OECD Economic Surveys: Estonia 2022

Report

OECD Economic Surveys: Estonia

28 June 2022

2. Estonia’s climate policy: challenges and opportunities

Srdan Tatomir
OECD

Abstract

Estonia has a relatively carbon-intensive economy among OECD countries. The government has committed to reducing greenhouse gas emissions by 70% in 2030 relative to their 1990 levels and is aiming to achieve climate neutrality by 2050. Considerable progress has already been made and almost one third of Estonia’s energy is now produced from renewable sources. However, a deeper transformation will be needed. Estonia has committed to phase out oil shale and will need to diversify its sources of renewable energy. There is scope to substantially reduce the use of fossil fuels in the transport sector and to increase the energy efficiency of buildings across Estonia. To achieve this will require a comprehensive approach that significantly expands carbon pricing, public investment and private-sector incentives. Adopting an inclusive approach will be essential to secure the support of consumers and workers.

This chapter focuses on Estonia’s transition towards a low-carbon economy. It discusses how the three sectors responsible for most of Estonia’s greenhouse gas (GHG) emissions -- energy, transport and buildings -- could reduce their emissions by adopting new technologies and increasing their investment. The decarbonisation of other sectors such as agriculture and industry will also be important. Across these sectors, achieving rapid decarbonisation will require transformative policies in both the short and medium term. Moreover, climate adaptation measures will be necessary to manage a warmer and more volatile climate. While Estonia is expected to be less directly affected than many other countries, as a small open economy it remains exposed to countries that are more affected by climate change. Adopting an approach that focuses on cost-effectiveness will be essential to contain the transition costs. The approach should also be inclusive and limit the negative impact on vulnerable consumers and workers.

Moving towards a low-carbon economy

Estonia has a relatively carbon intensive economy among OECD countries. One of the reasons for this high level of emissions is the role of oil shale, an energy-rich sedimentary rock similar to coal, in meeting Estonia’s energy needs. Oil shale has historically played a significant role in Estonia’s economy. After its establishment in 1918, the oil shale industry became prominent during the 1950s in the generation of electricity for use in Estonia and parts of the Soviet Union. The output of the oil shale industry has decreased since Estonia’s independence in 1991 partly as a result of an economic contraction but also due to structural change in the economy. However, oil shale has continued to provide a large share of Estonia’s electricity in recent years and has underpinned its energy independence. The burning of oil shale releases large quantities of carbon dioxide (Figure 2.1). But transport emissions have also increased and contributed to Estonia’s Greenhouse Gas (GHG) emissions (Figure 2.2). Furthermore, Estonia’s buildings, of which more than two thirds were built before independence from the Soviet Union are relatively energy inefficient and contribute to GHG emissions.

Estonia has a multi-level approach to the environment and the climate. As a member of the European Union (EU), Estonia’s climate policy is guided by the EU 2020 climate and energy package and 2030 climate framework. EU directives such as the Energy Efficiency Directive and the Renewable Energy Directives have been transposed into national law. Furthermore, Estonia has developed a national climate strategy consistent with the EU framework. In 2017, the Estonian Parliament approved the ‘General Principles of Climate Policy until 2050’ that outline Estonia’s transition to a low carbon economy. A more detailed policy approach is set out in Estonia’s 2030 National Energy and Climate Plan (NECP), which is supported by specific plans such as those for energy, climate change adaption, transport, forestry, waste management, and rural affairs. More recently, Strategy Estonia 2035 was adopted in 2021 with an aim to reach climate neutrality by 2050. A new NECP will be developed by 2024 and the ‘General Principles of Climate Policy until 2050’ are in the process of being updated.

Responsibilities for implementing environmental policies are spread across different central government ministries and agencies. The Ministry of the Environment organises and co-ordinates environmental and climate policy while the Ministry of Economic Affairs and Communications drafts and implements Estonia’s energy policy. Eesti Energia, the largest power company, is majority state-owned. The Competition Authority is the regulator for gas and electricity network tariffs and district heating prices while Elering is the energy transmission system service operator. The Ministry of Economic Affairs and Communications is responsible for fuel issues and manages commercial and residential buildings policy. The Ministry of Finance is responsible for state budgets and tax policies related to environmental matters. Local governments and municipalities are key players in energy and climate policy as they voluntarily compile local energy and climate plans. Different agencies such as KredEx, Elering, the State Shared Service Centre, the Environmental Investment Centre, and the Agricultural Registers and Information Board also play a role financing and supporting environmental and climate projects. For example, the Environment Agency is responsible for collecting and disseminating environmental data and houses the weather service. On research, the Research and Development Council plays a crucial role in implementing Estonia’s research and development (R&D) strategy and innovation policy.

Figure 2.1. Greenhouse gas emissions have decreased substantially but should be reduced further

Estonia is committed to reducing its GHG emissions and to contributing to global efforts to mitigate climate change. It has ratified the Paris agreement in 2015 and participates in EU climate efforts. Estonia has made international commitments to reduce GHG emissions by 70% in 2030 and 80% in 2050, relative to 1990 levels. The latest national strategy goes further than this and aims for Estonia to become carbon-neutral by 2050. As part of that, the government has also committed to phasing out oil shale in the energy sector entirely by 2040. Estonia has already made considerable progress towards its objectives (Figure 2.1) and preliminary data for 2020 suggests GHG emissions, excluding land use, land use change and forestry (LULUCF), were already around 72% lower than in 1990. Most of the reduction occurred in the 1990s as low oil prices made oil shale production less economically attractive and the modernisation of industry reduced Estonia’s energy intensity. GHG emissions, excluding LULUCF, also declined since 2005 by 40% even though some of the fall in 2020 is likely to have been a temporary effect due to the pandemic. It is important for Estonia to continue on this path and accelerate the progress towards net zero emissions. The latest annual report by the Inter-governmental Panel on Climate Change confirms that limiting global warming will require sharp reductions in GHG emissions (IPCC, 2021) but even if all the countries’ announced pledges to achieve net zero are achieved fully and on time, global temperatures would still rise by around 2.1°C by 2100 (IEA, 2021). New net zero announcements made at the COP26 summit in Glasgow in November 2021 are consistent with a lower rise of 1.8°C by 2100 (Climate Action Tracker, 2021). Halving global GHG emissions by 2030 will be a key milestone in the journey to net zero by 2050. It is within this context that the EU Green Deal, a more ambitious and comprehensive framework to accelerate the green transition, has been developed. Estonia has supported this process. The EU Climate Law passed in 2021 and upcoming EU climate legislation will strongly influence its national climate policies.

Figure 2.2. GHG emissions in transport have risen since the early 1990s

Figure 2.3. Energy industries account for most of the GHG emissions

2019 or latest year available

Decarbonisation of three sectors is essential to achieve Estonia’s GHG targets. These sectors are energy, transport and, to a lesser extent, buildings. Together they account for almost 80% of Estonia’s GHG emissions. The energy industry represented over half of GHG emissions in 2019, the highest share in national emissions among OECD countries (Figure 2.3). GHG emissions from transport made up another 16% with emissions from buildings accounting for 6%. Reducing GHG emissions in other sectors is also important to transitioning to a low-carbon economy, but reductions in three aforementioned sectors will make the largest impact on Estonia’s GHG emissions.

Climate adaption strategies will be important in helping countries manage and alleviate the effects of climate change. Estonia’s climate already experiences a range of 60°C between summer and winter. The coastal parts are accustomed to frequent rains and strong winds (ENFRA, 2015). However, under an extreme scenario of a rise in annual temperatures by 4.3°C by 2100, average annual precipitation will increase by 19%, wind speed will increase by 3-18%, there will be no permanent snow cover and the sea level on Estonian coasts will rise by 40-60cm. Coastal cities and settlements as well as areas inside the country near low-lying riverbeds might be more subject to flooding and infrastructure might be more costly to maintain due to more volatile and extreme weather. This will require specific adaptation measures to alleviate the consequences of climate change.

Estonia has a comprehensive climate adaptation strategy that provides a roadmap to building climate resilience. The main objective of the plan is to increase the readiness and capacity of the state to adapt to the effects of climate change at the regional and local levels. It is based on four in-depth scientific studies that helped Estonia to identify sectoral climate change impacts and vulnerabilities, and to determine adaptation measures for both the short term, up to 2030, and the long term, up to 2050 and 2100 (IEA, 2022). The strategy focuses on health and rescue capabilities, land use and planning, the natural environment, bioeconomy, economy, society, awareness and cooperation, infrastructure and buildings, and energy and security of supply (Government of Estonia, 2017). However, this is not likely to directly impose major costs on society and on the economy. The overall costs of climate change adaptation over 2017-30 are estimated around 0.6% of 2020 GDP, lower than costs faced by many other countries, although this is subject to large uncertainty (Government of Estonia, 2017). There may also be indirect costs as Estonia’s open economy is likely to be affected through trade and financial links with countries more affected by climate change.

Environmental taxation and subsidies are important tools in accelerating the transition to a low-carbon economy but the coverage of such taxes and subsidies is limited in Estonia. Estonia’s tax system is generally considered transparent and efficient but it only provides limited support to Estonia’s climate goals. The EU Emission Trading System (ETS) covers a large share of Estonia’s CO₂ emissions as it includes energy industries and energy-intensive manufacturing, and effectively acts as a carbon tax. But in non-ETS sectors, there is little additional taxation related to emissions and pollution (Figure 2.4 Panel A). Within energy, there is a small carbon tax and it is applied to a narrow tax base. The carbon tax of EUR 2 per tonne of CO₂ is implemented as a surcharge on CO₂ emissions but major electricity producers are exempt if they invest in retrofitting (IEA, 2019). Electricity is taxed at a flat rate. Within transport, taxes are not directly linked to carbon emissions. There are excise duties on transport fuels, which are relatively high compared to average Estonian income levels, and this partly encourages energy efficiency. There is a vehicle registration fee but no annual road tax. However, heavy goods transport vehicles are liable to pay road tax in line with the minimum level of tax rates applied in the EU. Overall, transport taxes and charges are not directly linked to transport use and vehicle carbon emissions. Emissions from buildings are also not subject to carbon taxes. That said, Estonia has used selective policies in the past to encourage renewable electricity through feed-in tariffs, subsidies for electric vehicles and public transport, and subsidies for energy efficiency improvements in buildings. Nonetheless, to effectively support Estonia’s low-carbon transition a uniform broad based carbon price should be introduced to price CO₂ emissions in areas of the economy where they are not currently priced.

The overall level of carbon-related prices in Estonia is too low. To meet the climate commitments of the Paris Agreement and to reduce GHG emissions, countries should price CO₂ at roughly around EUR60 per tonne of CO₂by 2030 and several studies suggest this could be higher (OECD, 2021b). OECD data on effective carbon rates suggests that Estonia is far behind on this measure (Figure 2.4 Panel B). Based on 2018 data, Estonia priced only 30% of its GHG emissions at least EUR60 per tonne of CO₂, lower than most OECD countries. Since 2018, carbon prices in ETS sectors have varied between EUR20 and EUR30 per tonne of CO₂ during 2019-2020 but have increased sharply in 2021, partly due to higher global energy prices. In the medium-term, to cut GHG emissions and meet its targets, Estonia could further reduce its particularly high GHG energy intensity by reducing the use of oil shale. Nonetheless, higher carbon pricing in Estonia is a necessary step to achieving meaningful progress towards further reducing GHG emissions. Estonia is currently in the process of reviewing its climate-related taxes and charges with the aim to better harmonising them across ETS and non-ETS sectors. To help with the review, Estonia could set up a technical climate change commission similar to the ones in the United Kingdom or in Denmark (see Box 2.1).The review is to expected to be completed by 2024 and should be consistent with EU climate legislation.

Box 2.1. The role of national expert climate change committees

Expert committees on climate change can help support national governments in planning and implementing climate change policies. Their role is to bring together various experts with scientific, technical, and policy experience in order to provide evidence-based and non-partisan multidisciplinary support to guide governments’ climate change efforts. Their expert advice can help individual ministries benefit from a range of expertise when designing public policies and it can ensure ministers have the best available evidence for making political decisions. The United Kingdom and Demark provide good examples of expert climate committees. A similar expert committee on climate change could support Estonia’s climate change policy now and for the coming decades.

