Iceland: Selected Issues
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International Monetary Fund. European Dept.
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Publication Date:
27 Jun 2022
eISBN:
9798400214608
ISBN:
9798400214608
Language:
English
Keywords:
climate goal; statistics Iceland; land use emission; carbon footprint; government of Iceland; Climate policy
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Meeting Iceland’s ambitious climate goals will be challenging in a growing economy and would require continuous determination and effort to advance the pace of technological development. Iceland has the lowest emissions in energy generation in the OECD, but lags in other areas, making emission reduction commitments crucial. The focus should be on reducing emissions under Iceland’s direct regulation without losing sight of emissions covered under the European ETS. Energy exchange in road transport and fishing could play a crucial role in meeting Iceland’s commitment. This will require uniform carbon pricing policies, a favorable evolution of global technological development, and large redirection or expansion of renewable energy production. The latter involves environmental concerns. Fiscal incentives to meet climate goals need to be revenue neutral and factor other fiscal objectives. Options for carbon sequestration are promising, but not economically viable in the short run. Research and development in this area needs to be continuously supported.

Abstract

Meeting Iceland’s ambitious climate goals will be challenging in a growing economy and would require continuous determination and effort to advance the pace of technological development. Iceland has the lowest emissions in energy generation in the OECD, but lags in other areas, making emission reduction commitments crucial. The focus should be on reducing emissions under Iceland’s direct regulation without losing sight of emissions covered under the European ETS. Energy exchange in road transport and fishing could play a crucial role in meeting Iceland’s commitment. This will require uniform carbon pricing policies, a favorable evolution of global technological development, and large redirection or expansion of renewable energy production. The latter involves environmental concerns. Fiscal incentives to meet climate goals need to be revenue neutral and factor other fiscal objectives. Options for carbon sequestration are promising, but not economically viable in the short run. Research and development in this area needs to be continuously supported.

On the Road to Carbon Neutrality, Fishing for Energy Exchange and Carbon Absorption

Meeting Iceland’s ambitious climate goals will be challenging in a growing economy and would require continuous determination and effort to advance the pace of technological development. Iceland has the lowest emissions in energy generation in the OECD, but lags in other areas, making emission reduction commitments crucial. The focus should be on reducing emissions under Iceland’s direct regulation without losing sight of emissions covered under the European ETS. Energy exchange in road transport and fishing could play a crucial role in meeting Iceland’s commitment. This will require uniform carbon pricing policies, a favorable evolution of global technological development, and large redirection or expansion of renewable energy production. The latter involves environmental concerns. Fiscal incentives to meet climate goals need to be revenue neutral and factor other fiscal objectives. Options for carbon sequestration are promising, but not economically viable in the short run. Research and development in this area needs to be continuously supported.

A. Starting from Behind with Clean Fuel

1. Iceland has the lowest emissions in energy generation in the OECD, but does not fare well in other areas, making reduction commitments crucial. Iceland is in the top quartile of greenhouse gas emissions per person and unit of economic activity in the OECD, but there are significant differences between energy generation and other sectors. Iceland has the lowest emissions in energy generation among OECD economies, whether measured on per capita or GDP basis. Most of the country’s electricity is generated from renewable sources, especially hydroelectric power, and most of its heating needs are covered by geothermal energy. However, Iceland’s industrial sector emissions are the highest compared to other OECD countries. This reflects mainly the operation of aluminum smelters located in Iceland partly to reduce their carbon footprint by using clean energy. Transport by air, land, and sea (including the fishing fleet) also generates significant emissions. Land use emissions are also high per capita and relative to GDP but are subject to significant uncertainty and may be measured more strictly in Iceland than elsewhere.

Iceland: Percent Rank in Historical Greenhouse Gas Emissions, 2019 1/

article image
Source: OECD

A higher number implies higher emissions. The percentile indicates the rank from 0 to 100 in which Iceland stands relative to the 38 countries in the OECD with available data. For example, 100 means the country would be the one with the highest emissions of the 38 countries.

B. Advancing on Separate Tracks: Emissions Under and Outside the European ETS

2. About half of Iceland’s emissions are regulated by the European Trading System. The four largest generators of greenhouse gas emissions are (1) the aluminum smelters accounting for about a fifth of the emissions in 2018; (2) international aviation related to the tourism industry accounting for another fifth; (3) road transport accounting for about 15 percent of emissions; (4) fishing accounting for about 10 percent of emissions, (5) ferroalloys production, accounting for about 7 percent of emissions, and (6) international navigation accounting for about 4 percent Of these, the European Emissions Trading System (EU ETS) regulates the emissions of the aluminum industry, international aviation, and ferroalloys production. Together these areas account for about half of the greenhouse gas emissions of Iceland.

