A funding strategy for EU own resources reform
Own resources and the EU budget
Gross National Income (GNI)-based own resources are essentially contributions to the EU budget made by member states out of national tax revenues, and currently constitute roughly two-thirds of the EU budget.
While GNI resources are transparent, fair and in line with the principle of subsidiarity, they are criticised for leading to political debates that emphasise the cost of EU spending rather than on the benefits, and for contributing to the framing of discussions on the EU budget in terms of net balances, rather than value added through common policies and the provision of European public goods.
The recent agreement on the Next Generation EU (NGEU) programme has led to a renewed debate on the possibility of introducing new own resources which would be used to service the debt incurred. At its meeting on 17-21 July 2020, the European Council decided that the EU should work towards the introduction of such resources. Its conclusions mention a plastics charge, a carbon border adjustment mechanism and a digital tax as well as a reformed emissions trading system (ETS), and finally a financial transactions tax (FTT).
In a recent paper delivered at ECOFIN, we examined these options across a range of criteria for the choice of own resources. Our conclusions bring us to recommend placing revenue from ETS allowances at the centre of the reform of the EU own resources system.
The shared benefits of green policies
The EU has given itself ambitious climate policy objectives. All but one of the member states have endorsed the goal of EU-wide climate neutrality in 2050. The main EU policy tool to translate these objectives into practice is the ETS, which currently covers emissions from the power sector, industry and intra-EU flights. In the future it would be desirable to expand further the scope of the ETS and to bring in more, ideally all, sectors.
It would also be desirable to give up national objectives, because they are incompatible with the EU-wide cost-efficient reduction of emissions.
Consistent with this approach, ETS revenues should accrue to the EU, rather than to the member state where the emissions occur. The main reason is that the emitting industry through its carbon emissions does not cause any particular damage in that country. Rather, taking the EU cap on emissions as a given, an additional emission in a particular member state should be regarded as a negative externality on the other member states. Emission reduction objectives are set at EU level. Whoever auctions off an allowance, wherever the corresponding emission occurs in the EU, and wherever the resulting good or service is consumed, the impact on common policy outcomes is the same. In this regard, proceeds from the sale of ETS allowances are not that different from customs duties.
The bulk of auctionable emission allowances are allocated to member states on the basis of historical emissions. These revenues therefore have the character of a rent that is granted to member states. The higher the carbon price on the ETS market, the more member states benefit from it. Under this set-up, a decision by the EU to increase the pace of decarbonisation and to reduce the overall volume of emissions may paradoxically result in a higher rent, especially for carbon-intensive countries.
The role of CBAs
A carbon border adjustment (CBA) mechanism has been proposed as a way of preventing leakage effects of EU carbon pricing. We do not primarily regard a carbon border adjustment mechanism as a direct source of revenue, but rather as a device intended to limit international competitive distortions.
A CBA would however have meaningful indirect revenue effects, through its impact on the ETS. Currently free allocations of ETS allowances are destined for carbon-intensive sectors facing international competition. In the presence of a CBA they could be reduced or possibly abolished; as a result more revenue would be raised from the ETS.
Other revenue strategies fall short
Compared to the ETS, the case for the other candidates for own resources is less convincing.
The digital services tax initiative plays a role in the context of stalled international discussions on a new allocation of taxing rights. In view of the single market, we certainly regard a European digital services tax as preferable to a collection of national digital services taxes. However, we doubt it could provide a structural response to the tax optimisation problem, and find the prospect of an agreement on minimum corporate taxation and more market-country taxation as part of the OECD process preferable.
If EU member states were to agree to pursue the plan of introducing a Financial Transactions Tax (FTT), doing so at European level would certainly be preferable to a multitude of national and uncoordinated FTTs, mostly because national FTTs would distort financial transactions within the EU. However, at this stage there is no broad-based consensus regarding the FTT in the economic and the policy debates. As a result, it is set to be introduced only by a minority of member states, making it hardly suitable as a basis for own resources of the EU as a whole.
Reliable revenue after a challenging transition
A shift of the ETS from being a national resource to an EU resource would raise significant transitional and distributional difficulties. ETS revenues will fall as the EU moves towards reaching its CO2 neutrality goal. But for a time of transition, the ETS will continue to generate revenue. Three factors will gradually contribute to increasing revenues despite falling emissions:
- The increase in the price of carbon;
- The substitution of free allowances by auctioned allowances;
- The broadening of the ETS scope to sectors currently not covered.
Simulations indicate that total ETS revenues in the 30 years to 2050 could approach €800 billion in a realistic scenario and even €1.5 trillion, or €50 billion per year on average in a maximalist scenario in which most free allowances would be eliminated and most sectors would be covered. ETS allowances are therefore a potentially significant resource.
Transforming auction revenues into an EU resource and reducing GNI contributions accordingly would also entail significant redistributional effects. In particular it would redistribute revenue from carbon-intensive to less carbon-intensive member states.
A possible way to smooth out these effects would be to transfer to the EU the whole proceeds from the auctioning of emission allowances but to redirect annually to member states notional auctioned emissions revenues computed as their shares of the 2019 auctioned emissions multiplied by the annual EU linear reduction factor and corrected for the impact of the MSR. These notional auctions would be valued at a priced capped at the level of the 2019 ETS carbon price. This grandfathering strategy would preserve countries’ initial revenues while making room for a gradual increase in the revenue accruing to the EU. In addition, side payments from and to the member states could be introduced to correct undesirable distributional effects from the swap of the GNI-based resource for ETS revenue.
A long-term solution for financing debt, revenue and transfers
Simulations suggest that under a realistic decarbonisation scenario, revenues from the ETS over the 2020-2050 period would be sufficient to repay the Next Generation EU debt, finance the notional auctioned emission revenues accruing to the member states, and leave enough additional revenue to help finance the EU budget or to finance offsetting transfers to certain member states.