In the United Kingdom, the Climate Change Committee (CCC) was established under the Climate Change Act in 2008 to advise UK government and the devolved administrations on climate policy objectives and monitor their progress. The CCC consists of the Mitigation Committee and the Adaptation Committee, with the chairperson sitting on both. More specifically, the CCC’s objectives are to advise the government on appropriate GHG emissions targets in each five-year budget period, to monitor and report progress towards those targets, and recommend actions to keep the targets on track. The CCC provides advice on climate change risk assessments and the national adaptation programme. It acts as a national centre of expertise by conducting independent analysis into climate change science, economics and policy, by responding to requests for advice from government departments, and by engaging with various stakeholders more widely (UK CCC, 2021).

In Denmark, the Danish Climate Act in 2015 established the Danish Council on Climate Change. This is an independent body consisting of members with wide-ranging expertise on energy, buildings, transport, agriculture, environment, nature and the economy. The Council’s tasks are to evaluate Denmark’s progress in implementing national climate objectives and international climate commitments. Furthermore, the Council analyses possible transition pathways to a low-carbon society by 2050, identifies appropriate measures and makes recommendations to shape the government’s climate policy. Lastly, it seeks to contribute to public debate and engage with other stakeholders (Klimaraadet, 2021).

Higher carbon prices might not necessarily result in lower output and employment. Theoretical models have previously suggested that higher carbon prices should lead to a contraction in output but empirical evidence is mixed. While some studies found negative effects on output, the temporary and negative effects on employment could be mitigated through a redistribution of environment-related tax revenues (see Box 2.2). Managing the size and speed of the transition to a low-carbon economy, which is likely to be large and fast, will be more relevant for Estonia. But Estonia is well placed to manage this successfully. By introducing widespread carbon pricing, Estonia can provide clear signals to firms and consumers, helping its dynamic economy reallocate capital from high-carbon to low-carbon activity. Through increased education, training and active labour market policies (Chapter 1), Estonia can also help facilitate labour reallocation towards less carbon-intensive activities.

Figure 2.4. Effective carbon prices are low and apply to a narrow range of economic activity

The transition towards a low-carbon economy will require large investments. The energy sector will need substantial investment to shift towards renewable sources, and major changes in consumer behaviour and price signals will be required in the use of transport and housing. The transition will require a large integrated and comprehensive effort from the government and private sector. While the cost of these transitions cannot be estimated precisely, it is likely to be high. So far, other studies have estimated that an additional public investment worth 0.2-0.3% of GDP per year and an extra private investment worth 1% of GDP per year in the period 2021-30 would be required to considerably reduce GHG emissions and reach net zero by 2050 (IEA, 2021). Gross investment will need to be even higher as some assets are divested and the total estimates might represent a conservative value (Pisani-Ferry, 2021). These are global figures but Estonia-specific estimates are similar in magnitude. A report by the Stockholm Environment Institute (SEI) indicated that reducing GHG emissions by 70% by 2030 and reaching net zero emissions by 2050, a total of EUR 17.3 billion will be required, representing annual investment of around 2% of Estonia’s GDP, over the next three decades (SEI, 2019). An additional challenge is that the investment will need to be frontloaded in 2021-30. The SEI suggests that total investment in Estonia would need to rise by 4% of GDP in 2021-30 before gradually falling to an additional 1% by 2050.

This will be a significant challenge for Estonia’s society and economy. In 2019, Estonia’s total investment relative to GDP, both private and public, was around 25%. As a result, a 4 percentage point rise is large in magnitude but not out of reach by historical standards. However, the required investment will be concentrated in a few sectors such as energy or transport. For example, in the energy sector the direct total investment in 2019 was 1.6% relative to GDP. Even a 1.5 percentage point increase would represent a near doubling of investment in that sector. While a large increase in investment is likely to boost overall GDP, given the necessary shift of capital and labour away from polluting toward greener activity, the aggregate impact on GDP remains uncertain.

Box 2.2. The economic consequences of climate policy

Climate change is highly likely to negatively affect economic output. Temperatures will gradually increase, accompanied by a rise in seasonal rainfall and sea levels as well as the higher frequency and severity of extreme weather events (Batten et al, 2020). This will adversely affect the economy’s level of output as productivity falls. On the supply side, rising temperatures could diminish effective labour supply as extreme heat makes it more difficult to work. Extreme weather is likely to affect existing capital such as housing or infrastructure and will become more costly to maintain. Volatile weather will also affect land productivity and agriculture. Moreover, the rate of technological progress may slow to the extent that more resources are diverted to climate adaptation and away from R&D. Higher investment in repair and replacement rather than investment in new technology may also limit ‘learning by doing’ effects (Batten et al, 2020).

On the demand side, higher uncertainty might lead to lower business investment and higher savings while lower wealth should decrease consumption. Climate change might not just affect the level of economic output but could also lead to lower and more volatile growth (Alessandri and Mumtaz, 2021). A comprehensive modelling exercise suggested that, based on the actions taken by 2015, global temperatures could rise by 1.5-4°C, decreasing the level of global real GDP by 1.0-3.3% by 2060 and by 2-10% by the end of the century (OECD, 2015). There is considerable uncertainty around these estimates since they do not necessarily take into account all aspects of climate change. The risks to the OECD projections are also likely to lie on the downside since there may be significant non-linear effects on the global climate. The probability of passing tipping points increases with rising temperatures and there is serious risk of major irreversible change (Stern, 2007).

Policy can reduce the negative impact of climate change on the economy through climate mitigation and climate adaptation policies. To mitigate the total impact of rising global temperatures, policies can promote a decoupling of GHG emissions from economic growth and support a transition to a low-carbon economy. Such policies can be composed of market and non-market based instruments such as carbon pricing, environment-related taxation, subsidies and regulation, public investment, as well as the provision of climate finance. Policies that develop low-carbon technologies such as renewable energy or promote energy efficiency can be complementary. Climate adaptation policies can help economies adjust to changing climate conditions through investment in more resilient infrastructure such as sea and flood defences, building design, and newer crop varieties (Ciccarelli and Marotta, 2020).

Policies have been shown to effectively reduce GHG emissions and this can mitigate the impact of rising temperatures. A range of market and non-market based policies can reduce emissions although each policy has its own advantages and disadvantages in terms of efficiency and political acceptability (Metcalf, 2019). Carbon prices are a particularly effective decarbonisation policy. They can be implemented as carbon taxes or determined through permit issuance in a cap-and-trade system. They reduce emissions as they make carbon-intensive activities more expensive relative to low or zero-carbon alternatives. This not only shifts demand away from polluting activities but a strong commitment to pricing carbon can create certainty for investors to use and develop low-carbon technology. An increase in the effective carbon rate by EUR 1 per tonne of CO₂ leads to, on average, a 0.73% reduction in emissions over time (Sen and Vollebergh, 2018). Such estimates can vary, though, and their effectiveness can be lowered by carbon leakage and carbon offsets. Carbon leakage occurs when carbon-intensive activities shift jurisdiction or countries, particularly when capital is mobile, in response to higher carbon prices or to other climate policies. Carbon offsets have similar effects as they allow firms to continue emitting by offsetting those emissions elsewhere. This is why it is important to complement carbon pricing with other policies to ensure a global reduction in emissions and a lasting shift towards low-carbon activity. In that respect, there is evidence to suggest that expanding climate legislation, which encompasses all climate policies, has led to a reduction of 15% in global CO₂ emissions between 1999 and 2016 (Eskander and Fankhauser, 2020).

Although the benefits of policy action should outweigh the cost of policy inaction in the long-term, the effect of emission-reducing policies on the economy, however, might be negative in short to medium term. Micro evidence from firm-level and industry-level data, however, suggests that the relationship between stricter environmental policies and productivity is ambiguous. There is some evidence that environment-related innovation rises following stricter environmental policy but this may just reflect a shift in R&D rather than an expansion of total R&D (Kozluk and Zipperer, 2014). Perhaps unsurprisingly, there are limited effects on competitiveness as negative effects on carbon intensive firms are likely to be offset by higher exports from low-carbon intensive firms (Kozluk and Timiliotis, 2016; Naegele and Zaklan, 2019; Dechezleprêtre and Sato, 2017). Macro evidence based on theoretical large-scale computable general equilibrium models suggests higher carbon prices lead to a contraction in GDP (OECD 2015; McKibbin, Morris, and Wilcoxen, 2014; McKibbin et al., 2017; Goulder and Hafstead, 2018). Empirical research, however, is more mixed. Studies focused on the macroeconomic effects of the carbon tax in British Columbia in Canada, did not find significant impacts on GDP perhaps because carbon tax revenues were redistributed (Metcalf, 2019; Bernard, Kichian and Islam, 2018). One limitation, though, is that many empirical studies were carried during periods when carbon prices were low, making it more difficult to identify a robust link between carbon prices and macro outcomes. More recently, in European countries, Metcalf and Stock (2020) found that higher carbon prices were not significantly linked to either higher or lower GDP or employment although Kaenzig (2021) finds higher carbon prices in the EU ETS had a negative but temporary impact on GDP in the euro area. Using the OECD environmental policy stringency index (EPSI), Ciccarelli and Marotta (2020) estimate that stricter environmental policies are associated with more environment-related technological innovation and a contractionary but temporary effect on industrial production. The study also finds that stricter environmental policies can lead to lower employment but that this can be cushioned through the redistribution of higher environment-related tax revenues. Both Ciccarelli and Marotta (2020) and Kaenzig (2020) find stricter environmental policies, that is, higher carbon prices can lead to more environment-related innovation.

The private sector will be key in financing the investment required to transition to a low-carbon economy. Assuming that firms and households will make 80% of the investment (IEA, 2021), this implies additional private financing needs of 3.2% of GDP and public financing worth 0.8% of GDP. Estonia’s historical growth since the mid-1990s has been around 4% so much of the investment could be financed out of current profits. In addition, Estonia has a well-capitalised banking system and should be able to finance low-carbon investments. At its disposal, the central bank has macro prudential and the Financial Supervisory Authority has micro prudential policy tools, which should also consider climate risks to support the low-carbon transition. Moreover, the Nordic Investment Bank, a regional development bank, is well placed to finance private investment. Finally, Estonian companies can also raise capital in international corporate bond markets.

Public investment should support private investment. The role of the public sector is to invest in infrastructure, R&D, skills and to help finance low-carbon projects insufficiently financed by the private sector. Better infrastructure, basic R&D and adequate skills will enable firms to compete and develop new and more environmentally friendly goods and services. At the same time, helping ensure widespread access to ‘green’ finance among firms and households will be important for a comprehensive transition. Assuming that 20% of the investment will be made by the public sector (IEA, 2021), this implies an additional 0.8% increase in public investment. The additional financing required between 2021 and 2025 should be more than covered by EU funds. As part of the Next Generation EU Funds, Estonia will receive financing from: i) the Recovery and Resilience Facility (RRF); (ii) the Recovery Assistance for Cohesion and the Territories of Europe (REACT-EU); (iii) The Just Transition Fund; and (iv) the Agricultural Fund for Rural Development. In addition, the new 2021-2027 Multiannual Financial Framework (MFF) will be complemented by the unused share of EU MFF 2014-20 Fund. Altogether, the EU funds can provide financing between 4-5% of GDP in 2021-25 even though not all funds are directly related to low-carbon growth and some 2014-20 MFF funds might remain unused to the extent there is a lower rate of absorption.

In addition to boosting investment, in the medium-term policy should rely on comprehensive environmental taxation, regulation and subsidies to facilitate the low-carbon transition. Carbon pricing can provide a powerful price signal to markets and this helps firms invest. In this regard, economy-wide carbon-based prices can move consumption towards a path consistent with a transition to a low-carbon economy. Carbon-based prices also provide correct price signals to companies and direct investment in the right direction. Carbon prices can take the form of carbon-based taxes as well as other policies such as subsidies and regulatory standards in order to achieve desired shifts to low-carbon activity in an efficient manner.

The introduction of widespread carbon-based prices without appropriate redistributive mechanisms is likely to be regressive. While higher taxes should lead to less GHG-intense consumption, some households will be affected more than others. For example, taxes on energy-inefficient vehicles and energy-inefficient buildings might affect poorer households more and they might not be able to afford to upgrade to newer but more expensive transport and accommodation. Carbon pricing could also create a divide between rural and urban areas as those living in rural areas rely more on private transport. In addition, workers employed in energy industries might face difficulties in reallocating and be at risk of poverty due to job loss.

