Policies to Tackle Climate Change in Estonia1
Despite substantial progress in reducing its carbon footprint, Estonia remains one of the most emission-intensive economies in the EU. Heavy reliance on oil shale for energy and electricity generation, a low effective carbon price, and high (explicit and implicit) fossil fuel subsidies are key hurdles to decolonization. Phasing out oil shale production as planned is essential for achieving the green transition. Further increasing the share of renewables in electricity generation, removing red tapes to the deployment of renewable sources, and improving the interconnectivity of the electricity grid will support greening the energy mix. Complementing this, ambitious actions on carbon pricing, energy efficiency, and reducing fossil fuel subsidies are necessary. Targeted sectoral policies in the residential and transportation sectors, which produce the most GHG emissions after electricity generation, may provide additional support to the transition.
A. Background
1. Estonia’s carbon footprint improved significantly in the early 1990s, but progress has stagnated since then. Estonia’s Greenhouse Gas (GHG) emissions declined sharply in the years immediately after regaining independence, as the country transitioned from a planned economy to a market economy and modernized its industrial base. However, this improvement was short-lived, and was quickly followed by a prolonged period during which emissions remained broadly stable (Figure 1).
Reported Emissions and Kaya Decomposition
Citation: IMF Staff Country Reports 2024, 178; 10.5089/9798400278334.002.A006
2. Emissions fell moderately in wake of the GFC in 2008. This improvement came mainly on the back of the sharp contraction in economic activity which followed the crisis and was quickly reversed in subsequent years.
3. A further fall in emissions was recorded after 2018. This reflected EU green transition policies and rising C02 prices but also the effects of COVID-19 on economic activity. These latter gains were partly reversed as pandemic-related restrictions to mobility and economic activity were lifted in 2021. In 2022, emissions are estimated to have further rebounded, as Estonia increasingly relied on oil shale for electricity production, following Russia’s war on Ukraine and the subsequent sharp increase in energy prices.
4. Over the past two decades, emissions have largely decoupled from economic activity. This is shown by the ‘Kaya identity’, which decomposes emissions into contributions from demographic, economic and energy factors:
According to this identity, the dynamics of Estonia’s GHG emissions during the past two decades reflect diverging patterns between per capita GDP, which grew strongly over the period adding to emissions, and improved energy efficiency and emissions intensity, which exerted downward pressure on emissions. Of these two factors, the main contribution to the decoupling came from an accelerated decline in the energy intensity of GDP (see Figure 1):
5. Estonia’s carbon-intensive energy mix is a key obstacle to decarbonization. While the energy intensity of output has come down significantly in the past two decades—similar to the EU average—the emission intensity of energy is high and has fallen only moderately. This is because Estonia relies on oil shale for about 60 percent of its energy supply and oil shale has a high carbon emission factor (Figure 2).
Total Energy Supply and Emission Intensities
Citation: IMF Staff Country Reports 2024, 178; 10.5089/9798400278334.002.A006
6. Lack of connections to Europe’s main electricity grids has prevented Estonia from fully diversifying its energy mix so far. Estonia is one of the few remaining EU member states, together with Latvia and Lithuania, with electricity networks that are still synchronized with Russia and Belarus. The interconnector project, which is supported by the EU and aims at connecting the electricity networks of the three Baltic States with continental Europe via Poland by February 2025, will ease some of these constraints.
7. Investments to greening dispatchable generation are ongoing. Currently the dispatchable generation is provided mainly from oil shale and biomass powerplants, which are C02 intensive and aging. Further, biomass usage for large scale energy production is controversial. At current trends in electricity demand, the authorities foresee a lack of dispatchable capacity already in 2027. They have identified the need for an additional reserve capacity mechanism by that date, for which state-aid permission has already been requested from the EU. Future choices for additional dispatchable generation capacity include gas and nuclear (Small Modular Reactors).
8. Estonia remains one of the most carbon-intensive economies in the EU. Reflecting the country’s inefficient energy mix and its heavy reliance on oil shale in energy production, Estonia’s carbon emission per unit of GDP is the second highest in Europe, after Bulgaria and on par with Poland (Figure 2).
9. Current and planned measures are expected to support decarbonization going forward. The Estonian government has set itself the aim to achieve climate neutrality by 2050, in line with EU objectives, with an interim target to cut GHG emissions by 80 percent by 2035, compared with 1990 levels. Estonia has already reduced its GHG emissions by about 42 percent since 2010 and has committed to phase out oil shale in power generation by 2035. However, at current policies, the goal to achieve climate neutrality by 2050 is largely out of reach, absent a deep restructuring of the country’s energy mix (Figure 3).
Emissions Forecast
Citation: IMF Staff Country Reports 2024, 178; 10.5089/9798400278334.002.A006
Sources: Ministry of Climate of Estonia; EDGAR and European Environment Agency.B. Mitigation Policies
10. Estonia’s ambitious climate goals require actions on various fronts. This section discusses several policy tools that policymakers could activate to address Estonia’s energy sector challenges and drive a clean, secure and just energy transition that maintains energy affordability and supports economic development in the oil shale region.