Iceland: Emissions by Subsectors

article image
Source: Icelandic authorities and IMF staff estimates.

3. Between 1995 and 2019, emissions generated in Iceland almost doubled. The expansion was mainly in sectors covered under the EU ETS. It was mainly a result of the large capacity expansion in the aluminum sector during 2005–08, and later of the takeoff of international aviation due to the tourism boom that started in 2012. The collapse in tourism during the pandemic resulted in a large reduction in emissions from international aviation, but those emissions are expected to pick up as the sector recovers.

uA002fig01

Iceland: Total Emissions

(C02 Tons Equivalent)

Citation: IMF Staff Country Reports 2022, 194; 10.5089/9798400214608.002.A002

Source: Statistics Iceland
uA002fig02

Iceland: Emissions of Base Metals, Air Transport and Others

(C02 Tons Equivalent)

Citation: IMF Staff Country Reports 2022, 194; 10.5089/9798400214608.002.A002

Source: Statistics Iceland

4. In the next few years, emission reductions are projected to be in areas not covered under the ETS. The latest projections of greenhouse gas emissions in Iceland envisages that emissions covered under the ETS will continue to increase through 2040, while other emissions will decline (Government of Iceland, 2022). The authorities envisage that emissions of the metal industry (aluminum smelters and ferroalloy production) and international navigation will increase very gradually, and those of international aviation will recover by 2025 from their low 2020 levels and will continue rising at a slower pace.

uA002fig03

Iceland: Emissions Official Forecasts

(C02 Tons Equivalent)

Citation: IMF Staff Country Reports 2022, 194; 10.5089/9798400214608.002.A002

Source: The Environment Agency of Iceland
uA002fig04

Iceland: Selected ETS Emissions Official Forecasts

(C02 Tons Equivalent)

Citation: IMF Staff Country Reports 2022, 194; 10.5089/9798400214608.002.A002

Source: The Environment Agency of Iceland

5. While the EU ETS creates incentives for the reduction of emissions at the European level, the incentives for individual countries with renewable energy resources are unclear. For instance, although at the European level it is important to reduce emissions from aluminum production, that reduction in emissions could be achieved by setting smelters close to renewable electricity sources, such as Iceland. The same applies for other energy-intensive industries such as ferroalloys. Although this would achieve reductions in European levels of emissions from those industries, emissions generated in Iceland would tend to increase. Tradeoffs among policy objectives could build up. Greater industrial production with clean energy could increase employment, exports, and the general well-being of the population, while at the same time contribute to climate goals at the European level. The aluminum industry produces a crucial input in the production of low emission vehicles using renewable power instead of coal as other global large-scale aluminum producers. The large expansion of aluminum and ferroalloy production in Iceland contributed to the economic recovery and welfare improvement following the global financial crisis. Aluminum smelters have also been a strategic and reliable long-term user of electricity in Iceland, which helped pay for the cost of capital invested in hydroelectric infrastructure. However, the expansion of such activities increases emission generation in Iceland and exposes the Icelandic population to greenhouse gases. The environmental and, in principle, health costs of such activities need to be factored in in considering industrial policy decisions for expanding activities whose emissions are covered under the ETS. The official emission forecasts do not currently envisage a large-scale expansion of existing or future ETS activity.

C. Doing Iceland’s Share: Ambitious Goals and Comprehensive Plans

6. The authorities’ goals for reducing the domestic carbon footprint are ambitious. Among areas outside the ETS, Iceland has committed to reach carbon neutrality (net zero emissions) no later than 2040 and to eliminate its use of fossil fuels by 2050 (Government of Iceland, 2021c). In the context of the Paris Agreement, jointly with the EU and Norway, Iceland committed to achieve a 40 percent reduction of total emissions, without land use, between 1990 and 2030. Iceland’s contribution to the joint commitment was to reduce emissions by 29 percent from their 2005 level. More recently, the group has raised its commitment to reduce emissions by 55 percent from their 1990 levels, but Iceland’s contribution to this commitment has not yet been established. The authorities’ latest forecast estimates that already quantified climate measures would deliver a reduction of 28 percent during 2005–2030 (2,261 kt CO2e), which suggests that more measures would be required to achieve their commitments (Government of Iceland, 2022). Under the Kyoto Protocol, Iceland was granted allowances for 15 million tons of CO2 for the period 2013–2020, whereas, net of carbon sequestration, Iceland generated 19 million tons outside the ETS. The fiscal cost of missing this target is yet to be determined.