Progressive taxation and income redistribution should be used to mitigate the negative impact on poorer households. This will be important from a fairness perspective. There is a range of tools that Estonia might consider. Targeted lump-sum cash transfers to affected households and firms can help cope with increases in energy costs. An alternative to lump-sum transfers could be targeted reductions in personal income or corporate tax. Social policies such as unemployment benefits and labour market training policies could be tailored to those affected by stricter environment-related policies. Local authorities in areas most affected by environment-related policies could receive extended support as well. For example, in British Columbia, the implementation of a comprehensive carbon tax in 2008 was complemented by reductions in personal income and corporate taxes as well as lump-sum transfers to low-income households (Yamazaki, 2017). The carbon tax in British Columbia was designed to be revenue neutral. The recycling of tax revenues can ensure that there is no additional tax burden on the aggregate economy and can mitigate some of the negative consequences of stricter environment-related policies. This will be essential for building support and avoiding creating resistance to the low-carbon transition.

Estonia has the potential to meet these challenges. Since its independence in 1991, Estonia has successfully managed the transition from a centrally planned to a market-based economy. The transition to a low-carbon economy brings several opportunities and Estonia’s fast growing, dynamic and entrepreneurial economy is well placed to meet those challenges.

Managing the decarbonisation of Estonia’s energy sector

The supply of energy in Estonia is still dominated by fossil fuels and oil shale in particular. However, this has been changing over time. Renewable resources such as woody biomass have become progressively more important and there is further potential for renewables to expand, especially for wind and solar energy. The use of different types of energy, however, is not equally distributed across sectors. This implies that the decarbonisation challenges and the type of policy actions required will differ.

Oil shale plays a significant role in the production and use of energy in Estonia

As mentioned, Estonia stands out among OECD countries due to a high reliance on oil shale in its energy supply (Figure 2.5). Oil shale is a type of non-conventional oil. It is an energy-rich sedimentary rock that contains kerogen, a waxy hydrocarbon rich material, and can be either used in a power plant or processed to produce shale oil (IEA, 2019). It has slightly higher energy density than lignite coal and, like coal, is a heavily polluting source of energy (see Box 2.3). In 2019, oil shale accounted for about 64% of Estonia’s total primary energy supply. However, renewable energy such as biofuels and waste, mostly woody biomass in practice, accounted for almost a quarter of all primary energy with Estonia reporting the fifth highest share of renewable energy in the OECD after Latvia, Finland, Denmark and Sweden. Renewable energy, excluding biofuels and waste, wind, solar and geothermal energy accounted for only about 5% of overall energy supply, slightly above the OECD median and similar to the UK and Germany. This highlights the potential for higher and more diversified renewable energy production. Indeed, more recent data suggests that the use of renewable energy has grown. In 2020, electricity production from wind expanded by 20% while solar production more than doubled.

Figure 2.5. Oil shale accounts for most of Estonia’s total primary energy supply

Total primary energy supply (TPES) is greater than total final consumption (TFC) within Estonia. TPES in 2019 was around six mega tonnes of oil equivalent (Mtoe) but the energy consumed domestically within Estonia was much smaller at around three Mtoe. This is partly due to trade. Estonia exports primary solid biofuels, electricity and shale oil produced from oil shale. At the same time, Estonia imports almost all of its refined oil such as gasoline and diesel and natural gas. Domestically, energy use is relatively evenly distributed across the transport, residential, commercial and industry sectors (Figure 2.6). These sectors consume a combination of oil, bioenergy, electricity and heat.

Box 2.3. A short explanation of oil shale and shale oil

Oil shale is a type of non-conventional oil. It is an energy-rich sedimentary rock that contains organic matter called kerogen, a waxy hydrocarbon-rich material. It can vary by genesis, composition, calorific value and oil yield. In most cases, the organic matter content is between 5% and 25% but in Estonian Kukersites, a specific variety of oil shale, the organic matter content can be as high as 50% (EASAC, 2007).

There are several uses of oil shale. Once extracted from the ground, oil shale can be used directly in a power plant (pulverised or in a fluidised bed boiler). In terms of its energy value, it is comparable to brown coal at best and can contain less than half of the energy in average bituminous coal. Oil shale can also be processed by pyrolysis, hydrogenation or thermal dissolution to produce shale oil (also known as kerogen oil or oil-shale oil). Shale oil can be used as a fuel in maritime transport or can be upgraded in refineries to remove impurities so that it may be used like crude oil (IEA, 2019). In addition, oil shale can be used to produce chemicals.

Deposits of oil shale can be found all over the world. Total estimated oil shale reserves amount to 3.2 trillion US barrels (EASAC, 2007). This is around three times larger than conventional oil reserves. Two thirds of all reserves are in North America and the single largest oil shale deposit is the Green River Formation in Colorado, Utah and Wyoming. Europe makes up 12% of all deposits with two thirds located in Russia and only 5% located in Estonia. However, most of the reserves are low to moderate grade making their use uneconomical. Furthermore, oil shale mining causes significant environmental pollution to land and underground water. Considerable quantities of oil shale are mined in Estonia, Russia, China, Brazil, Australia and Germany. Estonia holds less than 1% of the world’s reserves of oil shale but currently accounts for most of global oil shale mining, making it a global leader in the oil shale industry (World Energy Council, 2016).

Note that oil shale and the shale oil produced from it is not the same as light tight oil, which is sometimes also referred to as shale oil. Light tight oil is produced from shale formations, often in combination with shale gas in hydraulic fracturing. This is not done in Estonia (IEA, 2019).

Figure 2.6. Domestic production of energy is much larger than consumption

Different sectors have a different energy composition. Across sectors, oil shale plays the biggest role in the commercial and industry sectors. In those sectors, energy from electricity and heating account for 40-50% of overall energy consumption, most of which is generated through oil shale (Figure 2.7). In contrast, in the residential sector, oil shale only accounts for around a fifth of total energy consumption with most of it coming from bioenergy, that is, woody biomass. The transport sector is entirely reliant on oil. While Estonia exports shale oil, it imports all of its refined oil products.

Figure 2.7. The composition of energy use can vary widely across sectors

% of total energy supply

Oil shale use is declining and the transition will need to be managed

Oil shale continues to play a central role in Estonia’s energy supply. There are four companies that hold oil shale mining permits with state-owned Eesti Energia holding roughly ¾ of total allowances by volume while Viru Keemia Group, Kiviõli Keemiatööstuse OÜ and AS Kunda Nordic Tsement make up the rest. Oil shale is mined and burned in several power plants to produce around ½ of Estonia’s electricity and is, to a much smaller extent, used in heating.

The industry also produces shale oil, which is a type of fuel used in maritime transport. Over time, liquefaction of oil shale into shale oil fuel has become more prevalent while the share of oil shale used for heat and power generation has declined (Figure 2.8). The oil shale industry is highly concentrated in the eastern region of Estonia, the Ida-Viru region, where also most of the deposits are located. It employs 5,800 workers in Ida-Viru (Praxis, 2020) and, in aggregate, directly contributes 4-5% to Estonian GDP (World Energy Council, 2016).

The EU ETS market is important for Estonia’s energy sector. The ETS is a cap-and-trade system for large power and heat plants (at least 20 thermal megawatts) and heavy industry. It covers around 45% of the EU’s total emissions. By law, the ETS sector across the EU must reduce emissions by 21% below 2005 levels until 2020 and by 43% from 2005 to 2030 (EC, 2018). The ETS sector emissions are mainly subject to the EU policy framework. The non-ETS sector includes transport, residential and commercial sectors, non-ETS industry, agriculture, and waste management. They are covered under the EU Effort Sharing Decision (ESD). The EU-level targets for GHG reductions in the non-ETS sectors are a decrease of 10% by 2020 and 30% by 2030, compared with 2005 levels. While the EU ETS target applies for the EU as a whole, the EU-level target for the non-ETS sector is translated into binding targets for each member country.

Figure 2.8. Oil shale is increasingly used to produce liquid fuel

Emissions allowed under the EU ETS are set to decrease steadily. Phase III of the EU-ETS for the period 2013-20 has set a single, EU-wide limit on emissions. The number of CO₂ allowances for power stations and other fixed installations is reduced by 1.74% annually. Under Phase IV of the ETS (2021-30), the rate of decline is higher, at 2.2% annually. However, Estonia falls under the scope of Article 10c of the EU-ETS Directive (2009/29EC), which was introduced under Phase III of the ETS (2013-19), and provides a derogation from the requirement to auction all CO₂ allowances for power plants. Instead, Estonia has been given 18 million of transitional free CO₂ allowances for power plants under the ETS for the period 2013-19. The free allowances are deducted from the quantity that the respective Member State would otherwise auction. The objective of the derogation is to encourage investments in the modernisation of the electricity sector, diversification of the fuel mix, and to achieve carbon reductions by allowing more time for existing infrastructure to make the necessary changes. The EU-ETS price increased significantly in 2018 to around EUR 20 per tonne of CO₂, up from an average price of about EUR 7 per tonne of CO₂ between 2012 and 2017. With the new rules for Phase IV of the ETS, prices were expected to reach over EUR30 per tonne of CO₂ by early 2020 and traded prices were already exceeding EUR60 per tonne of CO₂ in 2021.

Using oil shale for heat and power generation has generally become less attractive over time. The EU ETS limits emissions from power, manufacturing and airline industries and covers around two thirds of Estonia’s emissions (IEA, 2019). Oil shale releases a relatively high amount of CO₂ when burned which makes it particularly susceptible to ETS CO₂ prices. As those prices increased, the production of heat and power from oil shale became more expensive and consequently decreased (Figure 2.8). However, rising ETS CO₂ prices made liquefaction of oil shale a financially more attractive option as exports of shale oil are not covered by the EU ETS and can be exported.

Oil shale is also facing competition from other energy sources. Recent IEA estimates suggest that many low carbon technologies can be cheaper than fossil fuel technologies (IEA, 2020). Oil shale is similar to lignite coal but low-carbon technologies such as wind, solar and nuclear can be a cheaper way to generate electricity (Figure 2.9). Previous Estonia-specific estimates showed that woody biomass could be cheaper to use for heating than oil shale. When considering the total cost of producing energy most woody biomass and wind were cheaper than fossil fuels (Ea Energy Analyses, 2013). Since then, renewables have become more competitive relative to oil shale because carbon prices have risen sharply. With further research and development the cost of renewable technologies is expected to decline. Moreover, the cost of electricity generated from oil shale, even with an additional carbon price, does not fully reflect the wider environmental pollution it causes. Oil shale mining affects underground water quantity while oil shale combustion and processing contributes to waste generation in Estonia. Air quality issues can be locally acute in the Ida-Viru region (OECD, 2017b).

Figure 2.9. Low-carbon electricity can be cheaper than fossil fuels

As part of Estonia’s climate commitments, the government will be phasing out the oil shale industry. The government has committed to ceasing oil shale electricity production by 2035. In practice, the production of heat and power from oil shale is likely to decline further as the price of CO₂ emissions in the EU ETS rises and alternative energy sources become cheaper. The government has also announced it will be phasing out shale oil in the energy sector completely by 2040 and has promised no additional fossil fuel investment. Public perceptions of climate risks have risen over time and the Estonian public seem to accept that action needs to be taken to transition to a more green and climate-friendly economy (SEI, 2021).

Part of the oil shale power generating capacity will be reduced even earlier due to old age. The total power generation capacity in the Eesti, Balti, Sillamae and Auvere oil shale power plants is around 2GW. But some of the installed capacity will be retired as it no longer conforms to current environmental requirements. These older power generating blocks will be gradually decommissioned from 2016 to 2023 reducing capacity by 501 MW with the remaining blocks set to be closed by 2031. Overall, this will leave two power generating blocks based on the more modern fluid bed technology and the newer Auvere power plant with the total capacity of 700MW. This is an effective reduction of around two thirds over a period of 15 years.

The impact on the Ida-Viru region and its workers is likely to be negative without policy support. The social and economic impact of a decline in oil shale production will be concentrated in the energy sector and, given the geographic concentration of the oil shale industry, it will be felt acutely in the Ida-Viru region. The oil shale sector employs 4,737 people in Ida-Viru of which around 3,500 employees work for Eesti Energia. The oil shale workers belong to households in which almost 16,000 people live, which is slightly more than ten percent of the region’s population. It is estimated that around 8,000 people are at risk of poverty if the oil shale sector were to rapidly shut down (Praxis, 2020). Most of the workers employed in the oil shale sector tend be older, are male and earn above-average salaries in the region. Half are skilled workers, craftsmen or machine operators (Praxis, 2020). Furthermore, the region’s economy is heavily exposed to oil shale as 40% of the largest firms in Ida-Viru operate in the oil shale sector and around 20% of Ida-Viru’s income tax comes from oil shale employees. Ida-Viru has consistently higher unemployment rates than the Estonian national average. Its labour market might be less integrated with the rest of the country given a large share of its population is non-ethnic Estonian and language might pose a barrier to labour mobility.

