Denmark’s Green Tax Reform: G20 Countries Should Take Notice

Despite mounting evidence of climate change, fossil fuels remain the major source of energy around the world. The quantity of fossil fuel consumed globally has tripled since the mid-1960s, with a corresponding rise in carbon emissions. This increase is projected to continue in 2022, reflecting strong demand for energy, including for coal.

G20 countries, which account for 80% of global greenhouse gas emissions, have high ambitions to break away from these trends. However, high carbon taxes are absent from the climate policy of most countries — despite being recommended by 3,600 U.S. economists as “the most cost-effective lever to reduce carbon emissions at the scale and speed that is necessary”. Around the world, the IMF could identify only 46 countries with carbon pricing policies, and in these countries the price of carbon is generally too low to bend the trend. According to the OECD, carbon taxes are less than €1 per tCO2 on average in G20 countries and prices on carbon markets are only €3 per tCO2.

Denmark’s green tax reform

Raising carbon taxes is not an easy road, but Denmark has just shown with its green tax reform that it can be done. A long-time leader in climate mitigation policy, Denmark has already sharply reduced its territorial emissions. Half of its electricity comes from wind power and an additional 25% comes from bioenergy.

Denmark’s climate policy tools include a carbon tax — introduced as early as 1992. The carbon tax is currently set at €24/tCO2 and is levied on transport and non-district heating (35% of greenhouse gas emissions). Denmark also participates in the EU Emission Trading System (EU ETS), which covers power generation and manufacturing industries (26% of greenhouse gas emissions). Installations in these sectors must purchase carbon permits (€98 per tCO2 in mid-August), unless they receive free allowances. Power generators get no free allowances, while manufacturing industries get 30% of their permits for free – benefitting mostly large emitters in oil refining, cement, bricks, and glass. Road transport is also subject to various fuel excise taxes resulting in an effective carbon price of €197.7 per tCO2.

Bringing all this together, the OECD estimates that 39% of Denmark’s carbon emissions from energy use were priced in 2021 above €60 per tCO2 – the level considered to be required in 2020 to reach the Paris Accord goals. This is much better than in the average OECD/G20 country, but less remarkable than in the best-performing countries — such as other Nordic nations, Switzerland and France. Therefore, more had to be done.

The political agreement announced on 24 June 2022 involves a large increase in the carbon taxes paid by companies located in Denmark. Firms outside the EU ETS will see their carbon tax raised from the current level of €24 per tCO2 to €100 in 2030 — one of the highest levels currently in the world apart from Sweden, Liechtenstein and Switzerland (see figure). Companies covered by the EU ETS are expected to pay a total €150 per tCO2 (carbon tax of €50 + projected ETS allowance price of €100). Other measures in the package include new spending programmes to facilitate the energy transition and tax credits, such as accelerated depreciation for green investments.

 

Source: World Bank Carbon Pricing Dashboard. The figure shows the level of carbon taxes in selected European countries. Carbon taxes are only one of various policies that affect the prices of CO2 emissions. Other tools include the EU ETS carbon permits (currently trading at €98 per tCO2) and excise taxes on fuels. In addition, it is important to note that carbon taxes are applied only to a fraction of total emissions. The share of greenhouse gas emissions covered by carbon taxes varies from 2% (Spain) to 65% (Luxembourg). In Denmark (2030), the carbon tax of 50€ for industries covered by the EU ETS will be levied in addition to the price for EU ETS allowances.

 

It is estimated that the green tax reform will reduce Denmark’s greenhouse gas emissions by 4.3 million tCO2 – about one-tenth of greenhouse gas emissions recorded in 2019. This will contribute to the country’s emission reduction goals (-70% in 2030 from 1990), but more will need to be done. Hence, the government intends to launch a second phase of the green tax reform later this year, focusing on the large emissions from agriculture.

A just transition

While curbing the trend of carbon emissions will bring large benefits, it will also create costs. Investments currently running on fossil fuels may see their economic returns fall. Some may become stranded. Moreover, large investments will need to be made in clean technologies such as wind, solar, hydropower, hydrogen, and carbon capture and storage. The cost of some of these technologies has declined in recent decades –-and further decline could occur – making it difficult to estimate the overall cost of climate mitigation. Additional investment of 3% of GDP per year has been estimated necessary around the world to reach existing decarbonization targets – but this estimate is likely to change. The cost could be lower as technology improves. On the other hand, existing bets on engineering projects such as CCS could be much more expensive than projected.

In Denmark, the cost of climate mitigation will also be felt by households as companies pass on higher carbon taxes to final consumers. It has been estimated that a carbon price of €100 per tCO2 in 2030 would impose an average burden on households of 1.8 % of consumption due to pricier consumption goods. The green tax reform plans to mitigate this additional burden on households by redirecting some of the revenue from higher carbon taxes toward the most vulnerable households. In particular, the green tax reform introduces a tax break on electricity, which will benefit low-income families disproportionately. Model simulations by the expert group in charge of advising the government suggest that a reduction in the electricity tax benefits people with low incomes relatively more than people with high incomes. In other words, cutting electricity taxes avoids that higher carbon taxes worsen income inequality.

Heavy industries need to decarbonize

Heavy industries are responsible globally for one-sixth of energy-related emissions, making their decarbonisation essential to reach net zero targets. In Denmark, the sector of non-metallic mineral products (covering, among other things, cement production and brickworks) accounts for more than 25% of carbon emissions from the total Danish industry. This includes Aalborg Portland, the world’s largest exporter of white cement, responsible for more than 4% of national emissions in 2018 (2.2 million tons).

Firms in this sector are today largely exempt from carbon taxation and would have to make significantly larger tax payments if subject to the same rules as other firms, which was feared to put their viability at risk. With the green tax reform, the sector will pay a carbon tax of only €16.5 per tCO2 in 2030, lower than other companies. The tax will be levied on emissions from energy use and on emissions from the production process, which are a particularly large by-product of the chemical conversion. Firms in this sector will be encouraged to invest in new technologies, with a pool of subsidies available to set up Carbon, Capture and Storage (CCS) systems.

Offering lower carbon taxes and subsidies to heavy industries has proved controversial in Denmark and elsewhere. Empirical research has provided ample evidence that innovation responds to economic incentives such as increases in energy prices. When confronted with strong price signals and competition from other firms, manufacturing companies are typically able to innovate and find industrial solutions. Examples include the automobile industry, which was quick to innovate and produce electric vehicles when faced with higher tax-inclusive fuel prices. The power sector was also quick to deploy wind turbines and photovoltaic solar panels when offered feed-in tariffs. While heavy industries face specific engineering challenges, recent studies show they could decarbonize rapidly by using climate-neutral technologies.

Denmark plans to review the carbon tax on non-metallic mineral processes in 2026 and 2028. This should be the opportunity to stimulate the sector’s innovation efforts with a higher carbon tax. Competition from non-EU countries and the risk of carbon leakages are often cited as good reasons to push against higher carbon taxes. Empirical research suggests, however, that risks of leakages are limited, and that affected industries are those in which relocation is easier, such as agriculture and the food industry. Moreover, it should be noted that these risks are addressed by the EU plans to introduce a carbon border adjustment mechanism, including a carbon levy on imported cement from 2026.

Denmark’s Green Tax Reform provides an ambitious framework of cost-effective decarbonisation. It addresses many complex challenges with pragmatic solutions. Like other Nordic countries, Denmark leads by example with its carbon pricing measures.

G20 countries should take notice.