7. The strategy to reduce domestic emissions is sound. Iceland has prepared a comprehensive climate action plan, updated in 2020, which contains 48 actions cutting across key aspects of economic activity and sectors of society. It includes a combination of fiscal incentives, government regulation, and provision of infrastructure to encourage activities and the use of technologies that reduce Iceland’s carbon footprint. The measures need to be periodically adapted to include technological and economic developments, and progress toward the objectives is envisaged to be measured periodically to adjust the pace of reform as needed (Ministry for the Environment and Natural Resources, 2020 and 2021). Achieving carbon neutrality would entail upgrading the capital stock toward one that produces less emissions, using cleaner energy sources and securing their supply, encouraging activities that generate less emissions, and expanding emission-absorbing activities, including through new technologies (Box 1).

D. On the Road and Fishing for Lower Emissions

8. The Icelandic climate action plan recognizes that progress in reducing emissions from road transportation and the fishing fleet would be crucial to achieving Iceland’s goals. Significant progress has been achieved in the last 25 years in reducing the emissions of the fishing fleet, The consolidation of the fishing quota system resulted in a reduction in the number of vessels, the use of larger ships, and a more sustainable and lower catch (OECD, 2021a, Government of Iceland, 2021a). However, the latest official forecast suggests that only moderate progress is expected in the next 20 years. The challenge is partly due to the young age of the existing vessels that consume the most energy but are otherwise efficient in getting the most catch (DNV Maritime, 2021, Government of Iceland, 2021a). In contrast, over the last 20 years, very little progress has been made in reducing overall emissions from road transportation. This is the sector, where most of the progress in reducing emissions is expected to take place in the future, as energy exchange in vehicles is already taking place.

uA002fig05

Iceland: Other Emissions

(C02 Tons Equivalent)

Citation: IMF Staff Country Reports 2022, 194; 10.5089/9798400214608.002.A002

Source: Statistics Iceland
uA002fig06

Iceland: Non ETS Emissions Official Forecasts

(C02 Tons Equivalent)

Citation: IMF Staff Country Reports 2022, 194; 10.5089/9798400214608.002.A002

Source: Statistics Iceland

E. The Energy Exchange Transition Toward Clean Vehicles

9. The emissions from road transportation have been relatively stable despite a significant increase in the number of vehicles, mostly reflecting substitution among fossil fuels. The share of gasoline in road transportation has declined from almost 60 percent in 2008 to about 30 percent in 2020. Most of the decline has been absorbed by diesel vehicles. The number of electric vehicles has increased since 2017, but they remain a very small fraction of the outstanding vehicle stock. Most of this substitution has taken place at the level of household vehicles, as the share of diesel cars has increased to 35 from 8 percent during 1995–2020. Of all diesel cars, the households’ share has remained stable at about 70 percent. Most heavy transportation is diesel.

uA002fig07

Iceland: Vehicles by Fuel Type

(Number of units)

Citation: IMF Staff Country Reports 2022, 194; 10.5089/9798400214608.002.A002

Source: World Bank Dashboard.
uA002fig08

Iceland: Share of New Passenger Vehicle Registration

(Percent)

Citation: IMF Staff Country Reports 2022, 194; 10.5089/9798400214608.002.A002

* Through April 2022.Source: Ministry of Finance.
uA002fig09

Iceland: Energy Used in Road Transport

(Percent)

Citation: IMF Staff Country Reports 2022, 194; 10.5089/9798400214608.002.A002

What Needs to Take Place to Reduce Net Emissions and Related Challenges: A Conceptual Framework

Four types of processes will assist in reducing greenhouse gas emissions, either jointly or separately: (1) upgrade the capital stock with embedded technologies that produce less or no emissions; (2) switch toward cleaner sources of energy and procure their supply; (3) reduce economic activities that generate emissions or increase others that generate low ones; and (4) absorb the emissions generated by other processes. Energy exchange requires the first two, but they can both be independent, for example upgrading the capital stock with more energy efficient technologies that use the same fuel.

The key challenge is that these processes take time to develop. Climate goals are set decades in advance because an immediate substitution of the capital stock is neither feasible nor desirable. It may be too expensive to acquire new capital and difficult to dispose of existing one. Gradual substitution can help ensure the replacement of the capital stock that has already been fully depreciated with other that uses cleaner technologies. This implies that the speed of substitution of the capital stock depends on its average life span, which, for instance is lower for cars (12–15 years) than for fishing trawlers.

Moreover, there are technological and economic viability limitations. Energy exchange may not be feasible at the current level of technology. Alternatives to fossil fuels may be too expensive even after accounting for the adverse cost of climate disruptions, may not yet be easily available, and may require acquiring capital stock with early technologies, that may be soon obsolete, or may not competitive. Methods to absorb emissions are already technologically feasible, but not yet economically viable.

