Increasing the carbon tax every year to reduce Luxembourg’s emissions and mitigate climate change is bearing fruit, but whether the tax will be renewed after 2026 remains up in the air as it could impact the country’s tax revenue down the line.

The carbon tax went from €35 to €40 per tonne of CO2 in 2025, as set out in the national energy and climate plan PNEC, and is set to increase by another €5 in 2026, following the adoption of a law in 2023.

Introduced in 2021 at €20 per tonne of CO2 and then increased by €5 each year since, the carbon tax applies to fuels (petrol and diesel), heating oil and gas.

“It is planned that the provisions relating to the evolution of the CO2 tax for the period 2027-2030 will be reassessed in 2026”, the national plan states. “A decision will be taken in relation to whether or not to maintain the national CO2 tax system beyond 2026.”

This reassessment is likely to spark debate, given that the carbon tax is a sensitive, politically controversial subject. While the added value of such a tax is undeniable, there are economic drawbacks, explained Andrew Ferrone, former head of the Climate Policy Observatory.

A ‘particularly effective’ tax

On the plus side, it turns out that in Luxembourg the carbon tax is “particularly effective” in reducing the country’s CO2 emissions. Transport represents more than 60% of the country’s emissions and the carbon tax alone could halve the sector’s emissions, according to a November 2023 analysis by Statec.

“The introduction in 2021 of a carbon tax, at a very low level, has had little impact on the price differential at the pump with neighbouring countries but seems to be bearing fruit in terms of reducing the sale of fuel on national territory,” Ferrone said in a collection of texts on “Luxembourg’s energy transition policies” recently published by the Idea Foundation, an economic think tank attached to the Chamber of Commerce.

Targeting pump tourism

Pump tourism – where non-residents come fill up their fuel tanks in Luxembourg – is largely responsible for emissions from the transport sector: two-thirds of climate emissions are attributable to fuel sales, with around 70% of these emissions coming from the sale of fuel to cars registered abroad, the Idea Foundation said in February 2024.

Limiting sales through the carbon tax has a positive impact on Luxembourg but effectively means that the emissions aren’t reduced but shifted to another country.

However, increasing Luxembourg prices at the pump could reduce the appeal of fossil fuels for residents and inhabitants of the Greater Region and encourage them to opt for electric cars or other transportation options.

Less tax revenue

One of the major drawbacks of the carbon tax for Luxembourg is the drop in tax revenue, since pump tourism is very beneficial to the state budget. In 2023, the various taxes and excise duties linked to fuel accounted for 4.3% of total expected tax revenues and 1.2% of GDP.

However, according to Statec projections, Luxembourg could – without even aligning its prices to neighbouring countries – lose around €650 million in tax revenue between now and 2030 if fuel sales fall due to the national strategy.

“A new balance will have to be found over the coming years, either by releasing new resources or by cutting spending while remaining in line with climate objectives,” Ferrone said.

Inequalities to be taken into account

Taxes on emissions also highlight the growing inequalities in higher energy costs for low-income households. This makes it more difficult for the public to favour the carbon tax.

The government’s national strategy predicted the issue and redistributes half the revenue from the tax through social mitigation measures aimed at the most vulnerable households.

“The amount of the ‘CO2 tax credit’ will be set each year in a way visible to the citizen through the law concerning income tax and will reflect the evolution of the CO2 tax,” according to the energy plan.

The other half of the revenue is earmarked for climate protection and energy transition measures.

‘No painless solution exists’

Taking all these aspects into account, “there is no painless solution” and, “in each case, Luxembourg will have to make concessions”, the Idea Foundation said in its analysis.

For now, “Luxembourg stands out from its neighbouring countries because of its relatively low fuel prices” even with its carbon tax. Despite a downward trend, this “advantageous taxation applied to fuel creates a strong price signal, enabling Luxembourg to be competitive and to attract many non-residents and commercial carriers”.

Carbon taxes in the various European countries are difficult to compare because of the heterogeneity of their scope of application, the Idea Foundation warns. However, of the 15 European countries that apply a carbon tax, Luxembourg ranks ninth, a long way behind Switzerland (€124.87) and Sweden (€114.17).

A tax at €200 per tonne of CO2?

The Luxembourg carbon tax is far below the €200 per tonne of CO2 the Climate Policy Observatory and the Klima-Biergerrot demand.

The OECD in turn said it would like to see an annual increase of €10 to reduce Luxembourg’s CO2 emissions by 50% by 2050.

The Chamber of Deputies’ scientific unit in a November 2023 research note said that an international carbon tax would be far “more effective than taxes at national level”, avoiding concerns about competitiveness and “carbon leakage”.

“A uniform and harmonised carbon price of $55.8 (€54) per tonne of CO2 would be likely to be compatible with the objective of containing the rise in the average temperature of the planet well below 2°C”, though a global agreement would be “highly complex” to achieve, the note said.

(This article was first published on Virgule. Translation and editing by Tracy Heindrichs.)