The speed of transition will be key in determining the impact on the energy industry and on its workers. An immediate transition away from oil shale would result in stranded assets and unemployed workers. This would be costly for the economy in terms of both creating direct losses for the energy sector as well as causing long-term damage in the labour market as some workers do not find alternative employment and withdraw from the labour force. Moreover, the decline in the supply of oil shale energy should be coordinated with the rise of renewable energy supply to avoid disruptive shortages. Therefore, the speed and manner in which the energy transition is handled will be crucial for its success. Reducing the use of oil shale should be gradual and managed while taking into account the need for reducing GHG emissions. Strong and long-lasting support to the affected regions, complemented by EU funds, will be key to ensuring success. In this respect, it might be warranted to maintain public ownership of Eesti Energia in order to flexibly repurpose or wind down existing capital assets and effectively reduce employment in oil shale-related activities.

Box 2.4. Key insights from previous and current industrial transitions

In Germany, the Ruhr and Saarland regions experienced a 50-year-long decline of their coal industries. Since 1960, there were many different structural and societal policy measures both at the national and state levels that aimed to regulate the transition. While the transitions eventually concluded in both regions, some policies such as public subsidies for the coal industry protected employment but prolonged the transition. Other policies insufficiently supported new and more sustainable industries. Oei, Brauers and Herpich (2020) offer a few key lessons that can help contribute to successful industrial transitions in other regions and that might be relevant to Estonia. These lessons are:

Refrain from subsidising and supporting the declining industry as formal and informal political influence can slow the transition process.
Take into account long-term effects and impacts beyond the local communities in decision-making. It is important to consider the directly affected workers but also the wider region, as there are indirect effects from a particular group’s loss of income.
Listen to external independent advice in addition to the incumbent industry regime. This will help facilitate the transition.
Diversification can minimise the risk but no ‘silver bullet’ exists. Attracting and predicting the success of new industries can prove to be difficult. In Germany, Saarland was more successful earlier on in attracting the automotive industry although it then became too reliant on exports and on one particular industry. In contrast, the Ruhr economy transformed more slowly but is now more diversified.
Participation enables locally adapted solutions and higher acceptance. Involving local stakeholders is important to effectively adjust, develop, and implement local strategies.
A comprehensive across-the-board approach should be taken. An effective strategy should involve appropriate levels of government and a range of relevant stakeholders to deliver an integrated and coherent policy mix.

In the United Kingdom, the oil and gas industry has been going through a contraction due to the decline in global oil prices in recent years. Consequently, the workforce has been reduced (an estimated 120,000 jobs were lost between 2014 and 2017) while development projects have been mothballed. Furthermore, the prospects for workers have also been dimmed by a projected 5% annual decline in domestic oil and gas production after 2022.

The case of the UK oil and gas industry is relevant for the low-carbon transition (i.e. oil and gas extraction), and because it provides valuable insights on innovative web-based tools to support displaced workers to find new jobs. More specifically, the Oil & Gas Workforce Plan, prepared by UK government with the aim of supporting displaced workers and of retaining sectoral expertise, underlines how the skills of Oil and Gas workers can be applied in numerous other industries. For example, systems engineers or signal designers can be employed in the railway sector while the growing oil and gas decommissioning industry can offer opportunities to workers with expertise in mechanics. “Skills connect” is among the various web-based tools that the UK government is planning to deploy. This platform should help displaced workers to identify occupations in other sectors that require similar set of competencies and relevant technical trainings. Furthermore, an additional dedicated online platform will allow companies interested in recruiting former oil and gas industry employees to have direct access to individual profiles (Botta, 2018).

In Canada, the Government of Alberta announced in 2015 an accelerated phasing-out of coal-fired power generators and the introduction of a carbon price. This phasing-out appears to be particularly ambitious since coal-fired utilities account for almost 55% of total provincial electricity generation employing than 3,000 people employed in the sector (OECD, 2018).

In particular, the case of Alberta represents one of the first “low-carbon just transition” strategies in place. Several initiatives accompany this structural adjustment. The revenues of the carbon levies represent the bulk of a fund to promote innovation and economic diversification. In addition, a dedicated Advisory Panel on Coal Communities has been established in order to ensure that the concerns of local communities and workers are considered. Building also on the recommendations elaborated by the Panel, numerous initiatives have been designed to support workers during the transition. These include top-ups to the employment insurance benefit, relocation grants to support geographic mobility and on-site career counselling (OECD, 2018).

Existing oil shale assets should be partly refocused on shale oil production. Oil shale has been increasingly used for liquefaction, which is not covered by the EU ETS. Liquid shale oil is essentially a synthetic crude oil, with a lower viscosity and lower sulphur content than heavy fuel oil derived from refining of conventional crudes. It is primarily used as a blending component in heating or bunker fuel oil to lower sulphur content, and as refinery feedstock. Shale oil can be exported. Producing liquid shale oil releases more than two times less CO₂ than burning oil shale for electricity. Thus, liquefaction can reduce the carbon intensity of Estonia’s oil shale sector although it still creates GHG emissions when the fuel is ultimately burned. In the short to medium term, the liquefaction of oil shale can be used to gradually wind down the oil shale industry allowing its assets and workforce to adjust and to be redeployed.

Oil shale heat and power generation should also be repurposed to use renewable or fossil fuels. Existing oil shale industry infrastructure could be adapted to generate energy from renewables. The newer Auvere power plant is able to co-burn oil shale with woody biomass. Existing power plants already burn 10-20% woody biomass and could burn a higher share of woody biomass instead of oil shale to generate electricity. Alternatively, some of the oil shale power plants could be repurposed to use natural gas to generate heat or electricity, where appropriate. Natural gas is twice as efficient as oil shale and it emits less CO₂ although methane leakages can be an issue. Repurposing existing oil shale infrastructure could both increase energy efficiency and lower Estonia’s GHG emissions.

The effects of the oil shale transition in Ida-Viru should be mitigated. Recent examples show that a transition away from carbon-intensive industries in countries like Germany, the UK and Canada can be successful (see Box 2.4). City, regional and national government should also be involved to coordinate a planned strategy to diversify the region’s economy by attracting new companies as well as boosting the region’s attractiveness by investing in education, cultural and recreational capacities. Active and passive labour market policies should financially support affected workers, re-train them and assist with finding alternative employment.

Current policies and development plans aim to support the Ida-Viru region. Estonia has an active strategy to support the affected region. At the regional level, the local government is involved with firms, business associations, educational establishments and non-governmental associations. The aim is to attract new business and investment, develop the local tourism industry, boost local green initiatives and support education in the region. At the national level, the Ministry of Finance is supporting the Ida-Viru region through the Just Transition Mechanism, which will be financed by EU funding. This is likely to alleviate some of the negative impact of the decline of the oil shale sector. However, it be will be important to ensure there is adequate capacity at the local level to withdraw and use the allocated EU funding for Just Transition projects. Furthermore, development plans should also be made beyond the current 2021-2027 EU budgeting period to show commitment to the transition in the region, particularly as experience from other countries has shown transitions can take longer than a decade.

Labour market interventions in the Ida-Viru region might need to be more extensive and supportive than current national policies. Ida-Viru’s unemployment rate has been persistently higher than the national average and the economy is dominated by oil shale. Moreover, many Ida-Viru residents speak Russian and have limited knowledge of Estonian language. Half of the workers in the oil shale sector in Ida-Viru will need some form of retraining (Praxis, 2020). The decline of activity in the oil shale sector is therefore likely to result in a higher need for training and extended support. With the help of Just Transition funds, Estonia intends to offer additional support to oil shale workers with extended job-to-job support schemes. A planned pilot programme will aim to facilitate a quick return to employment following a dismissal in the oil shale sector. The support entails temporary unemployment benefits amounting to 30% of their previous monthly salary, dependent on their length of previous employment, and additional counselling and training is provided for transitioning to a new job in a new sector. Such active labour market programmes will be essential in supporting the transition in the Ida-Viru region and should be long lasting and well-funded in order to provide sufficient support.

Estonia’s labour market policies, as a share of total public expenditure, are around the OECD average but this could be expanded for oil shale workers (Figure 2.10). Moreover, there remains a significant share whose skills are highly industry specific and thus not redeployable, and which then may need to be offered early retirement. Particular attention will need to be paid to income support. Finding a job might take more time than usual in the Ida-Viru region, given the large change in the region’s economy, and policy should provide adequate income support. Estonia offers unemployment benefits of around 20% after 2 years, among the lowest in the OECD (Figure 2.11). However, around a third of oil shale employees are in households with one income earner suggesting there is a real risk of poverty (Praxis, 2020).

Figure 2.10. Spending on active and passive labour market policies is average

2019

Figure 2.11. The generosity of long-term unemployment benefits could be expanded for the affected workers in the oil shale industry

Renewable sources of energy should be diversified and expanded further

Renewable energy in Estonia has significantly risen as a share of the energy supply and there is considerable potential for it to increase further. By 2020, the share of low-carbon energy in Estonia accounted for around 40% of all primary energy production and was the fifth highest in the OECD. This was predominantly due to the use of woody biomass. The share of wind and solar energy is low but expanding quickly (Figure 2.12). The potential for an increase in the use of woody biomass in Estonia might be limited but there is significant room for wind and solar energy to expand. Nuclear energy could also be potentially considered (see Box 2.5). This will need to be accompanied by cost effective network investment that can cope with a more variable energy supply as well as increased demand from increasing electrification. A boost to R&D will be required to support the development of necessary future decarbonisation technologies to reach net zero emissions by 2050.

Figure 2.12. Renewables account for a relatively high share of energy but are not diversified

% of total energy supply

Woody biomass is an important part of Estonia’s energy mix

Estonia’s forests represent a large resource of woody biomass. Around half of Estonia’s land surface is covered in woodland amounting to 2.45 million hectares. A social agreement embedded in Estonia’s forest development plans prescribes the allowed cut volumes over a ten-year period. In a moderate scenario, the sustainable volumes were estimated at 12-15 m³ per year (Government of Estonia, 2019). Actual cut volumes in 2019 were below that at 11.25 m³. Woody biomass can be produced from wood industry residues, from logging residues that result from regeneration and maintenance felling or directly from felling.

Figure 2.13. Bioenergy accounts for almost all the renewables in energy production

Woody biomass plays a large role in Estonia’s renewable energy supply. In 2005, biomass accounted for 10% of TPES but this grew to around 40% in 2020 and accounted for a large share of renewable energy (Figure 2.13). In 2020, Estonia produced almost two Mtoe of woody biomass, most of which was exported. Domestically, biomass is mostly used for heating. For example, in 2017, 58% was used to produce heat and electricity but almost all of this was used in district heating. 37% of the total biomass supply was burned in smaller residential systems that provide heat to smaller consumers not served by district heating. Only 2.9% of biomass was used in co-firing with oil shale to directly produce electricity (IEA, 2019). Woody biomass accounts for around 40-50% of all district heating and represents a stable domestic energy source that helps ensure energy security. Estonia plans to continue using woody biomass as a renewable energy source although it envisions limited further growth in its use (Government of Estonia, 2019).

Forest resources are actively used but are managed in a sustainable framework. Estonia’s forestry management is governed by Estonia’s 2006 Forest Act that seeks to ensure the protection and sustainable management of the forest as an ecosystem, and forestry management is guided by national forestry development plans as well as European directives. Estonian felling rates are higher than in most OECD countries (Figure 2.14). However, they are deemed sustainable as actual cut volumes in 2019 were below the estimated sustainable range. The largest forest owners own sustainable forestry certificates. Moreover, around a quarter of total woodland has economic constraints and 14% of forests are strictly protected. Thus, the management of forestry resources and the production of woody biomass follows environmental sustainability and biodiversity conservation standards. Given the importance of woody biomass, effective monitoring of forest use and effective data collection is important to ensure compliance with sustainability standards and to estimate accurately Estonia’s forests’ carbon absorption.