Energy exchange requires significant investment and capacity expansion. Maintaining reliance on renewable energy and fostering a substitution away from fossil fuels in transportation, would require investments in additional renewable energy infrastructure that may bring about environmental tradeoffs, such as the risks of environmental damage that may arise from the construction of hydroelectric dams.

Financial flows are crucial in energy transition. Financial flows (and stocks) have been involved in the capital stock being currently used in the generation of value added that currently generates the level of emissions that need to be reduced. These need to be redirected to help with the transition toward capital stocks that produce less emissions as the current capital stock depreciates in in generational waves and replaced with newer technologies over time. These changes add to the climate risks that financial institutions face. Not only do financial institutions may be affected by the materialization of losses from natural disasters associated to climate change, but they may also be affected by the risks of a too rapid transition of technological change.

Economic activities that generate significant emissions, such as aluminum smelters, may be a crucial source of revenue and foreign exchange for the economy that may not be easily substituted for other reliable income streams without lowering the net income of the population. On the other hand, industrial policy could help promote low emission activities.

Finally, Iceland’s growing economy and relatively high population growth, including through immigration, would increase demand for resources and economic activity. This could result in higher emissions even if these were to fall in per-capita terms or per unit of economic activity.

10. Although diesel vehicles have helped keep emissions from road transportation contained, the advantages of diesel over gasoline vehicles are not clear cut. Diesel has a higher carbon content than gasoline per gallon. However, per unit of energy (BTU), diesel generates less greenhouse gas emissions than gasoline. Because they achieve greater mileage per gallon, diesel vehicles on average generate about 40 percent less emissions than gasoline vehicles of similar weight (Nieuwenhuis, 2017). Although diesel vehicles generate less C02 emissions per mile, they also generate other emissions that have been associated with heart disease (Neophytou, 2019) and cancer (American Cancer Society, 2015).1 Based on these concerns, many cities in Europe have banned the circulation of diesel vehicles. Although new generations of diesel vehicles will address these concerns in the future, Iceland has taken the decision to shift toward electric vehicles and the action plan envisages a ban on the registration of fossil fuel-dependent vehicles by 2030. Several other countries have announced similar plans, including Norway—by 2025—, Ireland, Netherlands, Slovenia, and Sweden—by 2030—, Cape Verde, Denmark, United Kingdom—by 2035—, France, Spain—by 2040— (International Council of Clean Transportation, 2021). Ongoing discussions at the European Union level could support a ban on the 27-country block by 2035.

11. The ban on fossil fuel vehicles and adoption of electric vehicles will sharply reduce the emissions from road transportation. By 2021, the stock of electric vehicles amounted to about 4 percent of the total stock, plug-in hybrids amounted to 6.5 percent of the stock, and the share of electric vehicles in new registrations to 58 percent. Iceland’s high urbanization rate and relatively low driving ranges within the urban areas make electric vehicles well suited for the typical driver. The macroeconomic effect of a shift toward electric cars has been assessed as positive (University of Iceland and Reykjavík University, 2018). The shift toward electric vehicles helps with energy security and reduces dependence on the evolution of global oil prices. Iceland’s current energy policy through 2050 sets energy exchange in transportation as a key medium-term policy objective (Government of Iceland, 2020a). This would imply a reduction in fuel imports, but for a time would require higher imports of capital goods to increase the supply of renewable electricity and investment in infrastructure to charge vehicles on the road. Given the typical life span on cars (12–13) years, the transition toward electric cars should be well advanced by 2030 at the current pace of new registrations. The use of electronic fuels is technologically feasible, but not yet economically viable (Box 2). It would eventually play a crucial role in supporting the reduction in emissions of heavy transport.

12. The prohibition of fossil fuel-dependent vehicles as of 2030 may need to be complemented over time with other measures. The prohibition to register new fossil fuel vehicles could help achieve climate goals but could lead to the use of obsolete fossil-fuel dependent vehicles well after they have depreciated. This greater reliance on old vehicles, on the margin, may tend to increase emissions. To a significant extent, this depends on the cost of new electric vehicles by 2030, which will likely continue to decline with technological improvements. But, if the cost does not fall fast enough, and it is not possible to obtain new fossil fuel vehicles after 2030, there could be stockpiling ahead of the prohibition, and individuals may tend to keep older vehicles for longer. This would require incentives to keep such vehicles well maintained, and to invest in mechanisms to keep their emissions from increasing.