11. Gradually raising carbon prices is a key tool for climate mitigation. Raising the price of carbon to account for environmental externalities is the most environmentally effective and economically efficient approach to mitigation. The effective coverage of the EU Emission Trading System (ETS) in Estonia is low (Figure 4). As a result, the carbon price effectively paid by Estonian establishments is one of the lowest in the EU, as the carbon price is weighted by the emissions effectively covered by the ETS. Tightening the emission cap and increasing the carbon price will thus be key to help Estonia achieve its carbon reduction targets and climate neutrality by 2050 (Figure 4).
Carbon Pricing Coverage of EU ETS and Effective Carbon Price
Citation: IMF Staff Country Reports 2024, 178; 10.5089/9798400278334.002.A006
12. Reducing fossil fuel subsidies would be important to support decarbonization while limiting distortions penalizing greener technologies. Estonia provides relatively high fossil fuel subsidies (Figure 5). Fossil fuel subsidies may be of two types:
explicit subsidies, which occur when the retail price of a fossil fuel falls below the fuel’s supply cost; and
implicit subsidies, which occur when the retail price fails to internalize the externality cost of emissions, or the social cost of carbon, and other congestion costs.
Fossil Fuel Subsidies
Citation: IMF Staff Country Reports 2024, 178; 10.5089/9798400278334.002.A006
Source: IMF staff calculations.Explicit subsidies tend to be less frequent in advanced economies, although some examples can be identified in Estonia.2 Implicit subsidies depend on the country’s energy mix and energy efficiency. In Estonia, the most notable example of implicit subsidy is the undercharging of oil shale producers for their pollution level and the disposal of their production waste. Reducing high fossil fuel subsidies would require reforming explicit subsidies and setting pollution charges that more effectively reflect the environmental damage for society.
13. Gradually phasing out oil shale production as planned is essential for achieving the green transition. The use of oil shale has declined, but it is still Estonia’s largest energy source. Oil shale production carries significant environmental costs. It is one of the most carbon-intensive forms of electricity and heat generation, and of oil production. It generates substantial amounts of solid waste, contributes to air pollution, and requires extensive water usage. The authorities have committed to end oil shale use in electricity production by 2035 and in all energy production by 2040. However, these targets have not been made binding by law, raising the risk of policy reversal in the future. Moreover, a large part of the oil shale sector is concentrated in Ida-Virumaa, a region in the north-east of the country along the border with Russia. Plans to phase out oil shale will have a significant economic impact on this region, which relies on oil shale for 40 percent of its GDP (OECD, 2024). The authorities aim to reduce this impact through a Territorial Just Transition Plan that is supported with EUR 354 million funding from the EU. This funding is used for investments in renewable energy and the reskilling of local workers. This is important to contain regional disparities, prevent an increase in poverty and ensure broader societal buy-in for the green transition.
14. Greening Estonia’s energy mix will require a significant increase in the share of renewable sources while penalizing the use of oil shale in energy production. Estonia has made significant strides in developing its renewable energy sector, particularly in wind and biomass energy. The share of renewables in energy consumption has risen significantly since 2010, reaching almost 40 percent of total in 2022 (Figure 6). Building on this progress, increased investment in renewable energy infrastructure and technology could further reduce reliance on fossil fuels and drive down emissions. Moreover, prioritizing renewable energy sources would enhance energy security by diversifying the energy mix and reducing vulnerability to supply disruptions. Targeted subsidies, fast tracking of investment in wind and solar power generation, investment in grid integration, storage and dispatchable generation are also necessary to support the EU ETS in greening Estonia’s energy mix.
Renewable Energy
Citation: IMF Staff Country Reports 2024, 178; 10.5089/9798400278334.002.A006
Sources: Eurostat; and IMF staff calculations.15. To accelerate decarbonization efforts, Estonia could implement taxation and spending policies aimed at incentivizing emissions reduction and supporting the transition to a low-carbon economy. This could include measures such as carbon taxes, subsidies for renewable energy projects, and incentives for energy-efficient practices. While Estonia is broadly in line with the EU average for collection of environmental tax revenues, the transport tax component stands significantly below that of its EU peers, and the EU average, mainly reflecting the lack of a car tax (Figure 7). Estonia’s high emissions from the transport sector owes in large part to its relatively energy-inefficient car fleet. While this this is not necessarily related to the lack of a car tax, a car tax could be designed in a way to guide an accelerated improvement of the emission intensity of the existing car stock over time.
Environmental Taxes
Citation: IMF Staff Country Reports 2024, 178; 10.5089/9798400278334.002.A006
Source: EurostatC. Sectoral Policies
16. Targeted sectoral policies can complement carbon pricing. Together with the power and heat generation sector discussed above, residential, and commercial, as well as road transport are the other two economic sectors producing most GHG emissions in Estonia. Mitigation policies in these sectors, in the form of regulation, standard setting, and taxes for polluting activities and incentives for clean activities could support a faster transition to net zero.