Figure 2.14. Forest felling rates are relatively high but are deemed sustainable

2019

Woody biomass is a renewable source of energy that helps reduce Estonia’s GHG emissions. As a fuel, woody biomass can substitute fossil fuels in heating and electricity generation. The overall emissions of using woody biomass should amount to zero since they are offset by forest growth. However, the production of woodchips, briquettes and pellets causes some GHG emissions. Assuming woody biomass substitutes fossil fuels and is produced with no net-carbon emissions from land-use change, they can typically reduce GHG emissions by 52-95% in heating and by 32-93% in electricity depending on the type of fuel, its sources and processing technologies (EU, 2018). Although the lifecycle GHG emissions from biomass use are not zero, they can substantially lower emissions when they replace fossil fuels. That said, other renewables sources of energy such as wind and solar rely on zero emission fuel and can produce even lower GHG emissions over their lifecycle when compared to biomass (NREL, 2021). Furthermore, to be sustainable, the use of biomass requires careful accounting of GHG emissions from land use change. In Estonia, changes in net GHG emissions are captured in the accounting of Land Use, Land Use Change and Forestry (LULUCF) GHG emissions as per IPCC guidelines. However, these emissions have to be estimated and there are uncertainties in these calculations (JRC, 2021). Good data collection and monitoring as well as prudent use of forestry resources are essential to effective LULUCF regulation and ensuring that the use of forestry resources does not result in positive aggregate net emissions.

As the use of renewable energy grows, the composition of renewable energy should be further diversified. Woody biomass has reduced GHG emissions where it has replaced fossil fuels and, for more than a decade, it has driven Estonia’s growing use of renewables (Figure 2.13). Looking ahead, there might be limits to further growth considering maximum sustainable forest cutting volumes and other economic uses of forest resources including the demand for biomass exports. To an extent, this is foreseen in Estonia’s 2030 National Energy and Climate Plan. Moreover, renewable sources of energy such as wind and solar rely on zero carbon fuel and can achieve lower lifecycle GHG emissions. This will be important in helping Estonia reach net zero by 2050 and, to this end, the renewable energy mix should be diversified. In the medium-term, to lower GHG emissions further, electricity generated by wind and solar could even replace biomass in heating, where appropriate. Small or large-scale heat pumps could be used to provide heating to households where this is practical and appropriate. Some of these changes are already underway in Estonia. Households have increasingly been purchasing heat pumps and in 2018 there were 28.4 heat pumps per 100 households, one of the highest rates in Europe (EHPA, 2021). District heating that relies on biomass could be replaced in the medium-term with large capacity electric heat pumps, where appropriate. These heat pumps can act both as a store of energy and be a flexible source of electricity demand (Heat Pump Centre, 2019). In Sweden, district heating already relies on large capacity heat pumps to a significant extent and heat pumps also provide electricity, making up almost ¾ of total energy consumed by households (SEI, 2017).

There is considerable potential for wind energy to grow

So far, wind energy has accounted for a small share of Estonia’s renewable energy but it has considerable potential to grow. In 2019, the combined share of wind in Estonia’s TPES was around 5% although its share in electricity production has risen from 9% in 2019 to 15% in 2020. The Baltic Sea has a large potential for wind generation up to an estimated 93GW. That could provide around a third of all electricity in Estonia (Elering, 2020). More specifically, Estonia has an estimated potential of 7GW of offshore wind and additional onshore capacity, there is plenty of scope to increase the power generated from wind. There are specific plans for projects representing total capacity of 2.5GW with more in the pipeline (Invest in Estonia, 2021a). Estonia has also signed a memorandum of understanding with Latvia to cooperate on a 1GW project in the Gulf of Riga. Another memorandum of understanding has been signed between stated owned Enefit and the Danish wind developer Ørsted, which should facilitate the development of the wind industry in Estonia (Invest in Estonia, 2021b).

The previous feed-in premium support scheme helped drive growth in wind power in the past, which reached 17% of electricity generation in 2020 but new capacity has stalled around 2015 levels. Furthermore, Estonia’s transition away from a time-limited feed-in subsidy to competitive auctions should have encouraged greater private sector investment and accelerated wind power deployment as wind power is already one of the lowest cost technologies and the cost of both onshore and offshore wind projects continue to decline (IEA, 2018b). Nonetheless, wind power deployment in Estonia has slowed significantly with capacity in 2020 similar to 2015 levels (Figure 2.15).

Several restrictions have limited the growth of wind power. National security concerns have led the Ministry of Defence to object to new installations since wind turbines can affect the ability of radar to detect and track airplanes (IEA, 2019). For example, since 2008 the Ministry of Defence have objected to over 500MW of planned or permitted wind projects (EWPA, 2019) and defence considerations may partly explain the limited growth in new capacity since 2016 (EWPA, 2018a and 2018b). National defence concerns are now been addressed through investment in additional radars but possible environmental and spatial concerns can still hamper wind power development. Estonia has been developing a marine spatial development plan since 2017 to address such concerns and to engage with stakeholders and to better define offshore areas for wind power development. The plan is currently being finalised (EU MSP Platform, 2021).

Figure 2.15. Wind generation has increased although wind capacity has stalled since 2015

Estonia should provide a more certain regulatory environment to stimulate wind power development. To this end, the Environment Agency has developed a highly detailed ecological map of Estonia that will facilitate the planning of on-shore wind parks to minimise their impact on the environment such as possible effects on birds’ migratory patterns. Permits based on such maps should help alleviate any local concerns and provide more certainty for investors. For offshore wind, where there is greater potential, the maritime spatial plan is still being developed and should be expedited in order to encourage investment. It will be important that the finalised plans minimise potential obstacles to wind power development as well as incentivise local communities through sharing some of the benefits of new wind parks.

Solar energy can be complementary to wind energy and should also be expanded

Solar energy accounts for a small share of Estonia’s renewable energy mix but it has been rapidly growing. There is room to expand it further. In 2016, there was little electricity generation from solar energy but by 2019, solar energy accounted for 1% of all electricity generation and amounted to 73.5GWh. In 2020, solar energy production expanded threefold to 245GWh and its share in electricity production more than doubled. Solar energy is complementary to wind energy and would be a useful part of the energy mix. While Estonia’s ambitions in this field are relatively small and its 2020 national targets have already been exceeded, there is potential for solar energy to grow and expand further (IEA, 2019).

Estonia should encourage a wider take up of residential solar energy while attracting more investment in large-scale solar power plants. Previous policies seem to have been successful in encouraging the installation of new solar energy capacity. The feed-in premium scheme for larger systems (51kW to 1MW) that ended in 2018 and the scheme for smaller systems (<50kW) that ended in 2020 have driven a lot of the growth in solar energy production. This should be continued. Residential solar energy investment should continue to be supported by a guaranteed feed-in premium for smaller systems. This would also make financing easier to obtain and encourage other companies to enter the market. Companies like Eesti Energia are planning to increase their activity in this area by offering installation services and financing support. This would make it particularly attractive to households and firms located in more remote regions where there are fewer energy options. Most of Estonia’s landmass is conducive to capturing solar energy so large-scale solar PV parks are also possible. Larger installations should participate in energy auctions. Unfortunately, the siting and permitting process can be slowed by environmental and local concerns, similar to many of issues faced by wind parks, so implementing a spatial plan to facilitate the installation of solar PV panels could be useful.

The energy infrastructure will need to be flexible and robust in a low-carbon economy

The energy infrastructure and network will be crucial to ensuring a successful transition towards electrification of energy demand. This is because to move to a low-carbon economy, based on current technologies, Estonia will need to electrify as much as possible to take advantage of renewable energy such as wind and solar energy. This means its electricity network will become larger and more prominent in the economy. The future energy network will need to be flexible and robust to support a more variable and diverse energy mix as well as a more electrified economy. It will need to be transparent and encourage competition among companies but it will also need to be resilient to cyber threats.

Estonia’s electricity and gas grids are well connected and flexible. Estonia’s electricity network is connected to Finland through two undersea cables in the Gulf of Finland, Estlink 1 and 2, together accounting for around 1000MW of capacity. Estonia is also connected to Latvia and it completed a third interconnecting line at the end of 2020. Currently, Estonia’s electricity grid is synchronised with Russia although Estonia plans to switch to the continental European grid from 2025 onwards. Estonia regularly trades electricity, mostly by importing from Finland and exporting to Latvia. Its electricity grid is highly regionally integrated with an interconnection level of 63%, substantially higher than the 10% 2020 EU target (EC, 2017). The Baltic electricity system is integrated with the Nordic countries’ power exchange, Nord Pool. Its natural gas network is connected to Latvia and Russia as well as to Finland through the Balticonnector. Estonia has access to the natural gas storage facilities in Latvia as well as the LNG terminal in Klaipeda, Lithuania. As such, its gas grid is also well connected and flexible.

The shift away from fossil fuels will result in an increase in electrification that can take advantage of the renewable energy produced. Developing offshore and onshore wind parks as well as solar energy will also require additional infrastructure as well as strengthening the electricity grid. For example, all offshore wind parks will require an undersea cable connection to the main grid, which will need to be built. Furthermore, the Estonian electricity grid will need to be upgraded in the western regions to deal with increased electricity production (Figure 2.16). In this regard, cost effective investment plans by Elering, the transmission service operator (TSO), and participation in the Baltic Sea Network and the Baltic Offshore Grid Initiative, will be key to upgrading the energy network for the low-carbon transition.

Balancing power and regional cooperation will also become increasingly important. Balancing power exists in the electricity network to provide a buffer for temporary and small but unexpected increases in demand. In Estonia, the 250MW Kiisa emergency power plant provides emergency power in case of a shortfall. However, in an energy system dominated by renewables, energy production will be more variable and less predictable. This might require greater grid stabilisation and balancing power. In 2018, the three Baltic TSOs launched a common Baltic balancing market for Estonia, Latvia and Lithuania. All three Baltic TSOs are also members of the Manually Activated Reserves Initiative (MARI), an initiative by 19 European TSOs to create a European platform for the exchange of balancing energy as soon as possible (ENTSO-E, 2019). Regional cooperation to ensure sufficient electricity generation and to avoid volatility in the network will be paramount in ensuring a stable and secure energy supply.

Figure 2.16. Electricity infrastructure is less developed in western Estonia

Box 2.5. A case for nuclear energy?

In a low-carbon world, there will still be demand for stable power generation. Nuclear energy can provide stable and zero-carbon electricity as fossil fuel based power plants retire and renewables take over. Estonia does not necessarily need to build a nuclear power plant since it can import nuclear-powered electricity from Finland. But, to the extent that energy independence is important to Estonia, developing its own nuclear power capacity could provide a possible and cost-competitive path to a low-carbon economy either during the transition or as part of the final energy mix. Given that two thirds of oil shale capacity will be retiring by 2030 it might be an opportune time to consider developing nuclear power capacity.

Nuclear technology now allows for small modular reactors (SMRs). There are advantages to these reactors as they are deemed to be safer, can be installed in smaller capacities and so might fit smaller countries well, and can be installed closer to cities. The disadvantages are that the technology is still experimental and, although they are supposed to be cheaper, previous construction of nuclear power plants has often exceeded estimated costs. Furthermore, the long-term safe storage of nuclear waste is an important environmental consideration. Nonetheless, SMRs continue to attract interest in both established nuclear countries, such as Canada and the United States, and in newcomer countries in Europe, the Middle East, Africa and Southeast Asia. R&D and investment in SMRs and other advanced reactors is being encouraged through public-private partnerships (IEA, 2021).

Neighbouring Finland has been investing in nuclear energy as part of its net zero strategy. In mid-2019, the Finnish government announced that it will be supporting operating lifetime extensions for its existing reactors and that it will be commissioning two nuclear power reactors to increase electricity generation. Finland is exploring the potential use of SMRs for both district heating and electricity generation. Finland has also secured deep underground disposal sites for additional nuclear waste.

Estonia is considering the use of nuclear energy. A working group on nuclear energy, consisting of different government ministries and led by the environment minister, has been formed in 2020 to analyse the possibility of nuclear energy in Estonia and how it can support the country’s energy security and climate neutrality goals. The working group is expected to present its conclusions and report by September 2022 at the latest. In the private sector, Estonia is already planning to have its first nuclear reactor, an SMR, ready within about ten years. It is set to be located some 100 kilometres east of Tallinn (Vanttinen, 2021). Estonian Fermi Energia is in charge of the project while Fortum, a Finnish state-owned energy company, is consulting on the project. Fermi Energia has plans to develop up to four reactors delivering between 600-1200MW of capacity. This would largely replace the retired oil shale power plants. Nonetheless, the SMR technology will only be ready for deployment by the late 2020s and could start generating electricity from 2035 onwards.