In Search of Electric Fuels for Energy Exchange

The quest for a renewable low-carbon portable fuel source for transportation in land, sea, and air is at early stages. Electric cars store electricity in batteries that release the energy to move the vehicle. Similarly, electric fuels (e-fuels) convert renewable electricity into a low-carbon fuel that could be used in combustion. In this way, e-fuels can store renewable energy as batteries. E-fuels already produced in Iceland at low scale include green hydrogen, methane, and methanol. The possibility to produce ethanol and biodiesel is also being explored. Nevertheless, the cost of production of these fuels is very high relative to that of fossil fuels, or even batteries. Similarly, vehicles that use e-fuels tend to be more expensive than other vehicles. In the case of hydrogen, the energy use of the electrolysis to produce the hydrogen from water costs more energy than the energy stored in the hydrogen. It can nevertheless make sense to produce green hydrogen during periods of excess electricity power that would otherwise be lost, or when mobile energy is twice more valuable than energy on the grid (Rapier, 2020).

At the current level of technology, it does not seem viable to expand renewable electricity capacity to produce e-fuels, but it may become viable in the future. The e-fuel option is currently expected to become competitive between 2030 and 2040 (Government of Iceland, 2021b). The use of renewable energy to charge batteries or produce e-fuels may require expanding the generation capacity of renewable energy. Such an expansion will need to balance environmental concerns with the benefits of reducing emissions in road transportation.

F. Fiscal Incentives to Reduce Emissions in Road Transportation

13. The strategy to encourage a reduction in emissions from road transportation is adequately comprehensive. A good strategy should factor not only the substitution of the vehicle fleet for more efficient means of transportation, but also consider options for public transportation that reduce the number of emission-generating units on the road, traffic congestions and related time costs (Arregui and others, 2020, International Monetary Fund, 2020 Box 4). To this end, the authorities’ strategy already includes fiscal incentives encouraging the transition onto electric vehicles, initiatives to significantly enhance public transportation, provision of public infrastructure in the form of rapid charging stations and promotion of walking and cycling activities where feasible to support the transition (Iceland’s Ministry for the Environment, Energy, and Climate, 2022). An expansion in the renewable energy capacity may be required.

14. Fiscal incentives to meet climate goals need to be revenue neutral and factor other fiscal objectives. The incentives need to be sustainable and apply to the acquisition, ownership, and use of the capital stock used in transportation. The incentive structure needs to (1) favor the use of clean energy over other types of fuel, and (2) meet other road transportation objectives, such as achieving an optimal number of cars on the road, encouraging the periodic renewal of the car fleet, and allowing for maintenance and safety of the road infrastructure. The wedge in taxation of vehicle acquisition, ownership, and use should favor cleaner technologies and fuel use, but should be set at a level that still raises enough revenue to achieve other policy goals in addition to energy transition. The authorities already recognize this challenge and are considering different taxation structures (Ministry of Finance and Economic Affairs, 2018 and 2022).

15. The current incentive structure related to vehicle taxation is contributing significantly to the adoption of electric cars but is not sustainable. The current tax incentive structure for clean vehicles resembles the one prevailing in Norway, with similar effectiveness in encouraging electric vehicle adoption and some of the same fiscal challenges and room for improvement (OECD, 2021c Box 15 and ¶74). Taxes or fees are already applied on the acquisition of cars and have been tied to the emissions they are expected to generate during their economic life span. Tax exemptions have also been granted temporarily from some type of taxes to encourage adoption of capital stocks with cleaner technologies. These include VAT exemptions for clean vehicles and temporary accelerated depreciation rules for eligible green investments affecting corporate income tax colletions. Similarly, taxes are already applied to the carbon content of different types of energy sources, which has taken the form of a carbon tax applied to the carbon content of each fuel. Similarly, depreciation rates for tax purposes can also be calibrated, in principle to factor in the carbon content of different technologies and could be used to accelerate the replacement of capital stock with older carbon intensive technologies. Nevertheless, the structure is not sustainable because the tax base of fossil fuels will disappear once the transition has been completed. Tax revenue from vehicles has been declining over time, more recently with the ongoing substitution away from fossil-fuel vehicles. Changes in the tax structure would need to take place at the level of usage to transition from taxing the energy to a more direct measurement of actual use.

uA002fig10

Iceland: Tax Revenue from Vehicles, by Type of Tax (non VAT)

(Percent of GDP)

Citation: IMF Staff Country Reports 2022, 194; 10.5089/9798400214608.002.A002

* on heavy diesel vehicles.Source: Ministry of Finance.
uA002fig11

Iceland: Excise Revenue per Total Number of Vehicles in Circulation

(Thousands of kronas of 2021)

Citation: IMF Staff Country Reports 2022, 194; 10.5089/9798400214608.002.A002

Source: Ministry of Finance.

