Michael de Laine

Environmental economics council says green taxes will help reach GHG emissions cuts goals

By Michael de Laine, Copenhagen, 4 March 2009

The Danish Council of Environmental Economics said environmental (green) taxes should be introduced or adjusted to help implement the EU’s Water Framework Directive. As well as being an important source of public revenue, green taxes will play a central role in reaching the national target for reductions in GHG emissions.

The Chairmen of the Danish Council of Environmental Economics said environmental (green) taxes are part of the regulation suggested for implementing the EU’s Water Framework Directive. Green taxes will play a central role in reaching the national target for reductions in greenhouse gas (GHG) emissions and they are an important source of public revenue.

In its new report on the economy and the environment, released today, the council said new green taxes should be introduced, and existing ones adjusted.

It studied the implementation of EU Water Framework Directive, environmental or ‘green’ taxes and the reduction of GHG emissions.

The Danish Council of Environmental Economics said local pollution control of the discharges from agriculture is the most cost effective policy instrument to achieve the Water Framework Directive’s objectives. It added that national regulation is required to limit the use of nitrogen and phosphorus and thereby the general environmental damage such as emissions of ammonia and laughing gas.

The use of phosphorus is regulated by a phosphorus tax on mineral feed. The council recommended the introduction of a nitrogen tax on commercial feed stuffs and fertilizers to replace the existing crop-specific nitrogen quotas.

A nitrogen tax should also regulate the part of the laughing gas discharges that comes from fertilizer application. Furthermore, livestock discharge GHGs through the discharge of methane. The council recommended a tax per animal to regulate these discharges.

The existing pesticide tax varies with the retail price of the different categories of pesticides. Instead, the council said, the tax should be based on the potential environmental risk and damage of the different pesticide categories.

Because climate and energy policy has increased the focus on the development of energy consumption and emission of GHGs, the Danish Council of Environmental Economics has made some projections for the country’s future energy consumption and GHG emissions.

Denmark’s energy consumption has increased by approximately 15% since 1990, while production has increased by approximately 45%. The projection forecasts an increase in energy consumption primarily due to a significant increase in petrol and diesel consumption for road transport. Despite increasing end-use energy consumption, increasing efficiency in production of electricity and district heating implies that net energy consumption is expected to be reduced more than the national target of 4% in 2020. The council sees the share of renewable energy in total energy supply increasing to 40% in 2020 given the current regulation of subsidies, the assumed development in energy prices and the CO2 quota price. Since the aim is a share of 30%, the target is expected to be realised.

There are a number of objectives in Danish climate and energy policy involving emission of GHGs, energy consumption, and renewable energy. According to the Kyoto Treaty, Denmark is under an obligation to reduce GHG emissions 21% on average during the period of 2008-12 relative to the emission level in 1990. The projection indicates that, without further initiatives, Denmark’s total GHG emissions will lack a reduction of approximately 12¼ million tonne CO2 equivalents each year during the period of 2008-12. This is a smaller deficit than assumed in the Danish National Allocation Plan 2008-12 and it may be possible to meet that plan by buying emissions quotas.

Since the projected energy consumption and emissions were calculated in late 2008, the economic slowdown seems to have worsened, indicating that energy consumption and GHG emissions could be smaller in 2008-12 than estimated. This will reduce the need for buying quotas or emission rights outside Denmark.

Denmark and the EU are obligated to reduce GHG emissions. The regulation in the EU is not the same for the whole economy, which is divided into sectors that are within the Emission Trading System (ETS sector) and sectors that are outside the Emission Trading System (non-ETS sector). For the two parts of the economy there are different regulations and objectives. The ETS sector is regulated by the EU quota trading system, while national objectives are determined for the non-ETS sector.

In 2005 the emission of GHGs from the non-ETS sector in the Danish economy was 37.2 million tonne. The national reduction target for Denmark is that the emissions must be reduced by 20% to 29.9 million tonne in 2020.

However, the projection estimates that emissions from the non-ETS sector will be reduced by approximately 4% only from 2005 to 2020. This forecast is based on the expectation that non-energy related emissions from especially agriculture will decrease, while energy-related CO2 emissions, which are two-thirds of the emissions from the non-ETS sector, are expected to remain the same.

Increasing consumption of transport fuels in the future implies a substantial increase, the council said, while the emission from industries in the non-ETS sector and households is estimated to decrease.

On this background, the domestic reduction of GHG emissions in the non-ETS sector is estimated to be approximately 1½ million tonne in 2020 relative to the level of emission in 2005. This implies a deficit of approximately 6 million tonne in 2020.

The Chairmen of the Danish Council of Environmental Economics said there is therefore a need for additional initiatives to achieve the required reduction in GHG emissions in the non-ETS sector.

