The UK is watching the EU Commission unveil its roadmap to carbon neutrality with a high degree of interest

On Wednesday 14 July, the EU Commission published a package of proposals aiming at reducing net greenhouse gas emissions by at least 55% by 2030, compared to 1990 levels. The comprehensive and interconnected set of proposals combine EU climate, energy, land use, transportation and taxation policies. The far-ranging roadmap would lead the EU to be the first economic bloc to achieve carbon neutrality by 2050.

Key components of the Fit for 55 package

The bundle of proposals sets out updated and new targets for the EU, including:

• Revision to the Renewable Energy Directive to increase its target to produce 40% of the EU energy from renewable sources by 2030, compared to the original 32%.

• Regulation on Land Use, Forestry and Agriculture sets an overall EU target for carbon removals by natural sinks with a view to achieve climate neutrality by 2035 in this sector. 

• A recast of the Energy Efficiency Directive setting a more ambitious binding annual target to reduce energy use at EU level, almost doubling the annual energy saving obligation for Member States and requiring the public sector to renovate 3% of its buildings each year. 

• By 2030 sectors covered by the revised Emissions Trading System (EU ETS), including the power sector, energy-intensive industry sectors, aviation and maritime sectors, will need to reduce their greenhouse gas emissions by 61%, compared to 2005 levels. This is mostly drawn from Germany which achieved good results with a similar measure.

• Proposed phasing out of petrol and diesel passenger cars by 2035.

There are two tax elements within the package. The first is a revised Energy Tax Directive (ETD), which seeks to align the taxation of energy products with the EU’s climate ambitions, removing outdated exemptions and reduced tax rates that encourage the use of fossil fuels and replacing them with an innovative system which taxes according to energy content. The second is confirmation that the EU will pursue the implementation of a new Carbon Border Adjustment Mechanism (CBAM), putting a price on imports of a limited number of high-polluting goods based on their carbon content. The aim is to avoid the risk of “carbon leakage” whereby production is transferred from the EU to other countries with lower ambition for emission reduction and to maintain competitiveness of the EU producers. At the initial stage, CBAM will apply to iron, steel, cement, fertilisers, aluminium and electricity. EU importers of such products will be required to buy CBAM certificates from their national authorities, with carbon prices already paid on production deducted from the certificate price. The CBAM is expected to be fully operational from 2026, following a transitional phase where it first starts to take effect from 2023 to 2025.

Underpinning the whole strategy of a socially fair transition is the newly created Social Climate Fund (SCF). It will provide, in President Ursula von der Leyen’s words, a “dedicated funding to Member States to support European citizens most affected or at risk of energy or mobility poverty, promoting fairness and solidarity between and within the member states”. Approximately 25% of the expected revenue from ETS covering the building and road transport sectors would be redistributed through the SCF. Details as to how the fund will work and who will be entitled to subsidies is unclear at this stage. The press conference following the announcement on Wednesday very much revolved around the fairness aspect of the new proposals and the impact on end customers, with middle and lower income potentially being the most impacted.

It is also clear that innovative and green technologies and R&D will in future be a critical part of the EU Green Deal, with the green transition expected to create new markets and jobs.

Businesses and governments already signal some resistance

It will take some time to fully unpack what these announcements mean for business. Policy changes of this magnitude will have significant real-world ramifications – and as ever, there will be winners and losers.

The proposals have been met with a somewhat sceptical response from businesses and international trading partners so far. Some sectors, such as carmakers and metal producers, have made immediate representations, claiming the proposals would cause them to become uncompetitive in global markets, choke off investment and stifle innovation. Adversely affected businesses are widely expected to intensely lobby the governments of EU Member States to resist the plans, once they have had a chance to digest the content. 

The international dimension is even more complex. The extent to which the proposals could disrupt government-to-government relationships remains to be seen, but it will do little to address existing trans-Atlantic tensions and a legal challenge to the CBAM at the World Trade Organization looks inevitable, despite clear statements it is not a tax or a tariff but an environmental measure. This is exacerbated by the fact that alongside the CBAM proposal, reports suggest the EU will only phase out its allocation of free emissions permits for EU producers over ten years – stoking concerns domestic EU producers will get an unfair competitive advantage.

