Foreword

Europe has historically been at the forefront of the global shift to decarbonize economies. The European Union (EU) demonstrated its commitment to reducing greenhouse gas emissions with the launch of the EU Emissions Trading System (ETS) in 2005, the world’s first and largest carbon market, currently accounting for over four-fifth of the global carbon market in value terms. The leaders of EU member states agreed to achieve carbon neutrality by 2050 and a 55 percent reduction in emissions by 2030, compared to 1990 levels. Achieving this ambitious target will require determined action.

More recently, the Russian invasion of Ukraine has added energy independence and security to the on-going dialogue on greening the energy sector in Europe. Starting in mid-2021, gas prices had increased substantially, and they skyrocketed with the start of the Russian invasion of Ukraine in February 2022. The war has had adverse spillover effects through higher inflation, disruptions to trade and financial flows and increased uncertainty. The deleterious effects of the war come on top of the fragile recoveries in many countries that are still grappling with the effects of the COVID-19 pandemic. In addition, the effects of the war are higher on the Europe and Central Asian countries because of the influx of forcibly displaced persons (FDPs) and via closer trade and financial linkages with Russia and Ukraine. More than a quarter of Ukraine’s population is estimated to have fled their homes since February 24th, making this the fastest growing refugee crisis since World War II.

The immediate impact of the war on European Union (EU) countries is primarily through the supply and prices of commodities, particularly food and fuel, along with the inflow of FDPs. Higher fuel prices as a result of the crisis are likely to lead to an increase in the incidence and depth of poverty. The impact will be both, directly, through higher fuel costs, and indirectly, through second-round effects of higher fuel prices on goods and services. Although the poor are partially shielded from the price rises by the fiscal measures taken by governments, the higher proportion of expenditure on food products among poorer households is likely to increase in the depth of poverty. To mitigate the impact of high prices, targeted transfers to vulnerable and energy poor groups have been combined with retail price regulations and reductions in taxes on food and fuel for all households.

In addition to supporting the FDPs, EU governments are also discussing measures to reduce dependence on Russian fossil fuel imports. This could embolden the transition to net zero emissions, which will be a defining feature of the coming decade. It will require a diversification of natural gas supplies together with increased climate adaptation and mitigation efforts, particularly, towards renewables.

This report speaks to fiscal policy measures that countries can undertake to support the transition to climate neutrality by 2050. These measures will help provide the right price incentives to move away from fossil fuel-based energy and will also help correct for market failures. The fiscal measures proposed in the report will be critical for climate mitigation efforts and include the following: imposition of carbon taxes, elimination of fossil fuel subsidies and increase in green public investment.

Carbon prices are an interplay of carbon taxes and fossil fuel subsidies. It is important to get the price of carbon right because the public sector does not have the resources to undertake all the investment required to enable the transition to net zero emissions. The private sector will need to play a critical role and galvanizing the private players will require appropriate pricing. Getting the price right will require the imposition of carbon taxes and the elimination of fossil fuel subsidies. In addition to the appropriate level of prices, green public investment will also be needed to overcome market failures that hold back green innovation and infrastructure.

Overall, this report provides new insights on the impact of carbon tax scenarios, on the size and gaps in the assessment of fossil fuel subsidies, and on the challenges in measuring green public investment. Our hope is that the findings of this report will contribute to the debate on decarbonization with emphasis on the critical role of green fiscal policies in ensuring an inclusive transition to net zero emissions in the EU member states. Governments will need to weigh in on their options for the energy transition path that will vary for different countries. In addition, concerns on energy security make it clear that actions on the green transition are required sooner than later. Timing is of the essence to ensure that countries can reap the benefits from lower emissions along with increased energy security and independence.

Gallina A. Vincelette

Country Director European Union Europe and Central Asia Region The World Bank Lalita M. Moorty

Regional Director—Equitable Growth, Finance and Institutions Europe and Central Asia Region The World Bank