Price formation in European White Certificate markets: Theoretical and Empirical Insights from Italy, France, and the UK 
12 September 2023
CERI Seminar: Innovative Sources of Climate Finance with Benito Müller (Oxford University)
12 September 2023

How are high tax reductions (tax relief) justified by the public benefits of private energy efficiency investment?

©Maxx-Studio/shutterstock

By Marie Poff 

I. Introduction

Industry plays a vital role in supporting European economic prosperity. The sector, including steel and iron, cement, chemicals, and pulp and paper, is unsurprisingly energy-intensive; in 2020 the sector accounted for more than 30% of global final energy consumption, around 25% of European energy consumption, and around 20% of total global CO2 emissions in the same year. Within Europe, three heavy industries in particular – steel, chemicals, and cement – account for nearly 60% of industrial energy consumption and around 70% of CO2 emissions (IEA, 2022a). 

To meet Europe’s goal of climate neutrality by 2050, improving energy efficiency plays a significant role in a green transition for industry. While various policy tools are available, tax relief has proven to be a positive incentive towards increasing private investment (EC, 2020a). Several tax changes have emerged under broader climate measures, including a revision of the Energy Tax Directive (ETD), and the introduction of a Carbon Border Adjustment Mechanism (CBAM), operating in conjunction with the European Emissions Trading Scheme (ETS) (Dumoulin, 2022). While energy and carbon taxation does provide financial incentive, it does not resolve barriers to the current suboptimal level of investment, nor replace the Energy Efficiency Directive (EED) revised in March 2023 (DG ENER, 2021). This essay explores tax relief measures designed to increase private investment in industrial energy efficiency, and how these measures are justified by the public benefits achieved.

II. Overview of Energy Efficiency in Industry

Improvements in energy efficiency technologies have the potential to decrease industrial energy demand by 13.5% in Europe by 2050. With the adoption of complementary measures, for example full electrification, energy demand could decrease by 34%. When evaluating energy efficiency measures, it’s also necessary to ascertain the differences in innovation potentials between industry sub-sectors, reflected in their varying savings potentials, such as the iron and steel industry with 360 PJ, compared to pulp and paper with 75 PJ (Kermeli et al., 2022). 

The different innovation potentials between, and within, industrial sub-sectors, reflect differences in their energy and CO2 intensities which are mainly due to varying fuel inputs and production processes. For example, in 2021 the sub-sector with the highest global CO2 intensity was steel at 1.39 tCO2/t, where coal was used to meet 75% of its energy demand. In this heavy industry, the priority is thus replacing coal via electrification, increasing scrap recycling, and installing readily available energy efficient, cost-effective technologies. It was estimated that if all blast-furnace production facilities invested in these technologies, such as electric arc furnaces, this would result in a global energy saving of around 20% (IEA, 2020). For iron and steel, energy efficiency improvements are needed in the short-term, however, their technical potential is limited. As a result, there is high innovation potential towards new carbon zero production processes in the long-term, including integrating new technologies such as carbon capture, utilisation and storage, or hydrogen. While this industry is already incentivised due to rising production costs from energy and raw material inputs, tax relief would encourage investment into existing energy efficiency technologies (IEA 2022c). 

Generally, higher innovation potential and higher output value industries, such as aluminium, iron and steel, see lower value in energy efficiency over the long-term. However, relatively lower output value and non-innovative sectors, such as ceramics or cement, rely more heavily on energy efficiency measures to increase competitiveness while taking the road to decarbonisation. In comparison to steel, cement had a much lower carbon intensity at 0.59tCO2/t (IEA 2022d), while pulp and paper had an even lower carbon intensity at 0.45tCO2/t, and 43% of its global energy came from bioenergy (IEA 2022b). For both sectors, innovations towards improving energy efficiency, in conjunction with switching to alternative fuels, is critical to meeting climate targets. For example, RD&D into pulp and paper production processes resulting in reductions in water evaporation, or increased heat recovery and co-generation, would greatly improve energy efficiency. 

In short, energy efficient technologies are readily available for implementation in industry, and certain sub-sectors offer further potential for improvement in energy efficiency through RD&D. Despite this, global energy efficiency improvement slowed to only 0.8% in 2020, compared to 1.6% in 2019, and well below the 3% required to meet climate targets (IEA, 2021). 