This potentially has a long time to run until the proposed measures are implemented – and we don’t yet know whether they will be phased-in, what the timescales might look like or whether there will be an adjustment period. Member States will be keen to understand how funds collected are distributed fairly as part of the newly created SCF, and those with industries that are more fossil fuel dependent, including those in shipping, will no doubt seek some compensating funds to develop green alternatives. Taxation measures contemplated in the ETD require unanimity, so Member States have a significant position of strength with their vote.

Multinationals will also need to be prepared for any similar environmental measures adopted by other big players, such as the US and China. With a growing focus on environmental, social and governance (ESG) criteria, investors are increasingly seeking to invest in ‘green’ companies that would continue to be resilient in light of the various climate change measures that would undoubtedly continue to emerge – this may lead to reallocation of capital into more sustainable investments. 

Now is the time for the UK government to carefully consider its options 

Following the Paris Agreement in 2016, both the UK and the EU have declared their ambition to achieve carbon neutrality by 2050 and both further enshrined that ambition into law. Understandably, this is more challenging for the EU as a bloc of 27 countries than it is for the UK, with the reduction of greenhouse gas emissions already achieved as at 2019 showing the UK at an estimated 45.2% lower than the 1990 levels compared to just over 24% for the EU.

The UK is placed in a tricky position: despite the post-Brexit trade agreement, some British businesses will stand to be impacted by CBAM measures, in some cases squeezing already diminished margins as well as adding further admin requirements - and it raises yet further complications for the implementation of the Northern Ireland protocol, where for goods Northern Ireland remains aligned to the EU single market. The UK is yet to outline many of its own carbon tax policies or how it proposes to interface with the EU’s revamped emissions trading system – a task made difficult because of the number of government departments the strategy will need to accommodate, covering specifics ranging from transport to packaging. On the subject of transport, progress is clearly being made: a new plan to decarbonise the UK system was announced on the same day as the EU’s package, including a ground breaking plan for a net zero rail network by 2050.

Focusing on tax policy, the UK already has four environmental taxes in place as of today:

• Climate change levy: aimed at making businesses and the public sector become more energy-efficient;

• Carbon price support: helps electricity generators to invest in low carbon electricity through an increase in the cost of fossil fuels they use;

• Landfill tax: aiming to divert waste from landfill to other less harmful methods of waste management; and

• Aggregates levy: encourages the use of recycled materials (compared to extractions which damage the environment).

Whilst there is no comprehensive UK ‘roadmap’, we are starting to see new pieces of the tax system around net zero emerge. For example, the new UK Emission Trading Scheme was announced to replace the UK’s participation to the EU ETS from 1 January 2021. From April 2022, a new plastic packaging tax will take effect, aiming at taxing plastic packaging produced in or imported into the UK that does not contain at least 30% recycled plastic. More recently, the UK government launched a series of consultations and reviews of existing measures such as the R&D tax reliefs and Air Passenger Duty. 

Achieving net zero using the tax system will be a real balancing act for the UK government. In addition to putting in place a clear roadmap to flesh out the UK path to a greener economy, the government will need to choose a strategic balance between applying tax policy to incentivise ‘green’ businesses and technologies, including ‘green’ innovation, and to discourage carbon-heavy activities. These decisions will need to be made against the backdrop of ensuring business recovery and the need to maintain a credible fiscal strategy post-pandemic. In the medium-term, the government will also need to consider how to compensate for the future decline in tax revenue from fuel and diesel cars, which raises well over £30 billion today.

In the run up to COP26 in November, the UK government will likely spend the coming months watching the negotiations within the EU and reactions from other countries while it formulates its climate change strategy and notably how to use the tax system to help achieve carbon neutrality by or even before 2050. We should expect a raft of announcements in the Autumn Budget in this regard. Businesses now need to track developments in both the UK and the EU closely to determine the impact on them, engage with any related consultations, and plan to manage an additional layer in the tax system as it is used to play its part in achieving net zero.