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22/10/2013

Vat cut: Slashing the fight against global warming?

On October 4th, members of the government suggested to cut the VAT on electricity from 21% to 6%. Sia Partners highlights some of the (unexpected) consequences that such a measure could have. From an economic point of view, households would benefit from a EUR 70 decrease in electricity bill in 2014 which would cost about EUR 327 million to the Federal government. From a social point of view, the advantage for the poorest consumers would only reach 60% of what the wealthier households would gain. Lastly, from an environmental point of view, Sia Partners estimates that the measure would lead to 191,000 additional tons of greenhouse gases emissions as well as deterred conditions for investments in energy savings since their payback period would be increased by no less than 14%.

In 2012, the Federal government settled on a price freeze for electricity and gas. Sia Partners had then pointed out that suppliers would be considerably affected. In the fall of 2013, members of the government have alluded to a VAT cut from 21% to 6% on electricity. Sia Partners proposes to investigate the consequences of such a measure on three commonly scrutinized viewpoints: the economic, social and environmental ones.

Current situation

Belgium is often said to apply among the highest VAT rates in the European Union and particularly with regard to energy commodities. In fact, less than 10 European countries exhibit rates lower than 20% while they are 9 to apply rates superior to 21% (see Figure 1). Hence, there is no evidence to support the vision of a noticeable difference between Belgium and the rest of Europe. Such a view is probably influenced by the situation in the neighboring countries. The United Kingdom, Luxemburg, France (where two rates prevail) and Germany indeed apply (much) lower rates than Belgium.

However, the fiscal regime in neighboring countries is of little significance for 3 reasons. First of all, it does not affect companies since they recover the VAT on electricity. Second, it does not modify the Belgian position on the cross-border market because energy market prices are independent from the VAT rate. Third, the VAT rate does not seem to be the main driver of the energy price differences with these countries and cannot be the unique factor to blame for. Hence, it tends to have little to do with competitiveness.

Source: European Commission (2013)
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Economic point of view: a timid benefit for households but a large cost for the Treasury

The main argument of the proponents of a VAT decrease is its expected impact on purchasing power. The authorities aim at tackling inflation by cutting off the cost of electricity which is one of the main drivers of the CPI, the consumer price index. A former study by Sia Partners indeed showed that energy prices accounted for 40% of the increase of the price level between 2011 and 2012. It should be noted that energy as a whole impacts the CPI but only electricity would be affected by the measure. Moreover, the increase of transmission and distribution costs accounted for the half of the previous surge in electricity prices.

As shown in Figure 2, Sia Partners estimates that the benefit of decreasing VAT from 21% to 6% would, on average, amount to EUR 93 per household (for a EUR 750 yearly budget). This figure must be put into perspective. First, the project relayed by the media is supposed to become effective as of April 1st 2014. Consequently, the average benefit per household would be limited to EUR 70 in 2014 (i.e. 3/4 of EUR 93). Second, consumers usually pay fixed advances to their supplier and accounts are settled once a year. In other words, they would not effectively perceive this advantage as of April 1st 2014. For instance, a third of the consumers living in Brussels would not receive their money back before 2015.

Sources: Statbel (2013) and Sia Partners' calculations
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Furthermore, it should be borne in mind that the VAT does not affect companies which often claim that energy costs are their second competitive disadvantage after contributions on wages.

On the other hand, given the 4,693,295 households listed in 2012, the total cost for the State would reach EUR 436 million on a yearly basis and thus EUR 327 million in 2014. Unlike the delay in wage indexation, this effect would be a recurring one.

Social point of view: a VAT cut not likely to be sufficient for the poorest households

The value-added tax is widely acknowledged as an unfair tax since it makes no difference between lower and higher revenues. Paradoxically, removing or decreasing it is also unfair. Households with lower revenues consume (on average) less electricity than richer ones. Hence, if the VAT rate was to drop by 15%, the beneficiaries would mainly be the largest (and wealthiest) consumers.

As an illustration (Figure 3), the benefit of a VAT decrease for the households belonging to the first quartile of revenues (i.e. those who are among the 25% poorest) would only be 60% as high as the advantage for the households belonging to the fourth quartile (i.e. those who are among the 25% wealthiest). In absolute terms, this represents a EUR 50 difference.

Besides, electricity is a vital commodity and many stakeholders have called for its affordability. Though noticeable, a 12.4% decrease of the electricity bill will certainly not be sufficient for the first quartile households whose average energy expenses engulf 11% of their revenues (including gas, fuel oil, etc.). On the other hand, the usefulness of this decrease is questionable for the fourth quartile households who dedicate less than 4% of their income to energy.

