The transition to climate neutrality will significantly transform the EU economy but does not pose a threat to the sustainability of public finances, concludes a new study commissioned by the Commission’s Directorate-General for Climate Action (DG CLIMA). The study evaluates the direct impacts of the transition on revenues, expenditures and budget balances, while also taking into account indirect effects.
Impacts of the climate transition on public finances
The climate and energy transition will require substantial resources and public sector support to incentivise and boost low-carbon technologies, and to achieve behavioural changes. At the same time, the shift away from fossil energy sources will substantially affect public revenue sources from the existing tax base. In this report, the implications of the climate and energy transition on public finances are analysed, including impacts on revenues, expenditures and the long-term debt and its sustainability.
Impacts on government revenues and expenditures
As a result of the climate and energy transition, government revenues from fossil fuels are set to decline, while carbon pricing revenues are set to increase in the medium-term, until the economy’s decarbonisation sets them on a declining path.
The EU has already started to shift away from fossil fuels and is committed to phasing out fossil fuel subsidies. Revenues from fossil fuel taxation should decline as a share of GDP all the way to 2050, in line with the economy’s electrification and the shift to renewable and low-carbon energy sources. This decline in revenues is set to be partly compensated by the projected phase-out of fossil fuel subsidies by 2035, which are currently still significant in many Member States.
At the same time, carbon pricing has been a centrepiece of EU climate policy for two decades, and will expand to new sectors – buildings, road transport and additional sectors (mainly small industry not covered by the existing emissions trading system) – in the coming years under ETS2. This means that revenues from carbon pricing, through the ETS, ETS2 and the Carbon Border Adjustment Mechanism, are estimated to be a significant source of government revenues, reaching a peak in the mid-2030s.
Indirect effects on government revenue and expenditure are likely to arise due to changes in employment, private consumption, and investment rates. These effects are more uncertain than the direct impacts, but likely not very large. For example, a rise in unemployment would reduce income tax revenue while increasing social welfare expenditures. In contrast, a positive overall effect on GDP would raise government revenues and could lower some types of expenditures. Additionally, governments are likely to provide further public support to boost investment in the transition.
Comparing two scenarios
To evaluate the aggregate impacts of the climate transition on public finances, the study compares economic trajectories under a climate neutrality scenario and a limited mitigation ambition scenario using two macroeconomic models: a computable general equilibrium model (GEM-E3) and a macro-econometric model (E3ME).
The first model projects that the transition to climate neutrality will lead to a small reduction in GDP, private consumption and employment, compared to the scenario with much more limited mitigation ambition. This would result in a limited reduction in government revenues from general taxation and require a small increase in tax rates to avoid a negative impact on general government balances and the debt-to-GDP trajectory up to 2050.
In contrast, the second model projects that the transition to climate neutrality will lead to a small increase in GDP, private consumption and employment, as increased investment stimulates economic activity. This would lead to lower social expenditures and a limited increase in government revenues from general taxation, which in turn could result to financial transfers back to households or to a slight decrease in tax rates.
In both models, the indirect impacts are more uncertain and relatively small. The study also looked at additional policy scenarios to assess the sensitivity of the results to higher or lower fossil fuel price assumptions, with both models finding only limited impacts.
Key messages and recommendations
The study concludes that the transition to climate neutrality will not be a determining factor in the sustainability of public finances in the coming decades. While the two models diverge on the indirect effects, they converge that the impacts will be of a limited scale.
Even under the climate neutrality scenario, any required adjustments to tax rates would be limited in magnitude. Once the energy transition from fossil fuels to other energy carriers is well on the way, increased taxation of those new carriers could partly address the impact on revenues from the gradual phase-out of fossil fuels.
In both models, climate policy is associated with significant revenues. These reach their maximum in the medium-term to 2035, representing more than 1% of GDP.
It is important to note that the study focuses only on the impacts of the transition to climate neutrality on public finances and does not account for the impacts of climate-related hazards on economic activity or on public expenditure. These impacts are projected to be significant, as illustrated for example by the recent study on adaptation investment needs in the EU.