G. Realigning and Broadening the Base of Energy Taxation

16. The relative prices of alternative fuels play a role in the choice of vehicle types. They appear to have played a role in the transition toward diesel cars. Per liter, pump prices for diesel are generally lower than those for gasoline in Iceland. Diesel is cheaper to produce than gasoline, and in Iceland carries lower taxes. Although diesel carries a higher carbon per gallon tax than gasoline due to its higher carbon content, overall taxes end up being lower due to lower excises. For diesel and gasoline, the size of excise taxes is significantly larger than the corresponding carbon tax (OECD, 2019). As a result of the high taxes on gasoline and diesel, prices of gasoline and diesel are among the highest in the world. Electricity is not subject to excises or carbon tax, but it is subject to value added tax: Electricity for house heating is taxed at the lower VAT rate (11 percent) and other electricity at the standard VAT rate (24 percent).

17. High taxation of fossil fuels plays many roles other than discouraging their use. It is a way of charging for the public use of roads and a substantial source of revenue. To the extent that energy exchange in transportation were successful, and fossil fuels are taxed and electricity (or other alternative fuel sources with little carbon content, such as e-fuels) is not, the state would lose a nontrivial amount of fiscal revenue. Taxing electricity and e-fuels to the levels compatible with public services related to road transportation, such as road maintenance, security services, traffic control, among others, would be a way to replace the tax base after the transition. Other ways of charging for road usage, other than through the taxation of fuel sources, would need to be developed while maintaining the tax wedge between fossil fuels and clean sources of energy. Experiences with this type of usage charges are being considered by the authorities (Ministry of Finance and Economic Affairs, 2018).

18. To keep climate objectives, the explicit carbon tax coverage would need to be made universal or widely expanded. Climate goals require further shift toward cleaner energy fuels. This requires ensuring that different types of energy sources pay according to their carbon content. In practice, this would mean, for example, that diesel would pay more than gasoline because it has a higher carbon content, even if it were to generate less emissions per mile. The coverage of carbon prices should in principle be universal as emissions harm the environment independently of their source. This is also more equitable, sharing the burden of meeting climate goals across all sectors of activity that generate the emissions. Although the coverage in Iceland can be expanded, effective carbon pricing scores suggest Iceland fares comparatively well in terms of carbon pricing coverages around the world (OECD, 2021b). Expanding its coverage across the whole spectrum would include emissions from electricity generation, which would apply in practice mainly to those produced by geothermal energy. Although geothermal emissions are lower per unit of energy, they have increased substantially and need to be adequately priced. The capture of C02 emissions from geothermal energy could in principle be used as a credit to this tax (Government of Iceland, 202b). Care should also be taken to avoid double taxation of emissions from the industries subject to the ETS, as these already pay directly for the emissions they generate, factoring their free allocations to protect some industries from carbon leakage. For basic metals, the main energy input is renewable electricity, so the scope for double taxation is in principle small.

uA002fig12

Iceland: OECD – Share of Carbon Emissions Priced

(Percent)

Citation: IMF Staff Country Reports 2022, 194; 10.5089/9798400214608.002.A002

Source: OECD
uA002fig13

Iceland: Effective Energy Taxes by Sectors

(Average by sector, energy category and end-use energy (electricity or other) – rate in EUR per GJ)

Citation: IMF Staff Country Reports 2022, 194; 10.5089/9798400214608.002.A002

Source: OECD. Taxing Energy Use
uA002fig14

Iceland: Fuel Cleanliness

(Kilograms of C02 per Million Btu)

Citation: IMF Staff Country Reports 2022, 194; 10.5089/9798400214608.002.A002

19. Carbon taxes would also need to be significantly raised. Together with the expansion of coverage, raising carbon taxes would better align climate incentives across industries (International Monetary Fund, 2011). In terms of economic impact, increasing carbon taxes would affect fossil fuels used in the fishing fleet, which will help with the energy transition. Fuel excises are already a form of carbon taxes, that forms part of the effective tax on these energy sources. Increasing carbon taxes to the level of effective energy taxation of gasoline (carbon tax plus excises) and eliminating excises would leave carbon taxes in Iceland the highest in the word.

uA002fig15

Iceland: Carbon Taxes

(US$/tCO2e)

Citation: IMF Staff Country Reports 2022, 194; 10.5089/9798400214608.002.A002

Source: World Bank Dashboard.
uA002fig16

Nordic Countries: Carbon Taxes

(US$/tCO2e)

Citation: IMF Staff Country Reports 2022, 194; 10.5089/9798400214608.002.A002

Source: World Bank Dashboard.

