).

However, this does not mean the new rules will apply directly. The phase-in period which allows Member States to adjust their tax systems to the new rules is still unknown (the Commission estimates that it might take until 2023), but national administrators, as well as businesses, would expect sufficient time for implementation. Taking this into account, as well as the transition periods mentioned above, it could take a long time before we see taxation playing a role in the EU’s green economy initiative.


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