Why a carbon tax is the most effective price signal for the building sector

A carbon tax on the fuel used to heat Europe’s buildings is the most effective price signal to decarbonise Europe’s building stock, which is in desperate need of renovation to meet the EU’s climate ambition, writes Oliver Rapf.

In mid-July, we’re expecting a proposal for a reform of the EU Emissions Trading Systems (EU ETS) and the Effort Sharing Regulation (ESR) – the cornerstones of the EU’s climate regime, which regulate the world’s biggest carbon market.

Currently, emissions from buildings are not covered under the EU ETS, but regulated by national targets of the ESR. To achieve the 2030 and the 2050 climate-neutrality targets in the buildings sector, an additional carbon price signal alongside regulatory policy instruments can be an effective tool to drive necessary investments.

Carbon pricing isn’t a silver bullet for building renovation, but done right, it is a valuable addition to a well-designed policy mix

Considering its long-term investment cycles, fragmented ownership structure, and persisting non-economic barriers, a carbon price cannot be the silver bullet to reduce buildings’ climate impact, but rather a valuable addition to a well-balanced policy mix.

While ambitious standards for new buildings and mandatory requirements for existing buildings, such as minimum energy performance standards (MEPS), are key for the needed transformation in the building sector, a reliably increasing CO2 price placed on heating fuels can make investments in zero-carbon systems and energy efficiency measures more cost-effective and trigger ambitious policy initiatives.

Although a CO2 price cannot initiate the necessary investment in the buildings sector alone, it can potentially reduce payback periods of long-term energy service contracts and thus increase uptake of business models for deep renovation.

A carbon price compatible with decarbonisation targets will act as an important signal to incentivise investments in zero-carbon technologies and help their penetration in the market.

Due to the long lifetime of building components and heating systems, any investments in the coming years should already be in line with the target of a climate-neutral building stock in 2050. 

A carbon tax will support the switch to clean energy sources and provide long-term security for investors

As we describe in our analysis of carbon pricing options, a carbon tax system with a steadily increasing price path is superior to an ETS. Current discussions on carbon pricing are centred on introducing an ETS for transport and buildings, which could take the form of extending the current EU ETS, or introducing a new and separate scheme for buildings and transport emissions.

However, the allowance price in an ETS is always volatile and reacts to the market which makes decision-making difficult for investors, in light of long investment cycles. Insights into capping emissions of heating fuels in a trading system are still lacking (Germany introduced such a national ETS in 2021). 

On the contrary, experience from EU member states shows that a robust carbon tax can incentivise the uptake of renewable heating systems. The example of the Swedish carbon tax shows that it is effective: the phase-out of fossil fuels in heating started in the 1970s and was accelerated by a CO2 tax introduced in the early 1990s. Since the tax was introduced, CO2 emissions from Swedish buildings have decreased significantly.

That said, no example from practice gives clear evidence that a CO2 price, whether as tax or through an ETS, has triggered deep renovation. Rather, the carbon price was leveraging the effect of the broader policy mix.

An extension of the EU ETS should be avoided

After a carbon tax system, the second-best option would be a separate ETS in the building sector, combined with a price corridor to reflect some of the advantages of a carbon tax. A price corridor setting upper and lower price levels within which a market price can be formed would be important to trigger investments but not overburden consumers and small industries.

The third option, extending the current ETS to include buildings, raises significant concerns. Experts are split in estimating price effects if the EU ETS is enlarged to heating fuels due to the volatile nature of the price formation in the ETS.

Significantly higher prices as a result of the inclusion of the buildings sector could disproportionately burden industries and consumers, but may still be too low to make renovations more cost-effective. Emission reductions could, in the short-term, rather occur in the power sector which is more sensitive to price increases. 

Both options, extending the EU ETS or creating a separate emissions trading system for buildings and transport, require considerable administrative effort and would realistically only start in the second half of the 2020s, which would delay transformation in the building sector – a delay we cannot afford.

Any renovations happening now or in the coming years should already be climate-proof.

How the European Commission can set the stage for creating demand for building renovation

To create innovation in renovation actions, binding minimum requirements and financial support are needed. The European Commission should consider the introduction of an EU-wide carbon tax as an opportunity to align the national tax, levy, and subsidy schemes towards phasing out fossil fuels from buildings.

While some countries are making use of a carbon price at the national level for heating fuels with price levels ranging from €24 to €114/t CO2, not all Member States reap the benefits of it. The introduction of an EU-wide CO2 price in the buildings sector is a missing element in the policy mix.

Economic experts conclude that carbon prices well above €200/t CO2 are needed to trigger deep renovation. In light of non-economic barriers, it is unlikely that even high prices will unlock the energy-saving potential. 

The necessary high carbon price raises another question: How to avoid additional burdens on low-income households? For a fair transformation in the building sector and acceptance of the carbon price, a redistribution of the carbon revenues to alleviate regressive effects is crucial.

The costs of a CO2 price would always create a heavier burden on low-income households where heating costs present a larger share of their expenditure. This can be avoided by a just revenue recycling. One option could be to distribute 50% of the revenues as a lump-sum payment and earmark the remaining share to deep renovation programmes.

The latter can also be an effective way to alleviate energy poverty for those living in the worst-performing buildings. The relative share of revenue recycling vs. financial support for renovation could be adjusted over time.

For both a carbon tax or a separate ETS system, it cannot be said enough that a carbon price signal can only work as a complementary instrument to regulatory measures.

It is important to remember that the policy options will have varying implications for the fragmented building sector with different owner-occupier structures and long investment cycles which require careful assessment of all opportunities.

The easiest and most straightforward solution is to keep the ESR as the main compliance regime for the buildings sector and extend the policy mix to make sure that targets can be fulfilled. An extension of the EU ETS to include the buildings sector should be avoided.

As the Commission prepares to table this legislation in the next month, it’s crucial that we start on the right foot, with the right proposals. A carbon tax as an addition to other regulatory measures is the best price signal option for buildings. We won’t have the luxury of time to fix ineffective policies years from now. 

By Oliver Rapf

This article was originally shared by EURACTIV.