Exploring the trade-offs in different paths to reduce transport and heating emissions in Europe

EXECUTIVE SUMMARY:

European Member States agreed in December 2020 to an increased climate target for 2030 of -55% net emissions reductions. In July, the European Commission will propose an update of the EU’s key climate and energy legislation to turn that climate target into concrete policy. This report looks into the impact of an increase in ambition in the road transport and buildings sector on the European economy and on household purchasing power. Our analysis shows that, if well designed, more rapid decarbonisation in these two sectors leads to very positive macroeconomic impacts in Europe.

According to the European Commission impact assessment, a cost-efficient contribution by the non-ETS sectors to the EU’s new 2030 target of -55% (compared to 1990) would be to reduce emissions in these sectors by around -40% (compared to 2005). The non-ETS sectors consist of road transport, buildings, agriculture, waste and small industries. Note that the current target for these sectors is -30% (compared to 2005), so efforts would need to increase by 10 percentage points. The report looks at two different scenarios to achieve a -40% emissions reduction in the non-ETS sectors. According to our modelling, the contribution of road transport to this target could be to reduce emissions by 33% and in buildings by 41%.

The first scenario modelled to achieve these reductions is with policy measures (both at the EU and national level) where road transport and buildings remain covered under the national climate targets, as regulated by the EU’s Effort Sharing Regulation (ESR). Analysis shows that such an approach would deliver substantial economic benefits, while encouraging the take-up of low-carbon technologies and avoiding some of the potential regressive distributional impacts associated with the introduction of an emissions trading system (ETS) for these sectors (which taxes marginal fuel use but does not necessarily help consumers to afford new low-carbon technologies).

The second scenario modelled transfers the responsibility of emissions reductions in the road transport and buildings sectors to a new EU-wide ETS, starting in 2025. Analysis shows that the introduction of such an EU-wide carbon price would require very high allowance permit prices to deliver equally rapid decarbonisation of these sectors by 2030, reaching €180 per ton (in 2015 prices) by 2030. Without any revenue recycling, the parallel ETS has a negative impact on output (measured through GDP) and employment across Europe.

With 100% revenue recycling, the ETS scenario could have the potential to increase economic activity in Europe while delivering the same emissions reductions. But even with revenues recycled, the macroeconomic benefits (in terms of jobs and GDP) are slightly smaller than if the policy measures from our first scenario were deployed to meet the same aim. The extent of revenue recycling, and how such revenues are used, substantially alter the socioeconomic outcomes from an ETS. It also influences the resultant ETS price. The analysis examines two extremes; either all revenues are used to pay down government debt, or recycling of all revenues back into the economy. In reality, revenues will be used in a variety of different ways. The positive economic impact of the policy measures scenario on the other hand does not rely on effective recycling of revenues. The analysis shows that if a share of the revenues are used for low-carbon technologies and building energy efficiency, then this does not only lead to lower resultant low-carbon technology costs for all consumers, but also lower carbon prices. Conversely, if revenues are recycled back to consumers (through either tax cuts or lump sum transfers) the rebound effect leads to higher levels of consumer expenditure and economic activity, which puts upwards pressure on ETS allowance permit prices across the period to 2030.

There are substantial concerns around the distributional impacts of an ETS. There is the potential to leave low-income households ‘stranded’ using heavily-taxed fossil fuel technologies (as a result of the high up front costs of low-carbon alternatives or energy renovations, and other barriers to take-up such as the lack of incentives for landlords to invest in these technologies). The analysis suggests that, in the countries studied in depth closely (France, Germany and Poland) the cost of gas for heating would increase substantially in 2030 as a result of the application of the EU-wide ETS price. Such impacts have a major impact on poorer households; both because they spend a greater proportion of their incomes on heating, but also because reductions in demand by these households are more likely to lead to underheating and resultant detrimental social and health outcomes.

This highlights the need for careful policy design, particularly in respect of use of the revenues that accrue from the ETS. The modelling shows that these choices have a major impact on the distributional impact of the ETS; for example, lump sum transfers lead to better outcomes for lower income households, as the lump sum is a greater proportion of their expenditure.