Regional cooperation in the Baltic or Nordic countries to further develop nuclear capacity could be an alternative option. Estonia could potentially collaborate with Finland. Still, any new projects would take a long time to develop and are also likely to only start generating power from the mid-2030s.

It is worth emphasising that nuclear power is a source of zero-carbon electricity but it is not a sustainable and environmentally neutral source of energy. Given current available technology, it can play a role in a country’s energy mix by providing a stable source of energy. It cannot, however, be used to smooth out fluctuations in energy production as nuclear energy production is not easily adjustable. As large-scale cost-effective energy storage is developed, the need for nuclear power may be obviated in the future. In the meantime, though, it could help in the transition to a low-carbon economy.

Research and development will be key to developing better low-carbon technologies

Technological innovation will be key to reducing GHG emissions. The current set of available technologies can effectively be used to reduce GHG emissions and meet climate targets by 2030. But getting to net zero by 2050 will require technologies that are either nascent or do not yet exist (IEA, 2021). For example, zero carbon technologies such as solar and wind power can technically replace fossil fuel based heat and power generation. But their intermittency and the inability to store large amounts of energy makes it difficult to completely reduce the economy’s reliance on fossil fuels. Technologies to reduce emissions not just through energy supply but also through energy demand, such as energy efficiency in transport or buildings, will be also important. Expanding research and development (R&D) to explore solutions to these problems, for example, and supporting the deployment of new technologies will be essential to successfully transitioning to a low-carbon economy.

Estonia is committed to a knowledge-based economy. R&D in Estonia has been guided by the Estonian Research and Development and Innovation Strategy 2014-20, the Estonian Entrepreneurship Growth Strategy 2014-20 and, to a smaller extent, the Estonian Smart Specialisation Strategy. In 2021, these elements have been merged into a new joint development plan for research and development, innovation and entrepreneurship for 2021-2035. Some of the key institutions driving innovation in Estonia are higher education and research institutions and the Estonian Research Council, which as part of the Ministry of Education and Research, fund the public research and public collaboration projects with the private sector. The European Commission also supports Estonian research by financing projects on climate-related issues. Estonia provides financing to the Baltic-Nordic energy research programme. Within the Ministry of Economic Affairs and Communication, Enterprise Estonia supports foreign direct investment, company start-ups and innovation while KredEx provides finance to companies to support innovation. The Research and Development Council, chaired by the Prime Minister and composed of several ministries and non-government experts, advises the government on research and development strategy. Of course, Estonia’s private sector also contributes to innovation through its dynamic start-up scene and through R&D investment by existing firms.

Estonia’s public R&D investment on environment-related issues, however, is relatively low and should be substantially increased. Total R&D spending in Estonia was around 1% of GDP in 2019, slightly below the OECD average. Within that, public spending on R&D amounted to 0.17% of GDP (Figure 2.17). Furthermore, the composition of public R&D spending shows that only a third went to environmental issues such as energy efficiency and renewable sources (Figure 2.18). This was in the lower quartile of OECD countries and below the top performing countries such as Finland or Denmark that spend 70-80% of public funds on environment-related R&D. Other indicators also suggest R&D on environment-related issues might be too low. The number R&D personnel and researchers and the amount of eco-innovation related academic publications is below the EU average. Estonia’s science output is, on average, high quality and there are more areas of scientific excellence than might be expected given Estonia’s size. However, the research strategy has previously shown a lack of clarity on the relative importance of priorities and coordination at the thematic level could be improved (EC, 2020b). To support the transition to a low-carbon economy, Estonia should further develop its innovation capacity by increasing overall public R&D funding and also by boosting the amount from national research funding to complement EU funds. Estonia should also shift the focus of its funding and, more broadly, innovation efforts towards environment-related issues. This will help underpin a low-carbon technology innovation.

Private R&D investment and environment-related innovation is also relatively low and limited. Estonia’s corporate tax system does not tax retained profits and this supports investment, including R&D. Estonia has a dynamic start-up scene and start-ups focused on low-carbon technologies, so called ‘cleantech’, have received more funding than the EU average. But environment-related innovation still seems limited in many other dimensions. Estonian businesses lag behind most EU countries in environmentally-related patents and innovation (EC, 2020a). This might be due to a low share of large firms and a large share of micro firms (EC, 2019). Only 0.3% of all firms invested in any R&D although this may be underreported (EC, 2020a). Overall, Estonia’s private sector R&D was 0.9% in 2019 and lower than the OECD average.

Policies to increase private sector R&D should support the development of market-based low-carbon goods and services. Higher education institutions should increase their focus on environment-related research. On research, to translate public R&D into private sector applications, Estonia should strengthen the links between universities and the private sector by strengthening the role of technology transfer offices with a focus on environment-related innovation. Furthermore, Enterprise Estonia should focus more on R&D and environment-related R&D when attracting foreign investment.

Estonia should choose carefully the areas in which it has the competitive advantage and where to focus its R&D and innovation efforts. For example, in the National Environment and Climate Plan 2030, Estonia seeks to be at the forefront of next generation of renewable technologies, storage solutions, smart grid and home solutions, smart cities, building neutrality, clean transport, carbon capture and storage (CCS) and nuclear energy under the Horizon 2020 programme (the EU’s research, innovation and competitiveness dimension). Finally, it will be important for Estonia’s R&D sector to cooperate strategically within the EU on topics of mutual interest to maximise the return on its research.

Figure 2.17. R&D spending is relatively low and could be increased

Figure 2.18. Public R&D spending on environment-related issues is among the lowest in the OECD

2020

Driving transport sector emissions down

Transport sector emissions have grown since the early 1990s

GHG emissions in transport have steadily increased since 1992. The growth in the demand for road transport has led to a rise in overall transport sector emissions. Car intensity is particularly high in Estonia given its level of GDP. But there is considerable scope to reduce emissions from transport by increasing vehicle efficiency, improving transport infrastructure and using environmental taxation and subsidies to encourage the transition to low-carbon transport.

Since the early 1990s, GHG emissions kept steadily increasing (Figure 2.19). Transport emissions have doubled since 1992 and stood at around 2,400 tonnes of CO2-equivalent in 2019. They are now almost back to their 1990 levels. While transport emissions have increased by 20% in the EU and by 30% for the average OECD country since 1992, in Estonia they have doubled. Overall, emissions from transport account for around 6.5% of all GHG emissions. In terms of total final consumption of energy, transport accounted for 28% of all domestically consumed energy. Almost all of that energy came from refined oil, which was imported.

Figure 2.19. GHG emissions from transport have been rising since 1992

Figure 2.21. Estonia’s passenger car fleet is relatively old

2019

The increase in transport emissions has been driven by road transport. In Estonia, 98% of emissions in the transport sector arise from road transport. The number of vehicles, especially passenger cars, has been increasing over time (Figure 2.20 Panel A). Moreover, passenger cars accounted for most of the increase in the number of kilometres driven (Figure 2.20 Panel B). Although Estonia is less densely populated than the average OECD country, the population has not generally become more dispersed since 1990 (World Bank WDI, 2021). The increase in the number of cars is likely due to a strong income growth over the past three decades. Still, the prevalence of cars in the population in 2018 was similar to Germany and Australia, countries with higher living standards than Estonia (Figure 2.20 Panel C). However, Estonia’s passenger car stock is particularly fuel inefficient when compared to other European countries. Car engines tend to be the largest in the EU (IEA, 2019). But Estonia’s cars also tend to be the oldest (Figure 2.21). In 2019, around a third of Estonia’s passenger cars were 20 years old or older (Eurostat, 2020). Together, more cars and more miles in fuel inefficient cars has led to an increase in transport emissions.

Emissions from rail transport have fallen over time but growing use of public transport has helped push up emissions. The volume of freight transported by rail more than halved between 2008 and 2018 contributing to falling emissions from rail transport, although part of it was transferred to road freight which has pushed up transport emissions due to higher carbon intensity of road freight (UNECE, 2020). At the same time, passenger traffic on both rail and roads increased leading to higher emissions. The volume of passenger traffic on trains rose by almost 60% between 2010 and 2019 but rail represents a relatively small share of Estonia’s public transport. Most of Estonia’s public transport is served by buses (Figure 2.22). Bus passenger traffic also grew, expanding by a quarter between 2008 and 2019. This was almost entirely due to growth in international bus travel while domestic bus traffic was broadly stable over the same period.

Figure 2.22. Public transport is important for mobility and is mostly focused on buses

2019

Transport emissions can be driven down

There is significant potential to reduce emissions in the transport sector. The transport sector is not currently covered by the EU ETS. Estonia’s ambition is to reduce emissions by 30% by 2030 compared to 2005 while not exceeding total vehicle fuel consumption levels recorded in 2012 (MEAC, 2021). Since emissions have been rising, this could prove a challenge. Nonetheless, there is room to use targeted environmental taxation, subsidies and regulations to increase efficiency, improve infrastructure, and expand public transport in order to reduce emissions.

Estonia’s current set of policies has partly addressed the need to reduce transport sector emissions. Estonia collects revenue from environment-related taxation (8.3% of total tax revenue in 2018), higher than the EU average of 6.14% (EC, 2019). However, most of the revenue comes from a narrow base such as an excise tax on fuels (Figure 2.23). Environment-related transport taxes, excluding transport fuel taxes, were just 0.2% in 2020, the lowest in the EU. Currently, Estonia does not have a carbon-based tax on transport fuels and there is no vehicle registration tax or any other tax based on carbon emissions of vehicles. Since 2019, heavy goods vehicles pay a toll to use roads. In addition, Estonia does not levy any special congestion charges in its cities or counties. Estonia had previously limited subsidy schemes to boost EV adoption and has built a functioning nation-wide charging network. Some of the main barriers to improving energy efficiency in the transport sector are a lack of comprehensive fiscal measures to support higher fuel efficiency and to incentivise a modal shift, that is, a move from private car use to public transport. There has also been a lack of long-term funding schemes for public transport, cycling infrastructure and pedestrian zones (IEA, 2019).

There are ambitions to expand the set of environmental policies to reduce transport sector emissions. In its National Development Plan for the Energy Sector 2030, Estonia aims to reduce transport sector emissions though several measures. These policies would encompass car taxation to encourage adoption of more efficient cars including EVs. It also entails expanding public transport to encourage a modal shift by encouraging greater use public transport to travel to and from work (MEAC, 2017a). The measures described in the strategy, if implemented, could reduce transport energy by up to 40% (IEA, 2019). The latest Transport and Mobility 2021-2035 Masterplan goes further in its ambition to increase the share of population travelling to work by public transport, bicycle or foot from 38% to 55% (MEAC, 2021). It aims to improve mobility through more convenient, faster and more accessible public transport and better infrastructure. This entails improving urban and intercity connectivity. Higher use of public transport and rail electrification should also reduce emissions.

To complement its transport strategy, Estonia could benefit from carbon-linked taxes in the transport sector. Excise taxes on fuel such as petrol and diesel are high relative to average incomes. Given Estonia’s car stock is older and relatively less efficient, these excise taxes should encourage higher efficiency, which can reduce emissions as households upgrade to newer and less polluting vehicles (OECD, 2019b). They can be an efficient policy for encouraging lower emissions but they should be directly linked to emissions. Nonetheless, fuel taxes do not necessarily account for other externalities such as congestion, accidents, wear and tear, and noise. An alternative tax to fuel taxes, based on a fitted device in the vehicle, could charge drivers based on how much and where they drive. While there may be higher operating costs, the advantage of such taxes is greater flexibility to optimise car use across Estonia. For example, high rates could be charged in cities where there are also congestion concerns and on routes where public modes of transport exist. In contrast, lower rates could be set in rural regions and areas where there are few alternative transport modes. Such a tax could allow for charges to depend on geolocation and also on the time of day or week. Such a system could also allow for big data collection, which would better inform public transport policy and infrastructure investment. In addition, this could potentially allow for more efficiently priced car insurance. Privacy concerns are important but user data would be protected within Estonia’s world-leading X-Road infrastructure. Participation could be optional to address any additional privacy concerns. Cars without the device would be charged a flat rate based on an estimated average unfitted car profile.

A carbon-based transport tax should be complemented by means-tested incentives, particularly for most affected groups, to upgrade to EVs and more fuel-efficient vehicles as well as to scrap old cars. The revenues from a transport tax could be used to subsidise new EV purchases, up to a limit, in order to accelerate the transition to greener transport. Among EU countries, Estonia has the lowest share of registered electric and hybrid vehicles (Figure 2.24). Currently, Estonia has reintroduced subsidies to EV owners who commit to driving at least 80,000km over 4-year period (Broughel and Viiding, 2021). This scheme should be widened to encourage a greater number of EV sales although subsidies do not necessarily need to be as generous as before given the cost of EVs has significantly declined. The longevity of such schemes will be important until EV use becomes more widespread. In addition, a scrappage bonus could also be paid to those scrapping their old cars when purchasing newer and more fuel-efficient vehicles.