20. The impact of these changes need not significantly affect the consumer. In the event that carbon taxes are raised to the level of effective taxation of gasoline (with offsetting changes in excises), the overall level of energy taxation in road transportation would not materially change for individuals with a gasoline vehicle. Effective taxes would increase for diesel users as excises for diesel are currently lower than those for gasoline. Although gasoline and diesel are among the most expensive in the world, the cost of living in Iceland and incomes are generally high. The share of gasoline prices in the consumer price index, for example, has declined to below 3 percent. The higher taxation of fuel in the fishing fleet may increase on the margin the price of fish, but most of it is exported. Formal studies reach a similar conclusion that the impact on consumer prices and consumer purchasing power will be mild (Blöchliger, Johannesson and Gestsson, 2022; Institute of Economic Studies, 2019 and 2020; OECD, 2021).

uA002fig17

Iceland: CPI Weight of Gasoline Prices

(Percent)

Citation: IMF Staff Country Reports 2022, 194; 10.5089/9798400214608.002.A002

Source: Statistics Iceland

H. Insights from the Climate Policy Assessment Tool

21. The Climate Policy Assessment Tool is a benchmark for assessing climate policies around the globe. The IMF/World Bank Climate Policy Assessment Tool (CPAT) is a spreadsheet model that has been used to study the effects of climate mitigation policies in several flagships of the multilateral institutions and in the bilateral surveillance of member countries (Black and others, 2022; IMF-WB, 2022; Parry and others, 2018).

22. Simulations for Iceland suggest that, if the only policy to achieve climate goals were carbon prices, these would need to be increased further. This would depend on what happens to fuel excises. If gasoline and diesel excises were kept at their current levels, carbon prices would need to increase to about US$ 220 per tCO2e from 37 US$ per tCO2e to engineer a reduction in emissions of 40 percent with respect to their 1990 levels. In the absence of measures, emissions would grow with economic activity. Under the baseline carbon tax simulation in Panel 1, which assumes that the increase in carbon price takes place in 2023, the model suggests this would imply an increase of about 70 percent relative to 2018 CPI-adjusted gasoline and diesel prices. The year 2018 is used as reference because the model uses a cross-country dataset, whose latest observation is that year. Different combinations of fossil-fuel excises and carbon tax increases are possible to achieve this goal but are likely to require significant increases in the real price of fuel relative to their 2018 levels. Because Iceland does not rely exclusively on increasing carbon prices, this estimated increase in prices associated with higher effective taxation of carbon emissions should be viewed as an upper bound.

23. The envisaged increase in carbon taxes in the baseline would hurt GDP growth temporarily but has a net positive welfare benefit. The impact on GDP would depend on how the tax revenue raised from the increase in the carbon tax will be used. The envisaged increase in carbon prices would add about 1 percent of GDP in fiscal revenue. The baseline assumes that half the revenues are used to reduce labor taxes and the other half to increase public investment, which impact economic activity through fiscal multipliers. The model tool suggests that in the baseline the increase in carbon taxes would slow GDP growth by about 0.25 percentage points in 2023–2024, but the net effect on the growth rate (not the GDP level) would disappear by 2030. The model recognizes that tax increases may have efficiency costs, but suggests that the net benefit may be positive, not only because of their effect on climate, but also due to improving health with lower air pollution and lowering congestion and, with lower vehicle circulation, accident death (Figure 1).

uA002fig18

Iceland: Net Impact on GDP Growth of Carbon Tax Increase1

(Percent)

Citation: IMF Staff Country Reports 2022, 194; 10.5089/9798400214608.002.A002

1 Using 100 percent of fiscal revenue for reducing tax types or increasing spending.Source: IMF/World Bank Climate Policy Assessment Tool (version CPAT 1.0pre_097)

24. The pace of carbon price increases affects the profile of the impact on economic activity. Raising carbon prices immediately to a sufficient level to achieve climate goals with the current level of technology would imply unnecessary disruption in economic activity and social welfare. Partly because of this, climate goals are set to be achieved over a long period. Arguably, the increase in carbon taxes should be in preannounced stages to avoid unnecessary disruptions and to discourage fast adoption of earlier technologies that may soon become obsolete, or that end up affecting public health. Nonetheless, the CPAT model highlights that while the impact on GDP growth will be more stable, it would tend to be negative for longer. This is because the economic benefit from the alternative uses of the fiscal revenue—lower labor taxes and higher public investment under staffs baseline—would materialize later.

