Energy prices in Europe have been skyrocketing in the aftermath of the Covid-19 pandemic. The price increase can be attributed initially to a surge in demand for gas as governments were easing restrictions imposed during the pandemic. This was coupled with low supply of gas in the global markets.

In addition, the Russian invasion of Ukraine at the end of February was the straw that broke the camel's back. Russia is the EU’s main supplier of crude oil, natural gas and solid fossil fuels and the uncertainty around the war and the fear of sanctions in the energy sector has exacerbated tensions in the global energy markets. All of this has translated into rising energy prices that ultimately citizens will pay: only during the month of March 2022, Spain electricity prices in the wholesale market reached EUR 283,3, the highest ever (Figure 1).
 
This has put in question the sustainability agenda of both the EU and the Spanish government. To achieve the 2050 carbon neutrality objective, the decarbonization of the energy system is a must. However, this is a long-term process and in order to deal with the current crisis, governments are being forced to seek additional energy sources elsewhere (such as LNG, coal or nuclear) to move away from Russian supplies, and to implement exceptional measures to contain prices. In Spain for instance, the government has reduced taxation on electricity generation as an attempt to reduce prices for consumers.
 

The role of the EU

In this context, some might wonder about the role the EU have had so far and can play in the current crisis. Indeed, the current functioning of the market is attributable to action at all government levels; especially at the EU level. Since the late 90s, the EU has introduced several pieces of legislation to build up a framework for the current internal energy market. The EU has also set environmental objectives that also affect the energy sector since the production and use of energy is responsible for more than 75% of greenhouse emissions.

As part of the European Green Deal, the European Commission (EC) presented in July 2021 a series of legislative proposals to revise the entire EU 2030 climate and energy legislative framework, known as the 'Fit for 55 package'. The purpose of the revision is to prepare existing European legislation to reach the 55% net reduction of greenhouse emissions with respect to 1990. This is a key stepping-stone to achieve the 2050 climate neutrality target enshrined in the European Climate Law. Otherwise, according to the EC, without changes in the current legislation the European Union would only achieve a 60% reduction of emissions by 2050.

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Two key pieces of legislation set to be reviewed are the Energy Taxation Directive (ETD) and the extension of the European Emission Trading Scheme (EU ETS) to the transport and buildings sector, known as ETS2. These are crucial since they touch upon energy costs and these costs constitute a higher share of expenditure of lower-income households. Therefore, changes in these will impact energy prices for consumers and it can have potentially regressive impacts on citizens' welfare.

What would be the impact of such reforms in terms of price changes?

The change in taxation levels (and its income distributional consequences) caused by the ETD reform will depend on the current level of taxation applied for the different energy products in each Member State. For instance, Spain will be required to both increase certain fossil heating and/or transport taxes while also reducing electricity taxes. The reform is expected to increase the price for diesel by 2% and coal by 5% while reducing electricity prices by 3.6%. This would also imply loses of revenue for the government amounting to EUR 325 million annually. 

With the introduction of the ETS2 and assuming an initial carbon price of EUR 45/ton, consumer price changes would also change across the different member states according to their own idiosyncrasies. In Spain, petrol prices would increase by 10.6%, diesel by 13.9%, gasoil by 26.2%, natural gas by 14.4% and coal by 75.6% while electricity prices would not be affected.

So, is it the moment to undertake such reforms?

With this background and taking into account the risk of potential regressive effects of the ETD and ETS2 revision within the Fit for 55 package, some stakeholders might wonder if this is the right moment for such a legislative revision.

However, if well implemented, these reforms can have positive distributional and environmental impacts. New research by the Institute for European Environmental Policy (IEEP) shows that both the ETD reform and ETS2 implementation could have broadly progressive distributional impacts across the EU, with clear benefits for the poorest households.

The paper has found that, depending on how the reforms are implemented and how the revenues derived from changes in taxation are recycled (i.e., when income generated from carbon taxation is earmarked and returned back to society), these reforms can have a positive distributional impact while contributing to climate action.

Taking the EU as a whole, the report finds that:
 

• The implementation of both measures with no revenue 'recycling' would bring overall a regressive impact on welfare (blue bars in the graph below). 
• However, with the implementation of recycling the new ETD revenues and the allocation to each MS from the Social Climate Fund (SCF) (representing only 25% of total ETS2 revenues) as income support to the poorest 50% in each MS would achieve net welfare gains for the poorest 10% (worth approximately €100 on average per household). It would mitigate but not eliminate adverse impacts in other lower and middle-income households (orange bars).
• However, with additional recycling of all remaining national ETS2 revenues to benefit the poorest 50% of households in each MS the result is clearly progressive; except that the richest 10% of households incur notably lower costs than those in upper-middle-income groups (grey bars).

 
The figure below shows the specific results for Spain, reflecting moderate adverse impacts for the poorest 20% of households absent revenue-recycling (blue bars), which can be addressed through recycling just Spain’s SCF allocation (orange bars). However, if Spain recycles its remaining national ETS2 revenues in addition to those received from the SCF, it will lead to a positive welfare impact for the middle-income groups as well (grey bars).
 
In conclusion, the results show that the Fit for 55 reforms can contribute to an improvement of the current environmental taxation framework. The strengthening of the ETD and the introduction of ETS2 will reinforce the 'polluter pays principle' (i.e., those who produce pollution should bear the costs of managing it to prevent damage to human health or the environment). If combined with the recycling revenues resulting from increased taxation, the potential regressive impacts can be addressed. In fact, the study shows that such reforms can bring welfare benefits for the poorest households in both the EU and in Spain. This can also serve as an example of how well-implemented environmental taxation can be progressive. This has the potential to palliate the effects of the energy prices crisis due to the Russian invasion of Ukraine.



To accompany the ETD reform and the ETS2 implementation and to address the current energy price crisis, additional measures should be explored:

Temporary electricity tax rate cuts and exemptions for households at risk of poverty.- Temporarily, taxes linked to energy consumption, such as VAT, should be lowered in order to provide immediate relief for consumers. The Spanish government has already implemented the measure and this should be maintained as long as the energy prices are anormal. Such measures should ensure they result in a benefit for consumers, despite the loss of public income. 

Front-loaded recycling well-before carbon price is implemented.- ETS2 is set to start in 2026 and ETD reform would also follow a medium-term implementation to provide certainty to the markets. The SCF would start in 2025 to start addressing inequalities related to the upcoming proposals. However, this might be too late. Several stakeholders propose for the fund to start earlier (by 2023) to already start addressing the regressive effects of the Fit for 55 package.
 
It could start functioning using windfall profits, such as those extra funds arising from ETS1 due to recent high carbon prices. Using a tax on windfall profits has been recognised in the recent Repower EU communication in the context of the Russian invasion of Ukraine. Electricity providers have registered record profit increases due to the increase of energy prices. In the month of February only, electricity providers have increased their profits by a 121.4% in Spain. These windfall profits could be taxed to feed into the SCF.
Removal of renewable energy levies from electricity bills. 

Renewable energy is key not only to achieve the EU environmental objectives, but also to eliminate our dependency from fossil fuels from abroad, particularly from Russia.- To meet such objectives, renewable energy must count on public support. In 18 EU countries, renewable energy levies have been established on consumer bills to direct the revenues to promote renewable energy deployment. This measure is however, a regressive one. Taxing everyone the same percentage to support renewable energy has an uneven burden for poor households, since energy costs constitute a higher percentage of their expenses. Therefore, we believe renewable energy levies should be removed and these should be promoted with alternative instruments/funding (e.g., from general taxation, taxes on fossil fuels).