Regulation can also help reduce transport emissions. Setting a minimum emission standard could remove the most polluting vehicles and encourage drivers to upgrade to cleaner vehicles. Adopting and communicating a long-term timetable that sets out how minimum standards will be changing over the next few decades can provide a powerful signal to the transport sector. For example, announcing a phasing out of internal combustion engine vehicles by a specific date can show commitment to a reduction in emissions. In the EU, Austria, Belgium, Denmark, Greece, Ireland, Lithuania, Luxembourg, Malta and Netherlands have requested the European Commission to support a specific date for an EU-wide phase-out of the sale of new petrol and diesel passenger light duty vehicles (IEA, 2021). Similarly, the public sector can lead by example through reducing emissions in its use of zero-carbon official vehicles and by decarbonising public transport. In that respect, Estonia is heading in the right direction with its planned use of biomethane in buses.

Figure 2.23. Environment-related tax revenues are high but mostly come from transport

2020

Figure 2.24. The share of registered electric and hybrid vehicles is very low

2019

The public sector should invest more in cost effective electric charging infrastructure. In the past, range anxiety, lack of charging infrastructure and high upfront costs were the main factors that impeded EV adoption (Rezvani et al., 2015). To address these issues, Estonia developed the world’s first nation-wide fast-charging network for EVs in the early 2010s. However, alongside subsidies, the network insufficiently encouraged EV use as prevailing range anxiety and the high cost of owning EVs prevented a significant spread of EVs (see Box 2.6). But now ranges have increased to 300-400km even though they can be 20% lower in winter conditions (NAF, 2020). This should be adequate for Estonia where the maximum distance east to west is 450km and north to south is 240km. The cost of EVs has also decreased substantially since 2010, increasing their affordability, while the range of EVs on offer has expanded. To complement carbon-based transport taxation and EV subsidies, policies should invest more in the charging infrastructure. The existing charging network has been auctioned off to Elektrilevi, Estonia’s largest distribution grid operator (KredEx, 2018a). Elektrilevi will invest to upgrade the charging infrastructure (Broughel and Viiding, 2021). Additional investment in fast-charging stations could improve the network. More importantly, policy should focus on improving access to charging in residential areas as much EV charging is expected to occur at home. Many Estonians live in apartment buildings and might not have a readily available charger near their home.

The public transport network should also be electrified as much as possible. Most Estonian cities have a well-developed public bus network that could be electrified (Broughel and Viiding, 2021). At the moment, electric buses tend to be cost-effective on the busiest routes but, as purchase costs decline, an increasingly higher share could be electrified. This will also need to be accompanied by investment in appropriate charging infrastructure. This could complement efforts to use biomethane as a fuel for buses. Moreover, Estonia’s rail network currently relies heavily on diesel fuel and there is a considerable opportunity to further electrify the network (EC, 2019).

Additional investment in the public transport system coverage will be needed to encourage greater use. The use of public transport in Estonia accounted for around 20% of all distance travelled in 2019 and was around the EU average. But as passenger traffic in Estonia increased, most of it was due to higher car use given their larger share in transport. There is considerable scope to increase the share of public transport in overall travel in Estonia. For example, domestic bus travel stagnated between 2008 and 2018. Nationally, Estonia could consider using geolocation data to better understand where additional regional and national public transport services could be profitable and help reduce reliance on personal transport. Rail transport could be expanded as well. An investment programme to upgrade and extend the rail network by introducing new inter-city and suburban services finished in 2013 and led to strong growth in the number of passengers. Further connections, national and local, could be introduced to stimulate the use of trains. Locally, ensuring more convenient and more frequent public transport services could also encourage the modal shift to public transport.

Public transport investment should be complemented by a wider set of policies to encourage a greater shift to public transport. In 2013, Tallinn became the first capital city in the EU to provide free public transport for all permanent city residents and initially this led to an increase in public transport use. However, by the end of 2016 the share of public transport use fell and the use of private cars increased (IEA, 2019). In mid-2018, 11 out of 15 counties introduced free bus travel and initial evidence suggested an increased take-up although the overall impact is not yet clear. Thus, to maximise the impact of public transport policies it is important to take a comprehensive approach and to introduce policies to discourage private car use. For example, in urban areas increased parking charges and park-and-ride options could facilitate a large-scale shift to public transport. Greater availability of bicycle lanes could encourage more cycling. In addition, land use could be given increased consideration. Land-use projects, such as mixed-use urban developments within close proximity (walking distance) to mass transit facilities, that promote inter-modal transport use for commuters and encourage accessibility should be prioritised (ITF-OECD, 2017). The use of precise local indicators on accessibility to goods, services and opportunities, like the Public Transport Accessibility Level used in London, could help target areas and people that are most in need, to adjust the transport system but also land use policies (OECD, 2019c).

Increased use of lower carbon fuels will be important in helping reduce transport emissions in the interim. The transition to cleaner and low-carbon transport will take time. For example, even if all new car sales before the pandemic were EVs, it would take around 18 years for Estonia’s entire car stock to be replaced with new cars. In Norway, experience has shown that policy packages that include tax cuts, carbon pricing and reduced urban tolls for green vehicles can considerably increase the share of EVs but policy takes time to have an impact (OECD, 2021a). A sizeable portion of cars will rely on fossil fuels in the future during the transition. The EU Renewable Energy Directive (2009/28/EC) requires Estonia to ensure that 10% of energy used in the transport sector comes from renewable sources by 2020 but Estonia has not managed to meet this goal. Blending bio fuels into transport fuels can partly help Estonia achieve this objective. Suppliers are responsible for blending conventional fuel with biofuel but a lack of clarity on fuel standards impeded implementation. Policy could coordinate and facilitate standard adoption to speed up the supply of biofuels. Estonia is also promoting the use of biomethane in its public bus transport system. Since 2015, Estonia has provided subsidies to establish biomethane filling stations and has awarded grants to public bus operators that use it as a fuel. Biomethane has been locally produced since 2018 and there are subsidies for production, too (MEAC, 2018a). In 2019, the share of biofuels stood around 4% in Estonia below most other EU countries (Figure 2.25). Setting standards is important although a carbon-based tax on fuels might be more efficient in encouraging the market to provide the most cost efficient biofuels.

Figure 2.25. The share of biofuels remains relatively low

2019

Box 2.6. Pioneering the adoption of EV technology: learning the lessons

Estonia pioneered the use of EV technology. In the early 2010s, it was the first country in the world to develop a nationwide charging network. It introduced subsidies for EV purchases. Despite these policies and expectations at the time, EVs did not become widespread and many countries have caught up with Estonia since then. This experience holds a few useful lessons (Broughel and Viiding, 2021).

In the early 2010s, Estonia developed the world’s first nation-wide fast charging network. The network was based on a Japanese charging standard, the ChaDemMo protocol, which was successfully used in several other countries (Mitsubishi, 2011). By 2013, Estonia built 165 charging stations throughout the country (ABB, 2013). The aim of was to alleviate consumers’ range anxiety since most EV driving ranges did not exceed 100km (Pearre et al, 2011).

Estonia also introduced subsidies and a rental program to encourage EV adoption (Broughel and Viiding, 2021). Funded by the sale of CO₂ emissions quotas to Japan, Estonia subsidised new EV purchases up the 50% of the EVs’ listed price or up to a ceiling of €18,000. This programme was quite generous with the average subsidy amounting to €16,500 (KredEx, 2018a). The initial programme was extended with further funding until 2014 (KredEx, 2012). Estonia also introduced an additional EV rental programme to familiarise the public with electric mobility. This led to over 8,000 users. But the average distance per user was around 300km and only 24 customers used rental EVs more than once a week (Broughel and Viiding, 2021). The funding for the programme expired by the end of 2014.

These policies did not lead to widespread EV adoption in Estonia. Between 2011 and 2014, only 650 private EVs were purchased and 507 EVs were purchased by the public sector (Broughel and Viiding, 2021). The programmes ended in 2014. In the meantime, other countries developed EV charging networks and introduced EV subsidies. By 2020, the share of newly registered electric vehicles in the total passenger car fleet in Estonia was among the lowest in Europe (Figure 2.24).

There are three reasons why Estonia’s pioneering policy was not successful. First, the assumption of the EV programme was that EV prices would decline much faster than they did, reducing the need for subsidies (Broughel and Viiding, 2021). Second, consumers were not ready to accept relatively short driving ranges and longer charging times compared to refilling at a gas station. EVs were mostly purchased by consumers who could charge at home. Apartment building residents were much less likely to purchase EVs despite the possibility of using publicly available charging stations (Broughel and Viiding, 2021). Third, Estonia’s EV program adopted a Japanese charging standard. At the time, there was no universal charging standard in Europe although eventually a different standard, the Combo-2, was adopted Europe-wide.

Reducing emissions through increasing building efficiency

Buildings contribute to Estonia’s GHG emissions by consuming heat and electricity. Reducing their demand for energy means building or upgrading buildings so that they more efficiently retain heat in winter and keep cool in summer. For Estonia’s ageing building stock, there is lots of potential to improve energy efficiency. Renovation should be prioritised over new construction, as this is less carbon intensive. Still, improvements will take a few decades to fully implement. Progress will depend on how fast such projects are implemented and on the capacity of the market to provide the requisite services.

The buildings sector accounts for a significant share of total energy demand in Estonia. In 2019, buildings’ share of total final consumption of energy within Estonia was 32% (Figure 2.26 Panel B). Most of the energy consumed came from bioenergy and waste and heating but around 20% can be accounted for by electricity (Figure 2.7). Altogether, this contributed 882 thousand tonnes of CO₂equivalent in 2019, making up around 3% of total GHG emissions. The amount of GHG emissions has been broadly stable since the early 1990s and has shown little improvement (Figure 2.26 Panel A). In contrast, across the OECD and the EU there has been a steady downward trend in buildings’ emissions.

Figure 2.26. GHG emissions from buildings have been broadly stable since the mid-1990s

Most of the energy demand and related GHG emissions came from the residential sector. In Estonia, residential buildings account for three quarters of all building floor area (EC, 2021). In 2018, space heating accounted for 59% of the energy demand with water heating making up 16%. Cooking accounted for 17% and electricity consumption of appliances was 9% of the sector’s consumption (ODYSSEE, 2021). Between 2000 and 2018, energy consumption in residential buildings increased by about 3.5%. This was partly due to more dwellings and, to a smaller extent, larger homes. At the same time, energy efficiency improved and the energy used by space heating fell, decreasing emissions (Figure 2.27).

Figure 2.27. More dwellings pushed up on GHG emissions but energy efficiency improved between 2000 and 2018

Still, Estonia’s residential building stock remains somewhat energy inefficient. Compared to other EU countries, energy use in residential space heating in Estonia in 2019 was among the highest. In part, this can be explained by a relatively cold climate with an average yearly temperature of 6.7°C, which translates into higher heating demand. Nonetheless, the high use of energy in heating is driven more by low energy efficiency since that Estonia’s heating energy consumption is much higher than in its Nordic neighbours (Figure 2.28). This is related to the fact that Estonia’s residential buildings are quite old with 86% of buildings constructed before 1991 and only 7% built after 2006 (IEA, 2019) – Figure 2.29. Most of the residential buildings are owner-occupied and around 60% are organised into apartment associations. In 2018, renewed legislation also created apartment associations in buildings where none previously existed. The public sector owns a small fraction of residential real estate, less than 4% of the residential housing stock, while social housing accounts for less than 1% (MEAC, 2017b).

The current set of policies to improve the energy of buildings have focused on subsidies. Apartment associations can apply to the Credit and Export Guarantee Fund, SA KredEx, for expert advice and grant support and this can provide 35-40% of the total cost of the renovation. Additional support can be given with up to 50% of total cost with technical consultant or renovation supervisor fees reimbursed. Bigger grants require a larger and more extensive renovation plan. For example, a full 40% grant would require 20% energy savings, heating system reconstruction, façade and roof insulation, new windows installation and ventilation system with heat recovery (MEAC, 2017b). EU funds, as part of Cohesion Policy Funding, also include support for renovation of apartment buildings built before 1993 with financing up to 50% of total costs (ODYSSEE, 2021). Given that renovation projects can be costly, many apartment associations in Estonia often finance part of their renovation through loans. This works for some buildings but in some cases finance can be restricted when the building profile is more risky due to its location, size, etc. For example, lower property values can be a barrier in most regions outside of Tallinn and its surrounding area. SA KredEx can provide loan guarantees in such situations and can cover up to 80% of the loan amount. House owners can also access grants and loans for renovations.