III. Tax Instruments to Increase Investment in Energy Efficiency for Industry

Governments can use a range of policy measures to scale up private energy efficiency investments in industry, including tax relief (referred to as tax expenditures by the OECD), subsidies, and certificate trading schemes. Supply-side tax instruments improve business performance from ‘within’ by sharing the costs or risks of investment with the public sector. This essay explores supply-side tax relief instruments, defined as tax credits, reductions, rebates, exemptions, and accelerated depreciation allowances (Ryan, 2016). Tax policies are evaluated by “input additionality”; for R&D tax credits this means taking into account the R&D expenditure attributed to the policy intervention, relative to the size of the tax reduction itself, with outcomes ranging from an optimal ‘increase with additionality’ to ‘over-full crowding out’ (CPB, 2014). In terms of economic savings from energy efficiency, gains are calculated as the absolute reduction of electricity consumption (i.e., the sectoral decrease in energy intensity), while considering the market price of the tax relief (Energiepartnerschaft, 2022). 

R&D tax credits when well-designed, are very effective in stimulating both investment expenditure and innovation, with most studies finding that each unit of tax credit results in at least one additional unit of R&D. These credits directly increase support for energy efficiency investment through compliance cost savings and by reducing the user cost of capital, while also serving to make Europe an attractive destination for mobile capital. For example, the introduction of an R&D tax credit in Norway increased both R&D investments and imports (Boler, 2015), while in the UK generated increased patenting and created positive spillovers on innovations (Dechezleprêtre, 2016). As innovation and R&D investments are subject to positive horizontal externalities, namely knowledge spillovers to other firms, these tax expenditures are economically justified and correct market failures. 

Tax allowances are effective in reducing capital costs, namely through the full expensing or accelerated depreciation of investments into energy efficiency. An example is Canada’s accelerated Capital Cost Allowance program (Gov Canada, 2019), first introduced in 1996, which allows for a write-off of up to 50% annually for specified equipment, such as heat recovery systems or capital for the electrification of steel mills. Also included are “intangible expenses” such as the costs of pre-feasibility and feasibility studies, as well as provisions for emerging technologies (Price, 2005). Many countries have similar measures, such as the United Kingdom, who has recently reinforced their Capital Allowances policy which provides industry with 100% first year relief for capital investments into energy efficiency (Gov UK, 2023). 

Tax exemptions have also proven to increase investment, whereby firms investing in energy efficiency measures are exempt from energy, income, or other taxes. An example was Germany’s full exemption from the petroleum tax for industrial facilities using combined heat and power (CHP or cogeneration) with utilisation rates of 70% or higher (Price, 2005). Conversely, exemptions for fossil fuels under energy taxation policy have previously served to disincentivise investments in energy efficiency (Rosenberg, 2011). However this seems to be changing; for example, as part of Europe’s Fit for 55 measures, proposed revisions to the ETD include that fuels be taxed according to their environmental performance and energy content. As electricity will be taxed at the lowest rate, while polluting fossil fuels will be taxed at the highest, this effectively introduces a tax reduction for electrification in industries such as steel (ECEEE, 2023). However, some research found that in the short term, tax relief policies to reduce the up-front costs of efficiency investments were more effective than higher energy prices (Anderson, 2004). 

Other tax instruments, such as special corporate tax regimes which tax patent revenues less, were found to be inefficient (Criscuolo et al., 2022). Further, corporate tax structures must work harmoniously, otherwise components may instead introduce barriers to industrial end-use energy efficiency (US DOE, 2015). Tax measures must be implemented carefully to avoid introducing negative market distortions, for example with steel subsidies, which resulted in excess capacity by discouraging the exit of inefficient producers and capacity expansion not justified by market demand (GFSEC, 2021). 

IV. Public Benefits of Energy Efficiency in Industry

Energy efficiency is crucial for mitigating climate change. Decreasing industrial energy intensity will significantly help to decarbonise the sector by lowering energy demand as well as reducing CO2 emissions. These measures directly help nations meet their climate targets and minimise the enormous potential damage of global warming, while also resulting in immediate public benefits such as decreasing air pollution. Increasing investment in energy efficiency has net positive economic benefits, while also being cost-effective for investors (Rosen & Guenther, 2015). Studies have long demonstrated that even with payback periods of less than two years, these investments could reduce constraints and production costs by 10-15% (McKinsey, 2010).

Further, investment in energy efficiency creates a comparative advantage and enhances the competitiveness of European industry. A key challenge faced by producers of hard commodities is that there is often no green premium. As such, energy efficiency is a way to ensure competitive advantage by reducing operational costs, especially when facing supply constraints and increasing input prices. For example, iron and steel have considerable cost-saving potential simply by adopting scrap-based electric-arc furnaces, which are 60‑70% less energy-intensive than blast furnaces (IEA, 2021). An important public benefit is also the potential for job creation, as improving energy efficiency relies on skilled workers to both supply and install technologies; for example, retrofitting existing facilities or installing new energy-efficient equipment, energy recovery technologies, and introducing digital improvements for optimal energy management. It’s estimated that per 1 million USD invested in industrial efficiency, 18 jobs could be created (IEA, 2020a).