17. A more fuel-efficient vehicle fleet could support reducing emissions in the transport sector. GHG emissions in the transport sector have increased steadily since the early 1990s, driven by road transport. The increase in the number of vehicles—mostly passenger cars—and kilometers driven over time, which has been a key factor explaining the increase in emissions in the sector, reflects rising living standards over the past three decades. The high average age of passenger cars in Estonia adds to the problem. Although the emissions of new passenger cars have declined in recent years, the emission efficiency in C02/km has been below the EU average, mainly reflecting the low share of zero- and low-emission vehicles. A well-calibrated registration and road tax could promote greater vehicle efficiency and reduce emissions generated by the transport sector.
18. Enhancing energy efficiency in the residential sector will also be key to achieve energy savings targets. Around 90 percent of Estonia’s residential housing stock is rated below D on the Energy performance Certificates (EPCs), a rating scheme that summarizes the energy efficiency of buildings in the EU. Reducing buildings’ energy demand will thus require accelerating renovations to increase energy efficiency. As a thought experiment, a full upgrade of Estonia’s housing stock to the highest energy efficiency standard (EPC=A) would reduce emissions per capita by 42 percent relative to current levels. Considering country-specific retrofitting costs for renovation, energy cost savings would fully repay the investment costs in a shorter time than required on average in the EU, which would justify prioritizing the related investment from an EU-wide perspective.
Sectoral Policies
Citation: IMF Staff Country Reports 2024, 178; 10.5089/9798400278334.002.A006
D. Physical Risk and Adaptation Policies
19. Despite significant warming trend, damages from extreme weather events have been relatively contained in Estonia so far. Estonia has experienced a faster temperature rise than the world average, with steady decline in winter ice and snow coverage. However, cumulated losses from extreme weather events have remained contained so far, at less than 1 percent of 2020 GDP over the period 1980–2020, against an EU average of around 3.5 percent of GDP (Figure 9). Estonia’s geographic location and climate characteristics contribute to its resilience against extreme weather events. Additionally, investments in infrastructure and disaster preparedness, as well as the country’s advanced economy status, have bolstered its capacity to withstand and respond to climate hazards.
Temperature Anomalies and Damages from Extreme Weather Events
Citation: IMF Staff Country Reports 2024, 178; 10.5089/9798400278334.002.A006
20. Estonia’s overall limited exposure to physical risk is supported by various comprehensive, forward-looking metrics. According to the IMF-Adapted ND-GAIN Country Index, a commonly used score of a country’s vulnerability to climate-related natural disasters and its preparedness to deal with the consequences of such disasters, Estonia ranks in the upper quartile of the distribution of 182 countries globally, together with most EU peers. This high ranking reflects the country’s relatively contained vulnerability to natural disasters due to its geographical position and its high readiness to deal with the consequences of such disasters, as it is generally the case for advanced economies. The INFORM index, a more forward-looking score which assesses the climate risk exposure of a country under several known warming scenarios, suggests that Estonia’s vulnerability will remain unchanged even under more extreme warming scenarios.
21. Despite its relative resilience, Estonia faces adaptation challenges that require proactive planning and policy interventions. Shifts in precipitation patterns, rising sea levels, and increased frequency of extreme weather events pose risks to infrastructure, the economy, and ecosystems. Ongoing monitoring and evaluation are essential to address emerging threats and vulnerabilities.
IMF-Adapted ND-GAIN
Citation: IMF Staff Country Reports 2024, 178; 10.5089/9798400278334.002.A006
Source: IMF-Adapted ND-GAIN; Findex – The Global Findex Database 2021; Worldwide Governancelndicators; and IMF staff calculations.E. Conclusions
22. Mitigating climate change requires comprehensive and coordinated policies that address barriers such as low effective carbon pricing and high fossil fuel subsidies while leveraging opportunities in renewable energy, taxation, spending, and technology. By adopting these measures, Estonia can accelerate its transition to a sustainable, low-carbon economy while enhancing energy security and fostering long-term economic prosperity. While Estonia may currently exhibit resilience to immediate climate risks, proactive adaptation planning is imperative to address emerging challenges and ensure long-term sustainability.
References
International Energy Agency (2023), Estonia 2023, Energy Policy Review.
Ministry of Economic Affairs and Communication (2023), National Energy and Climate Plan.
OECD (2022), Economic Surveys: Estonia.
OECD (2024), Economic Surveys: Estonia.
Prepared by Gianluigi Ferrucci and Sadhna Naik.
Notable examples include: the energy tax relief for companies in agriculture and forestry for gas oil, the reduced energy tax rate for light fuel oil used in mobile machinery, the excise duty exemptions on diesel used for agricultural, fishing, aquaculture and navigation purposes and the excise tax exemption and tax relief for natural gas for industrial consumers. See European Commission (2023), COMMISSION STAFF WORKING DOCUMENT 2023 Country Report -Estonia Accompanying the document Recommendation for a COUNCIL RECOMMENDATION on the 2023 National Reform Programme of Estonia and delivering a Council opinion on the 2023 Stability Programme of Estonia, SWD/2023/606 final, available here.