Hot Tax Topics for the Industrial sector: ESG and the EU’s environmental tax measures

The tax world is changing rapidly, with major developments around the taxation of multinationals and a growing number of initiatives around hot topics such as sustainability, including greater focus on transparency and environmental matters.

In this third blog in our series aimed at the industrials sector, we look at the various environmental measures that have been introduced recently at an EU level, and which could have a substantial impact on groups active in this area.

The backdrop to the EU’s recent environmental measures is the “Fit for 55” package that was published in July 2021. The idea behind this is to bring the EU's environmental and energy regulatory framework in line with the overall goal to reduce greenhouse gas emissions by 55% by 2030 (hence the name “Fit for 55”), and to attain climate neutrality in 2050 using a number of different mechanisms, including tax measures. If accepted by Member States, these measures will take effect from 2023.

The three most significant measures in this package from a tax perspective are: (i) amendment of the existing Energy Taxation Directive; (ii) amendment of the Emissions Trading System (which operates within the EU); and (iii) the new Carbon Border Adjustment Mechanism (or CBAM) which is intended to ease the burden of the Emissions Trading System for EU market participants by applying similar rules to those importing goods from third countries into the EU. 

In addition to these measures which all form part of the EU’s Business Taxation for the 21st Century package (or EU BT 21), the EU has also been looking at amendments to the VAT Directive to support the green transition. 

Looking at each of these four elements in more detail:

Updates to the Energy Taxation Directive

The Energy Taxation Directive is to be amended to remove certain exemptions from the system. For example, fuel that is used for aviation purposes or in the shipping industry currently benefits from exemptions from the energy taxation system. These exemptions are to be reduced and eventually removed completely. There will also be a shift in the overall system of energy taxation. Whilst the current system is disjointed with different tax rules for particular fuel types or particular types of energy carriers, the new system will be structured in a way that the level of tax will be linked to the energy content of the energy carrier and its environmental performance. By way of illustration, consider the treatment of normal fuel and diesel fuel. Diesel fuel is currently subject to a favourable energy tax regime, despite having a much higher energy content than normal fuel. Whereas, in the future, it will be subject to a higher level of taxation than normal fuel because of its higher energy content. Environmental performance means the more pollution is triggered in getting the energy, the higher the tax payable. The result of this will be a spectrum of taxation with, for example, energy from wind plants subject to little or no taxation and coal, for example, subject to a high tax rate because of the high levels of pollution triggered by that type of fuel.

Updating the Emissions Trading System

The Emissions Trading System is also being updated. At the moment, certain emissions-heavy industries benefit from exemptions by way of being granted emissions certificates for free. For example, steel, aluminium, cement, and other industries get free certificates, which makes them very competitive globally because ultimately they are not bearing the impact of the Emissions Trading System. The proposal is that these free certificates will be phased out over the next few years and, as of 2026, will be abolished in certain sectors. This will have a substantial impact on those industries because those emission certificates will add a substantial cost element to their production methods and the economic modelling for their products, making them less competitive in the worldwide market.

The Carbon Border Adjustment Mechanism

The Carbon Border Adjustment Mechanism (or CBAM), the third element of the package, has been introduced in order to compensate for this. CBAM addresses embedded emissions in certain products that are imported into the EU. Like the ETS, CBAM will be based on a system of certificates. What this means is, if a group outside the EU produces products and triggers certain carbon emissions through such production, in the future they will have to buy and hand in CBAM certificates in order to introduce those products into the EU market. The price for the CBAM certificates is essentially the same as for comparable ETS systems. But the difference is, it is not the production that triggers the need for certificates, but the import of goods. 

This will impact carbon heavy production methods outside the EU to the extent such producers want to access the EU markets. This will have a very substantial impact on the day-to-day business for those importing goods into the EU. On top of the additional cost, there is also a significant administrative burden, as the new rules will require analysis of the amount of carbon emitted in relation to goods that are to be imported; there are verification standards to be satisfied; and CBAM returns to be filed. This can become very complicated and could be challenging for importers because, to the extent they cannot comply with the CBAM system, they will be prevented from importing those goods into the EU. So third country importers and third country producers will have to get to grips with these rules if they want to do business in the EU in the future.

Amendments to the VAT Directive

Changes have recently been agreed in relation to VAT rates under the VAT Directive to support environmental policies: new products and services that are good for the environment will be eligible for reduced VAT rates and, by 2030, Member States will no longer be able to apply reduced rates and exemptions to goods and services deemed detrimental to the environment and to the EU's climate change objectives. There are also due to be changes to the VAT Directive to remove VAT exemptions on international air and maritime passenger transport and these changes are expected in 2022 or 2023.

Impact on Industrial clients

The most tangible impact on Industrial clients will be from the CBAM system, for the reasons set out above, as companies who want to import CBAM goods into the EU will have to comply with those standards. This will start having an impact from 2023 (although, between 2023 and 2026, the requirements are limited to reporting on the import of such goods, with the obligation to buy certificates only kicking in from 2026), but due to all the additional processes that will need to be put in place, this is something companies will have to deal with quite quickly.

The changes to the ETS system will also have a material impact. As free emissions allowances for certain industries are removed, groups operating in those industries within the EU will have to change their business models. This is in addition to having to deal with the CBAM system. Even though CBAM is designed to protect EU companies from competitors from third countries, it will still result in additional costs and administration for those operating in the EU as well.

These measures will substantially impact global manufacturing conditions and distribution channels. There are equivalent proposals to CBAM in the US, so if implemented, there would in effect be a multilateral zone where the principles are similar. However, if this does not happen, then there could be heavy disruption for the international manufacturing and distribution channels as products move in and out of different systems.

In addition, there are the administrative challenges of complying with the new measures and assessing what CBAM certificates have to be acquired, with the potential for differences of opinion and disputes. You only have to think of the infamous Jaffa Cake saga where the question of whether a Jaffa Cake was a cake or a biscuit for VAT classification purposes went all the way to the ECJ. Similarly, under the CBAM system, there is a high likelihood of disputes as to how certain products should be treated, not only when it comes to base goods and their classification, but there will also be tricky points around base materials being used as components in other products.

The changes in VAT rates could impact pricing decisions and push businesses towards more environmentally friendly supply chains. This trend is only set to continue with other green taxes and carbon taxes being discussed at both national and international levels across the globe, so this is an area where we can expect to see more changes in the future.

For more on the tax aspects of ESG and sustainability, see our recent blog on Trust and Transparency and how this could impact the Industrial sector here and our dedicated pages on the Sustainability aspects of EU BT 21.