Finally, a reduction in energy demand both strengthens energy security and reduces energy bills for consumers (IEA, 2021). The European energy market has experienced multiple shocks, namely the COVID-19 pandemic and Russia’s invasion of Ukraine, which drove an energy crisis where natural gas prices peaked at nearly 350 EUR/MWh – compared to normal levels below 50 EUR/MWh (EC, 2022). This presented a high risk for European industry, who faced eroding competitiveness and potentially losing companies who could relocate to countries with secure domestic energy supplies (UN, 2022). Reducing energy demand thus reinforces Europe’s energy independence and the economic security of workers in industry sectors.  

V. Case Studies

Energiepartnerschaft – Sino-German Energy Partnership (Efficiency First!)

The importance of international collaboration for energy efficiency, including the exchange of information on best practices and policies, cannot be understated. As global leaders of the ‘Efficiency First!’ approach to the green transition, Germany and China proved that decoupling energy consumption and economic growth is possible, even with large industry sectors. In terms of tax relief for example, the German National Action Plan on Energy Efficiency (NAPE) increased energy efficiency retrofits through tax breaks, leading to primary energy consumption savings of 40PJ, and a reduction in GHG emissions of 2.1MtCO2e. Another effective policy is offering energy tax credits for firms to obtain energy management system certifications and conduct energy audits – industrial energy-intensive firms in particular received breaks of up to 90%. As Germany has relatively high fuel taxes, linking energy efficiency efforts to tax breaks both improved energy management and industry competitiveness through cost saving (ERINDRC, 2018). The comparison of energy efficiency policies under Germany’s NAPE and China’s Five Year Plan (FYP) resulted in useful recommendations, including the need to balance efforts between SMEs and larger energy consumers, cultivate energy management professionals, and integrate energy efficiency with renewable and smart energy. A conclusion from the final stage of the partnership in 2022, was that building on an effective administrative approach with economic incentives, namely tax breaks, effectively promoted industrial energy efficiency (Energypartnerschaft, 2022). 

Europe – Common Consolidated Corporate Tax Base

In Europe’s new Industrial Strategy, launched in 2020, a fundamental point raised was reducing barriers for businesses operating across borders in the single market. To create business certainty and allow for a more digital single market, evidence pointed to enhancing tax harmonisation – notably by implementing a common consolidated corporate tax base (EC, 2020b). In 2023 the European Commission has re-launched proposals for a Common Consolidated Corporate Tax Base (CCCTB), initially proposed in 2016 (EU Parliament, 2023). If accepted, this would include tax incentives for R&D treatment including two new allowances; one for R&D, and the second for growth and investment to address the bias towards debt financing. Operating in conjunction with national innovation policy, these reforms would help incentivise industry to invest in energy efficiency. Allowances would help increase investment without crowding out private investors, and implemented reforms would work harmoniously within a common framework to strengthen the single market by reducing uncertainty and distortions. To ensure these outcomes, the differentiation of incentives across firms and sub-sectors is also recommended, allowing for a more targeted policy approach (d’Andria, 2017). 

United States – Inflation Reduction Act

The Inflation Reduction Act (IRA) passed in August 2022, is challenging global competitiveness and the economics of industrial energy efficiency. The IRA includes $270 billion in tax incentives, as well as grants and loans, with $37 billion alone going towards the advanced manufacturing industry (Dumoulin, 2022). An example is the extension of the Advanced Energy Project Credit, which has been expanded to include industrial emissions reductions. This credit supports investment into energy efficient measures and equipment for industrial facilities, as well as measures designed to reduce emissions by at least 20% (White House, 2023). As opposed to carbon pricing or regulation, the US is the leading example of employing positive incentivisation to increase investment into energy efficiency for industry.  

V. Conclusion

Tax relief instruments effectively increase private investment in energy efficiency for industry, and when well-designed, are justified by the public benefits achieved. There is no clear consensus on whether positive approaches to incentivising investment, such as tax relief, are more effective than negatively viewed instruments which put a price on externalities, such as the ETS. Rather, policymakers must remain aware of the specificities between industry sub-sectors, so as to implement targeted support to industry firms. Transparency is also useful in this regard, such as linking programs to cost-effectiveness criterion or voluntary agreements (Price, 2005), while collaboration between sectors and across borders further advances global energy efficiency policy. Further, as digitalisation will play a key role in improving energy efficiency in industry, increasing collaborative R&D will also prove important for the future transformation of industry (Gov Sweden, 2021). 

Bibliography