Do energy tax breaks work?

June 12, 2024 Energy transition

For more than two decades, a climate levy on German consumers’ electricity bills helped to power the rise of wind, solar and other renewable energies. Was the government wise to shield energy-intensive plants from this tax? Supported by TSE Energy and Climate Center, a new working paper by Andreas Gerster and Stefan Lamp investigates the impact of this exemption on production levels, employment, and input choices in the manufacturing industry.

Why are energy tax breaks controversial?

Supporters of climate tax exemptions argue that they protect domestic firms from ‘leakage’ of industrial activity and emissions to unregulated jurisdictions. However, critics worry that they will induce rent seeking, distort production decisions, and increase energy use, as well as reducing tax revenues.

This debate has gained momentum following the introduction of carbon tariffs at Europe’s borders. Existing research suggests that such policies are more effective at preventing leakage. More evidence is needed; however, especially as environmental tax exemptions remain widely used and their impact has not been equally studied.

What makes Germany an interesting case study?

In 2000, Germany introduced one of the world’s most ambitious support schemes for renewable energy. Its generous feed-in tariffs guaranteed long-term investment security by providing a fixed, above-market price for electricity producers. By 2014, this policy had boosted the renewable share of energy production to 30%, while the subsidy costs rose to €22 billion. To finance these payments, the government imposed the Renewable Energy Levy (REL) on consumption. While this surcharge was initially low, by 2017 it accounted for more than a third of average industrial electricity prices in Germany.

To bolster the international competitiveness of its manufacturing sector, the government began introducing REL exemptions for energy-intensive plants as early as 2003. Initially, a ‘notched’ policy design offered lower marginal prices for eligible firms, as well as large infra-marginal benefits. A 2012 policy reform largely removed the infra-marginal benefits and expanded the eligibility criteria. The scale of the REL exemptions, the use of regulatory thresholds, and the contrasting policy designs offered us a valuable opportunity to examine the effects on firm behavior.

How does your study evaluate the impact of the German tax exemption?

Our empirical approach consists of two quasi-experimental methods and counterfactual simulations, using rich administrative data to examine how production levels, employment, and the use of energy inputs were affected by the two policy designs.

To estimate the causal effects under the notched policy design, we take advantage of the fact that exemptions were only granted to plants that used more than 10GWh of electricity two years earlier. We provide evidence that the 2008-2009 financial crisis prevented plants from potentially manipulating their electricity use in those years. This allows us to identify the effect of exemptions two years later, comparing virtually identical plants that barely met or failed to meet the eligibility threshold.

To identify the effects of the 2012 reform, we exploit the reduction of the eligibility threshold to 1GWh. Using a difference-in-differences approach, we compare the outcomes for newly exempted plants and non-exempt plants with very similar characteristics.

Finally, the model and counterfactual simulations allow us to evaluate the extent to which plants strategically manipulate their consumption to gain exemptions, leading to a higher density of plants above the eligibility threshold. We find that not all eligible plants seek the exemption, which might be due to compliance cost that may arise for example if firms must hire independent accountants to certify their eligibility status.

Do your findings support the use of tax breaks?

Our results confirm that tax exemptions for energy-intensive plants are an imperfect anti-leakage policy. We further show that REL exemptions lead to significant increases in electricity consumption under both policy designs. In contrast, the exemptions had no significant impact on sales, export share, or employment.

These results do not necessarily apply to larger plants as the variation in REL exemptions only allows us to identify their impact on medium-sized plants with about 1-10 GWh of electricity use. That said, our evidence casts doubt on the effectiveness of a costly exemption policy that puts an additional burden on all electricity consumers. If policymakers wish to boost the competitiveness of domestic manufacturing and minimize leakage risks, our findings suggest they should consider other tools such as carbon-border adjustments or output-based subsidies.

What does your analysis reveal about firms’ response to different policy designs?

We find that exempted plants increased their electricity consumption by 3% in 2013. In contrast, the original notched policy led to increases that were larger by about one order of magnitude. Our simulations offer a nuanced explanation of these effects, showing that notches substantially distort firms’ production input choices, especially when financial stakes are high and compliance costs are low.

We show that many eligible plants choose not to claim an exemption to avoid compliance cost. While this can mitigate rent-seeking behavior from bunching, the compliance burden may also have adverse welfare effects.

Our findings may be useful to improve policy decisions in wider contexts, such as government support for businesses during the pandemic and the 2022 energy crisis. We hope that our research can help to avoid welfare losses due to the unintended consequences of such policies, which have design features that are likely to interact with market outcomes.


FURTHER READING Energy Tax Exemptions and Industrial Production’ and other related publications are available to view on Stefan’s webpage.

Article published in TSE Reflect, June 2024