The public sector is leading by example. The EU Energy Efficiency Directive stipulates that 3% of central government building stock must be renovated each year. This is implemented by the Ministry of Finance. The sale of CO₂ allowances funds such green investment with roughly half going to central government and half to local government (MEAC, 2017b). The funding of CO₂ allowances also finances other green investment such as district heating system renovation, street lighting, etc.

Figure 2.28. Energy use in residential space heating is comparatively high

2019

Figure 2.29. Most of Estonia’s buildings are old

New buildings standards should improve buildings’ energy efficiency. In 2013, the new building code introduced requirements for nearly zero-energy buildings (nZEB). From 2019, all new public sector buildings must comply with the new standard while all new private buildings must do so from 2021 onwards. This should represent a significant improvement in energy efficiency although the challenge will be to upgrade existing skills and competences in the construction sector to be able to deliver the new nZEB standard.

The potential for improving energy efficiency for residential buildings is substantial. Government studies suggest that if the buildings were fully renovated it would be possible to lower heating consumption by up to 70% (~6.4 TWh/y) and electricity consumption by up to 20% (~0.5 TWh/y) (MEAC, 2020). To achieve the targets set out in its national energy strategy, the annual renewal rate in the residential building stock would need to be 1% of new construction and 2% of renovation but the actual renewal rate is around 0.5%, on average (IEA, 2019).

Renovation should be further incentivised and accelerated. The government has designed efficiency packages for five energy performance levels of buildings to help facilitate the renovation process. However, the efficiency packages that represent the best economic value are not the packages that achieve highest energy efficiencies and will not deliver the targeted energy savings set out in the national energy strategy. To mitigate the upfront costs of renovations, boosting and widening the existing availability of long-term credit and focusing on the least energy efficient buildings would help increase renovation rates. In this respect, a special loan facility is being prepared by the Ministry of Economic Affairs and Communication. For those residents unable to finance and/or obtain credit for renovation, more extensive support could be offered through KredEx than has previously been done in order to support the most vulnerable households. Furthermore, renovation requirements could also take spatial and financial risks into account. For example, exemptions or extensions could be given to areas where incomes and property prices are lower, and areas where depopulation might limit the need for renovation.

Policy could help expand the private sector market for renovations. The capacity of the market to meet the demand for renovation will be crucial in accelerating energy efficiency improvements. One approach that has worked in other countries is to set up a market for energy service companies (ESCOs). ESCOs are integrated companies of energy engineers and experts that provide energy saving solutions. Such companies can be very effective in delivering energy efficiency savings across sectors (IEA, 2019). While the Estonian market appears too small to support ESCOs, renovation projects could be bundled so that companies can bid on multiple apartment buildings. This could encourage and attract the interest of larger companies and could allow expertise to be developed. An active renovation market could also encourage the development of renovation service companies that offer owners technical advice as well as financing and renovation construction solutions. The public sector, through its renovation programme, can also help stimulate an active renovation market through larger projects which, once established, can then continue with private building renovation. As mentioned, it will be important to train new workers and build skills in the industry so that increased demand for renovations can be met with a sufficient supply of workers. But given tight labour markets and scarce skills, a higher supply of workers could come from existing workers in construction shifting to renovation, a rise in labour market participation or through increased immigration. Policies to boost the supply of skilled workers will be important. Otherwise, the increased demand for renovation could push up wages, increase costs and reduce the financial benefit of renovating which could, on the margin, slow down the pace of renovation.

Policies for a low-carbon transition should be comprehensive and balanced

The implementation of policies to reduce GHG emissions in Estonia will be a challenging task. The policy mix should be comprehensive and balanced. It should rely on combination of policies such as carbon pricing (including carbon taxes or ETS), regulation and subsidies. But it should also be complemented by policies that specifically target infrastructure investment and R&D. The transition to a low-carbon economy will require substantial financing and both the public sector and the private sector will be important in driving the change. The transition to a low-carbon economy will also need to be just and fair. The impact of taxation and subsidies should be progressive in order to mitigate the effects on those most affected by environment-related policies but least able to cope with them. Understanding public attitudes towards climate change and policies to mitigate climate will be key in building support and maximising policy effectiveness.

The role of the state will need to be larger in Estonia. Even in a low-tax market-based economy such as Estonia’s, the state will need to play a larger role in getting to net zero GHG emissions by 2050. This is because there are market failures associated with climate change. The social costs of carbon-intensive activities are not fully reflected in private costs and investment in certain areas such as basic R&D and infrastructure might be too low if left to the private sector alone. To correct these market externalities, carbon-based prices should be widened and increased while the public sector should spend more on basic R&D. The net effect on public finance is ambiguous. Carbon-related taxation and subsidies can be designed in a revenue-neutral way through targeted redistribution of tax revenues. Moreover, to the extent that it is financed through higher debt, investment in R&D and infrastructure should yield a positive return in the long run especially given the current historically low costs of finance.

The key policies suggested in this chapter could amount to around 3% of GDP per year by 2050. Widening carbon pricing to include the remaining 30% of unpriced CO₂ emissions and pricing them at EUR 5 per tonne of CO₂ would amount to 0.2% of nominal 2019 GDP per year. But to fully meet the commitment under the Paris agreement, carbon pricing would need to be at least EUR60 per tonne. Increasing the carbon price EUR60 of Estonia’s CO₂ emissions that are currently priced below EUR60 would amount to another 1.8% of nominal 2019 GDP per year. Such carbon price increases apply to all sectors except the road sector where current carbon prices are well in excess of EUR60 per tonne of CO₂. The tax revenues raised could then be recycled and redistributed to target those households that are affected but much less able to adjust. This could be done through lump-sum transfers, lower taxes for those groups or active social and labour market policies, for example. Part of the additional carbon tax revenue could also be invested in low-carbon projects. Additional and targeted R&D spending would require at least another 1% of GDP per year to bring it in line with OECD average of 2% of GDP and close to strong performers like Denmark. Overall, these estimates suggest the net investment in the Estonian economy could be around 3% of GDP per year although this is subject to lots of uncertainty and there are upside risks. This estimate does not include additional infrastructure investment or the potential cost of stranded assets in the event of an accelerated transition to a low-carbon economy. This can push up the cost of the transition. The impact on public finances could be smaller, though. Carbon-taxes can be designed to be neutral as higher tax revenues are redistributed. At the same time, the increases in R&D and higher investment infrastructure is likely to be covered by EU funds implying little additional pressure on public finances. Nonetheless, the precise effect of carbon prices and environmental regulation on GHG emissions reduction is uncertain and the nature of the low-carbon transition might require more investment to be made at an earlier stage. It will be important to recognise these uncertainties and maintain a flexible policy approach.

This is consistent with Estonia-specific estimates of the amounts investment required for the low-carbon transition. The top-down estimates of around 3% of GDP per year presented above are on the same order of magnitude as bottom-up SEI estimates of investment required to reduce GHG emissions in Estonia. Based on specific projects across different sectors in the economy, the SEI estimated that total investment in Estonia would need to rise by an annual 4% of GDP in 2021-30 before gradually falling to an additional 1% by 2050. The SEI targets net zero emissions by 2050. Of course, there is considerable uncertainty around these estimates. It is unclear what levels of average effective carbon tax rate are needed to significantly reduce emissions and the required investment in low-carbon projects might be higher than anticipated, particularly over the next decade.

Public support for comprehensive and significant environment-related policies is crucial for the low-carbon transition. Estonian attitudes towards the environment are generally positive. In 2020, 95% of Estonians were interested in information about the environment and 83% appeared concerned about some environmental issues (MoE, 2020). Around 80% of Estonians consider themselves environmentally aware. However, there is not always a clear understanding of the links between personal behaviour and the impact on the environment. For example, Estonians’ behaviour is more related to dealing with the consequences of environmental harm, such as sorting waste, rather than preventing further environmental damage through changing consumption behaviour (MoE, 2020). These results are partly echoed in an OECD cross-country survey which suggests that, across Germany, Denmark, France and the US, most people believe climate change is an important problem but do not think that it will have a negative impact on their lives. There is limited willingness to adopt a sustainable lifestyle. Public support seems to be largest if revenues are used to fund low-carbon infrastructure and to subsidise low-carbon technologies. Support can be higher in urban areas than rural areas (Dechezlepretre and Kruse, forthcoming). Understanding public acceptability of environment-related policies is key to taking effective policy action. It will be important to continue studying such attitudes in Estonia in order to better inform and prioritise environment-related policies. This can then allow policies to address potential obstacles and to build widespread support.

MAIN FINDINGS	RECOMMENDATIONS (KEY RECOMMENDATIONS IN BOLD)
Carbon pricing in the economy
Estonia’s pricing of greenhouse gas emissions has been incomplete and prices in some sectors have been too low to effectively discourage carbon-intensive economic activities.	Ensure comprehensive carbon pricing across sectors. Gradually increase effective carbon prices in the medium term while mitigating the impact on vulnerable groups.
Transforming the energy sector from brown to green and managing the transition
Estonia has a relatively carbon intensive economy among OECD countries. The energy sector in Estonia accounts for a large share of the country’s greenhouse gas emissions. Fossil fuels and oil shale, in particular, are prevalent in Estonia’s energy production.	Reduce oil shale output over time as planned but mitigate the social impact on the Ida-Viru region through a funded comprehensive and long-term development plan. Use regional development policies to incentivise and support new industries in Ida-Viru, particularly those that capitalise on existing capital and labour resources. Deploy targeted active labour market policies to retrain and reallocate workers in the oil shale industry. Provide extended income support to those workers during the transition to prevent a rise in poverty.
The use of woody biomass is important but sources of renewable energy should be further diversified.	Encourage private investment to shift district heating, where appropriate, towards new technologies in the medium-term, such as large capacity heat pumps, that can also utilise other renewable energy sources.
So far, wind and solar energy have accounted for a small share of Estonia’s renewable energy but they have a large potential to grow. Several restrictions have limited the growth of wind power as well as solar power.	Provide a more certain regulatory and business environment through clear and definitive spatial plans and permitting processes.
Electrification of energy demand and a renewable energy supply will require a strong electricity network. The importance of balancing power and regional cooperation will increase.	Invest to strengthen and expand the electricity grid, based on cost-benefit analysis. Continue with implementing investment plans by Elering, the transmission service operator, that develop and strengthen energy infrastructure in a cost-effective manner.
Future electricity production will be more volatile.	Continue and enhance regional cooperation to ensure sufficient electricity generation and to avoid volatility in the network by ensuring a stable and secure energy supply.
Estonia’s investment in R&D is low but technological innovation will be key to getting to net zero and transitioning to a low-carbon economy.	Further encourage low-carbon technology innovation by expanding public R&D investment and by increasing the share of funding on environment-related issues. Focus public research on environment-related issues. Support deployment of new technologies.
Reducing transport emissions
Transport emissions have increased since 2005. This has been driven by a rise in passenger car transport. The car stock is relatively old and fuel inefficient.	Provide and encourage the development of user-friendly and low carbon alternatives to private car use by making active mobility, public transport, low-carbon shared mobility more attractive and adapt land management in order to reduce the need for private car use.
The uptake of low-carbon vehicles is low relative to other European countries.	Broaden subsidies for EV purchases, up to a limit, and offer a scrappage bonus for old cars. Boost investment in charging infrastructure. Electrify public transport, including rail, and consider expanding the regional and national public transport network. Accelerate the adoption of sustainable biofuels such as biomethane.
Increasing buildings’ energy efficiency
The buildings sector accounts for a significant share of total energy demand in Estonia. Estonia’s residential building stock is comparatively energy inefficient. The pace of renovation is too slow and below the targeted rate.	Provide more extensive financing and counselling support for renovations and retrofitting through KredEx. Focus on the least energy efficient buildings, where appropriate, while considering the impact on vulnerable households.
Skills and competences to improve energy efficiency in the buildings sector are in short supply.	Increase the supply of skilled construction workers through increased training provision. Consider boosting labour market participation and/or increasing immigration to ensure adequate supply of required skills.

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