I. Carbon Absorption to Net Down Emissions

25. In addition to reducing carbon emissions, reaching carbon neutrality would require absorbing some of the emitted c02 (carbon sequestration) through a variety of means. This involves efforts at afforestation, wetland restoration and protection, land reclamation, and more innovative means that are at early stages of technologic development and economic viability. It remains unclear if land reclamation offsets, though valuable, should count a credit for emissions, as land emissions are not counted, and would be subject to a different set of international standards and commitments. A variety of carbon capture and storage technologies are being developed. For relatively concentrated sources of CO2 emissions, such as from geothermal steam or silicon production, it is now feasible to capture the greenhouse gas emissions and convert them either to rock or to green methane. The gas-to-rock method of Carbfix is already applied to geothermal emissions and the feasibility to expanding it to other areas is being studied (Veal, 2020, Government of Iceland, 2022). Methods to capture CO2 directly from the air (Orca from Climeworks) have been used since 2020 in combination with mineral storage technology, such as CarbFix to contribute to offsetting some of the emissions. The gas-to-green methane option is currently being studied by the national electricity company and silicon producer PCC SE at Bakki. These methods are technologically feasible, but not yet economically viable on mass scale (Government of Iceland, 2021b).

Figure 1.
Figure 1.
Figure 1.

Iceland: Climate Policy Assessment Tool Baseline Simulation: 2022–2030

Citation: IMF Staff Country Reports 2022, 194; 10.5089/9798400214608.002.A002

1/ With half marginal revenue reducing labor taxes and half raising public investment.Source: IMF/World Bank Climate Policy Assessment Tool (version CPAT 1.0pre_097)

J. Conclusions

26. Iceland’s climate goals are appropriately ambitious given that its average levels of emissions per capita and GDP are above the median of the OECD. Although Iceland has the lowest emissions in energy generation in the OECD, it does not fare well in other areas. While the authorities’ goals rightly focus on emissions under domestic regulation, the authorities should not lose sight of emissions under the European ETS, which have accounted for most of the growth in emissions in Iceland since the 1990s. The country’s extensive reliance on renewable energy could attract high-energy intensive firms, which could reduce European greenhouse gas emissions but will end up increasing those in Iceland. The expansion of energy-intensive sectors should be assessed with care, taking into consideration environmental concerns, economic viability, international commitments, and public health implications.

27. Meeting the ambitious climate goals on the non-ETS front will be challenging in a growing economy and would require continuous determination and effort to advance the pace of technological development. Energy exchange in road transport and fishing will benefit from uniform carbon pricing policies, realigning the energy taxation base, and large expansion or redirection of renewable energy production. Fiscal incentives need to be revenue neutral and factor other fiscal objectives. They will need to maintain a gap favoring cleaner technologies while being set at a level high enough to support other fiscal objectives. In road transportation, these incentives should apply at the level of car acquisition, ownership, and usage. The largest reform may need to take place at the level of usage with the transition toward cleaner technologies reducing the tax base on fossil fuels, through which vehicle usage has traditionally been taxed.

References

1

Prepared by Jorge Iván Canales Kriljenko.

1

Chronic ischemic heart disease is the main cause of death in Iceland, although the number of cases has been on the decline since the mid-2010s.

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Cover IMF Staff Country Reports
Iceland: Selected Issues
Author:
International Monetary Fund. European Dept.
Volume/Issue:
Volume 2022: Issue 194
Publisher:
International Monetary Fund
ISBN:
9798400214608
ISSN:
1934-7685
Pages:
34
DOI:
https://doi.org/10.5089/9798400214608.002

Iceland: Total Emissions

(C02 Tons Equivalent)

Iceland: Emissions of Base Metals, Air Transport and Others

(C02 Tons Equivalent)

Iceland: Emissions Official Forecasts

(C02 Tons Equivalent)

Iceland: Selected ETS Emissions Official Forecasts

(C02 Tons Equivalent)

Iceland: Other Emissions

(C02 Tons Equivalent)

Iceland: Non ETS Emissions Official Forecasts

(C02 Tons Equivalent)

Iceland: Vehicles by Fuel Type

(Number of units)

Iceland: Share of New Passenger Vehicle Registration

(Percent)

Iceland: Energy Used in Road Transport

(Percent)

Iceland: Tax Revenue from Vehicles, by Type of Tax (non VAT)

(Percent of GDP)

Iceland: Excise Revenue per Total Number of Vehicles in Circulation

(Thousands of kronas of 2021)

Iceland: OECD – Share of Carbon Emissions Priced

(Percent)

Iceland: Effective Energy Taxes by Sectors

(Average by sector, energy category and end-use energy (electricity or other) – rate in EUR per GJ)

Iceland: Fuel Cleanliness

(Kilograms of C02 per Million Btu)

Iceland: Carbon Taxes

(US$/tCO2e)

Nordic Countries: Carbon Taxes

(US$/tCO2e)

Iceland: CPI Weight of Gasoline Prices

(Percent)

Iceland: Net Impact on GDP Growth of Carbon Tax Increase1

(Percent)
Figure 1.

Iceland: Climate Policy Assessment Tool Baseline Simulation: 2022–2030
Figure 1.

Iceland: Climate Policy Assessment Tool Baseline Simulation: 2022–2030