Sources: Statbel and Sia Partners' calculations
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Environmental point of view: a deterred climate for promoting energy savings

Energy-related debates are inevitably closely linked to concerns for the environment and no decision can be taken without properly assessing its impact on, for instance, greenhouse gases emissions. Accordingly, two effects of a VAT cut must be assessed: the so-called "rebound effect" and the impact on investments in energy savings.

Sources: literature review (see Appendix 1), EURELECTRIC and Sia Partners' calculations
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The rebound effect would lead to additional greenhouse gases emissions

A highly-covered price cut is likely to impact consumption behaviors and if the constantly repeated message from the authorities is that electricity is cheaper, households will tend to divert their attention from well-reasoned consumption.

According to economic theory, consumption is negatively correlated with the price of the good under consideration. In other words, if prices decrease, consumption will tend to increase and vice-versa. The link between the former and the latter has been coined as "price-elasticity".

A reliable estimate of electricity price-elasticity is -0.2, meaning that for a 1% decrease in price, consumption will increase by 0.2%. Hence, if prices drop by 12.4%, consumption will surge by 2.5% (i.e. 12.4% times 0.2). This leads to the so-called "rebound effect".

Even though residential electricity consumption accounts for only a part of the total off-takes of the Belgian grid, this 2.5% rebound effect reaches 410,000 MWh in absolute terms. This is equivalent to the consumption of 116,000 households. Since this electricity has to be produced somehow, it will generate additional greenhouse gases emissions. These will represent 191,000 tons of CO2 equivalent.

The electricity price decrease would jeopardize the profitability of energy savings

When a household invests in energy savings, it faces an upfront cost. For instance, buying economic light bulbs or A++ appliances is more expensive than buying regular ones. The upfront cost then corresponds to the price difference between these two products.

This upfront cost is expected to be recovered with the energy savings. Indeed, since the efficient appliance consumes less electricity, the household has to spend less for the same comfort. These savings are a function of the quantity saved and of the electricity price. A decrease in the electricity price thus reduces the savings to be realized in monetary terms.

This effect can be illustrated as the choice for a household to purchase regular or efficient light bulbs. Fictitious data are displayed in Table 1:

From the data, it is easy to calculate that it will require 2.5 years (i.e. 10/4) to recover the upfront cost. In other words, after 2.5 years, the household's investment becomes financially neutral. It should be noted that the investment will generate profits only after these 2.5 years.

As mentioned earlier, the VAT cut would decrease the electricity price by 12.4%. In the example, the new electricity price would thus be 0.175 EUR/kWh. Consequently, the corrected yearly savings would amount to 3.5 EUR and it would take 2.85 years (3.5/10) to recover the investment (see Table 2).

Cutting the VAT on electricity thus increases the time to wait before recovering the investment and, hence, jeopardizes the profitability of energy savings. This point does not change with the amount of the upfront cost or the yearly savings (in kWh). In all cases, a VAT cut from 21% to 6% would increase the payback period (i.e. the number of years needed to break even) by 14%. Table 3 highlights the new payback periods and shows that for an investment with a payback period of 7 years, a full additional year would be required.

Such an impact must not be underestimated. On the one hand, all projects would have a lower profitability. On the other hand, some projects would even become financially uninteresting. This would be the case for, for instance, an efficient light bulb that would break after 2.75 years. This deterred investing environment would definitely hamper the fight against global warming.

Conclusion

The debate on a decrease of VAT on electricity from 21% to 6% has already generated fierce debates. With this study, Sia Partners aims at uncovering some of the consequences that this measure would have on the very unique sector of energy, where economic, social and environmental considerations are closely intertwined.

In 2014, the measure would, on average, benefit to the consumers up to EUR 70 per household and cost EUR 327 million to the Federal government. In the subsequent years, these amounts would climb to EUR 93 per household and EUR 436 million for the government. It should be borne in mind that the households would not actually recover their money before their supplier settles their electricity account (which depends on the meter reading).

This average benefit also hides a social discrepancy. Since poorer households tend to consume less electricity, their advantage would be limited to 60% of what the largest (and wealthiest) consumers will gain.

With regard to the environment, such a highly-covered price reduction could have negative effects. Due to price-elasticity, electricity consumption would rise by 410,000 MWh (the annual consumption of 116,000 households) and generate 191,000 additional emissions of greenhouse gases. It should be noted that this is a conservative estimate. Households who would still be looking for electricity savings would face deterred investment conditions. Indeed, the 12.4% price reduction will increase the payback period of any project by 14%. In other words, the VAT cut jeopardizes the profitability of energy savings and, as a matter of fact, the fight against global warming.

Alexandre Viviers - Sia Partners


Electricity typically accounts for less than 40% of a household's energy costs. For the poorest households, the VAT cut would only represent 0.5% of their revenues.

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