Green taxes or tradable emission permits are generally cost efficient economic instruments in environmental policy, the council said. Green taxes should be levied as close to the environmental damage as possible.

Several of the Danish green taxes have been introduced without a prior assessment of the environmental damage and without an environmental target. Green taxes should be continuously adjusted to reflect new knowledge on the size and the monetary value of the environmental damage.

The council said that all polluters, that is services, industries and households, should pay the same green tax if the tax is levied with an environmental purpose. This ensures that the environmental improvement is achieved at the lowest possible costs.

Taxes introduced with the purpose of raising government revenue should only be levied on final consumption, the council added. The least price elastic commodities should be taxed the highest as this will minimize the social economic costs of raising a given revenue. In this case, industries and services should not pay a revenue-motivated tax on their intermediates, as this distorts the input choices of producers.

Green taxes on households’ consumption and intermediates in industries and services affect consumption of commodities in households and the use of intermediates in industries and services directly and indirectly.

The economic consequences of increasing the level of green taxes are highly dependent on how the resulting revenue is spent, the council said. A public revenue of DKr 5 billion, collected by proportionally increasing all green taxes and used to increase the personal tax free allowance, implies a social economic cost of DKr 1.5 billion – not counting the value of changed environmental conditions.

However, the social economic cost is reduced to approximately DKr 1 billion if the revenue is spent to reduce the bottom tax rate as this would stimulated the labour supply, and thereby economic activity. The labour supply will be stimulated even more if the revenue is spent to reduce the top tax rate.

The economic council said it is often thought that higher green taxes would increase inequality because inequality is often measured as differences in annual income rather than annual consumption. Annual consumption may arguably be a better measure for life-time income than current income, which can be affected by several temporary factors. It is therefore from a lifetime perspective more relevant to measure the distributional consequences of green taxes using differences in annual consumption.

The council said high-income households (measured by total consumption) pay more in green taxes than low-income households and households outside the labour force. This holds in particular for green taxes on transport, while green taxes on water and electricity represent a higher consumption share for low-income households.

How the revenue resulting from higher green taxes is spent determines the distributional consequences of higher green taxes, the council said. Low-income households will gain from higher green taxes if the personal tax-free allowance is increased. The distributional consequences are closer to neutral if the bottom tax rate is reduced instead. However, low-income households also gain in this case.

Progressive green taxes, i.e. where only consumption above a certain level is taxed, cannot be recommended, the council said.

Households with low consumption levels will not have sufficient incentive to reduce consumption of polluting commodities. The environmental effect does not depend on whether the consumer is rich or poor. Therefore, from an environmental perspective, green taxes per unit of pollution should be equal across all consumers. Distributional concerns should be addressed by other means, e.g. via the income tax system or by direct income transfers.

A tax based on the emissions of air pollutants, such as CO2, SO2 and NOX (particles), should be levied uniformly on households and industries. That is, all polluters should pay the same for a given amount of emissions of air pollutants.

Consequently, a tax reflecting the emission of particles should be levied on households’ use of firewood and other bio-fuels. Taxes levied to increase the security of energy supply should be limited to the use – by households and industries – of oil and natural gas. The supply of coal is not considered to be limited from reliable trading partners.

The existing general tax on energy needs focusing and rethinking, the council said. In its current form it is neither targeted to raise public revenue efficiently, nor to address environmental externalities or concerns about security of energy supplies.

The economic council recommends that the present tax on energy is split into various elements. Households would have to pay all elements of the new tax, whereas services and industries would only pay relevant parts.

Today’s taxes on transport come in the form of fuel taxes, taxes when buying a vehicle and a yearly tax from owning a vehicle. The latter taxes are differentiated according to either size or fuel efficiency, and in some cases purpose of use (i.e. business or private).

Because the system is not well designed to account for the extern impacts attributed to transportation, such as congestion, noise, accidents and local and global air pollution, the Chairmen of the Councils recommend studying the possibilities of introducing an intelligent road-pricing scheme.

The advantage of a road pricing scheme is that the tax payment can be made to depend on where, when and with which type of vehicle transportation take place. This would allow the payment structure to address a larger range of extern effects resulting from transportation. With the introduction of road pricing, taxes levied when buying vehicle should be reduced. Taxes related to households’ ownership of vehicles could to some extend be maintained for reasons of public revenue generation.

Since GHG emissions depend entirely on fuel use, this can be corrected by fuel taxes. In addition to regulating GHG emissions, fuel taxes should possibly include an energy security element. Such a system is likely to lower the direct taxation of transportation fuels compared with the current level. However, depending on the costs of other externalities, the price of using vehicles would increase, the council said.

Whether the total amount of taxes paid for a given amount of driving will increase or decrease will depend of the type of vehicle used, the time and the place of use. Trucks and lorries will face an increase in transportation taxes, since the current tax on freight traffic is lower than the external effects.