Climate neutrality transitions seem compatible with stable public finances

The European Union’s transition towards climate neutrality is expected to reshape the economy

A recent study commissioned by the European Commission’s climate department explores how the shift to a low-carbon economy will influence government revenues, spending, and long-term debt.

Sifting sources of government revenue

An immediate financial impact of the climate transition is the gradual decline in revenues linked to fossil fuels.

As economies electrify and shift to renewable energy, income from fossil fuel taxes is expected to decline steadily through 2050.

This reduction is not expected to create a major gap. Governments are already working to phase out fossil fuel subsidies, which are still substantial in many countries. Removing these subsidies by around 2035 is expected to offset some of the lost tax income.

Carbon pricing mechanisms are also becoming increasingly important. Existing systems, along with new schemes covering sectors like buildings and road transport, are set to generate significant revenue. These revenues are expected to peak in the mid-2030s before declining as emissions decrease.

Spending pressures and economic effects

The transition will require considerable public investment to support clean technologies and encourage behavioural change. Governments may also need to provide incentives for businesses and households to adopt low-carbon solutions.

These changes are also expected to create indirect effects on employment, consumption, and investment; however, these effects are less predictable and are generally expected to be modest. For example, shifts in employment levels could affect tax income and welfare spending, while increased investment in green technologies may stimulate economic activity.

The study compares two different economic models to understand how the transition might unfold. One model suggests that climate neutrality could slightly reduce economic output, consumption, and employment compared to a scenario with weaker climate action. In this case, governments might need to make small tax adjustments to maintain stable budgets.

The second model suggests that increased investment in the green transition could boost economic growth, raise employment, and increase taxes or provide financial support to households.

Although they differ, both models agree that the overall fiscal impact is relatively small.

Limited impact on public debt

The study concludes that the transition to climate neutrality is unlikely to be a decisive factor in determining the long-term sustainability of public finances.

Any required changes to taxation or spending are expected to be manageable.

As the energy system grows, governments may also adapt their tax structures. New forms of energy could eventually be taxed, helping to replace declining fossil fuel revenues.

While the study focuses on the fiscal effects of the transition itself, it does not account for the economic costs of climate-related damage. These could include increased public spending on disaster recovery and adaptation measures, which are expected to grow in the coming decades.

Overall, the findings suggest that, with careful policy design, the path to climate neutrality can be aligned with stable, sustainable public finances, offering governments flexibility as they navigate the transition.