copy the linklink copied!Chapter 3. Towards green growth

Latvia has managed to decouple several environmental pressures from its sustained economic growth, although challenges remain. It has significant opportunities for accelerating the transition towards a low-carbon, greener and more inclusive economy. This chapter analyses progress in using tax policy to pursue environmental objectives, as well as the steps taken to reform environmentally harmful subsidies. It also discusses public and private investment in low-carbon energy and transport infrastructure and services. The chapter examines the country’s eco-innovation performance and opportunities for the green industry. Finally, it briefly reviews progress in mainstreaming environmental considerations into development co-operation.

    

“The statistical data for Israel are supplied by and under the responsibility of the relevant Israeli authorities. The use of such data by the OECD is without prejudice to the status of the Golan Heights, East Jerusalem and Israeli settlements in the West Bank under the terms of international law.

copy the linklink copied!3.1. Introduction

Latvia has a small open economy, with a small industrial base and a large agriculture and forestry sector. The economy has grown strongly since 2010, with annual average growth rates above 3%. However, growth is expected to slow down to 2.7% in 2020 (OECD, 2019a). Convergence with more advanced OECD economies is far from accomplished. Real income and well-being increased over the past decade, but gross domestic product (GDP) per capita is still much lower than the OECD average. Unemployment, poverty and inequality remain high. The population has been declining and ageing, and regional disparities persist with regards to access to public services (Chapter 1).

Progress has been made in decoupling economic growth from environmental pressures such as emissions of greenhouse gases (GHGs) and most air pollutants. Use of renewable energy sources has increased. Access to and quality of water and waste services have improved (Chapter 1). However, some environmental pressures are likely to increase with sustained economic growth and rising income levels. These include emissions of GHGs and air pollutants from transport and agriculture; waste generation (Chapter 4) and use of fertilisers and pesticides; and pressures on biodiversity from changes in land use and intensive farming (Chapter 5).

Latvia is on a good pathway towards reaching many of the Sustainable Development Goals (SDGs) (OECD, 2019b). It has significant opportunities for accelerating the transition towards a low-carbon, greener and more inclusive economy, especially by investing in energy efficiency, renewables, sustainable forestry and sound waste and material management. To seize these opportunities, it should make better use of economic instruments, remove potentially perverse incentives and improve the quality of its environment-related infrastructure and services. Sustaining growth in the long term will also require more investment in education and innovation to further diversify exports towards products and services with higher technological content and value added (OECD, 2019c).

copy the linklink copied!3.2. Framework for sustainable development and green growth

Latvia has a well-developed and comprehensive framework for sustainable development. It is defined by law, and adopts the principle of vertical (hierarchical) and horizontal co-ordination of planning documents.1 The Sustainable Development Strategy of Latvia until 2030 (Latvia 2030) is the highest-level and longest-term development planning document. The strategy includes long-term priorities, goals and action lines, and is broadly consistent with the SDGs. It is based on a capital approach to sustainable development, which primarily focuses on wealth creation within the planet’s ecological limits, with an emphasis on the correlation between environmental and economic systems.

Latvia 2030 has a higher political standing than the previous sustainable development strategy. It is the result of a multi-stakeholder participatory process and was adopted by the parliament in 2010. The broad public participation helped the strategy gain the legitimacy of a social contract and the broad support needed for its implementation. The Cross-Sectoral Coordination Centre under the Prime Minister’s Office co-ordinates its implementation, and the Parliamentary Commission on Sustainable Development oversees progress (Chapter 2). All these are welcome changes from the previous strategy, which was approved by the government in 2002 and overseen by the environment ministry.

The seven-year national development plans (NDPs) include the main policy objectives, outcome indicators and indicative financing for most sectors of the economy. The latest NDP covers 2014-20 and is linked to the EU fund planning period. Sectoral policies, guidelines and plans, such as for transport and energy, also address sustainable development objectives.

The Cross-Sectoral Coordination Centre periodically reviews progress towards the objectives set in Latvia 2030 and the NDP 2014-20. The latest assessment of Latvia 2030, conducted in 2017, identifies a few areas where more efforts are needed to meet the goals. These include energy efficiency, waste separate collection, monitoring and inspection capacity, research and innovation, and co-operation among local governments. In addition, in 2018, Latvia submitted its voluntary review on SDG implementation to the UN High-level Political Forum on Sustainable Development (Box 3.1).

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Box 3.1. Voluntary national review of SDG implementation

Latvia’s 2018 voluntary national review of SDGs was based on a mapping of the SDGs within Latvian policy, the midterm impact assessment of the NDP 2014-20 and a wide array of indicators. According to the review, all SDGs are being integrated into the planning system and Latvia is making progress towards achieving them. The report emphasises that the country needs to seize the economic, environmental and social opportunities of moving towards a circular economy, enhancing innovation and eco-efficiency, reducing inequality and improving access to education and health.

The review identifies several areas for action, including:

  • increasing productivity of the economy, including through more efficient use of resources and larger investment in research and innovation

  • improving labour market performance

  • improving the health care and social welfare systems

  • improving service provision to low-density areas, including road infrastructure, public transport and housing

  • adapting to climate change, reducing GHG emissions and promoting wider use of renewable energy sources.

Source: Cross-Sectoral Coordination Centre (2018), Implementation of the Sustainable Development Goals.

Despite a robust framework, it is not always clear how Latvia 2030 and the NDPs ensure coherence among policies. Integration of environmental considerations in sectoral policies is more advanced in some areas, e.g. energy, than in others. There is scope for enhancing environmental mainstreaming in the post-2020 planning cycle, as well as in sectoral policies such as those on agriculture, forestry, industry and transport.

The law-enshrined 2030 horizon of the development planning framework is too short to allow for the radical economic and societal changes implied by the Paris Agreement. For example, there is no statutory place for the Low Carbon Development Strategy to 2050 (expected to be approved by the end of 2019) within the current development planning framework.

copy the linklink copied!3.3. Greening the system of taxes, charges and prices

Latvia has extended the use of economic instruments to put a price on environmental externalities and encourage efficient use of natural resources. Like many OECD countries, it applies energy and vehicle taxes. It puts a price on carbon dioxide (CO2) via a carbon tax and participation in the EU Emissions Trading System (EU ETS). It has also long applied a wide range of levies on pollution and resource use. Since the mid-2010s, the government has increased several tax rates, removed or reduced some tax exemptions and reformed vehicle taxation. However, the carbon price signal is weak and tax rates are generally too low to encourage changes in production and consumption behaviour.

3.3.1. Environmentally related taxes: An overview

Latvia adopted a major tax reform in 2017, aiming at improving competitiveness, reducing income inequality and increasing tax revenue. The tax/GDP ratio was 30% in 2017, below the OECD average of 34% and the government objective of a third of GDP. Widespread informal activity and low tax compliance limit Latvia’s tax revenue. The tax system relies on consumption and labour taxes. The system is not progressive enough, with particularly high labour taxes on low-income earners, which exacerbate poverty and inequality. The 2017 tax reform lowered personal and corporate income taxes and raised excise duties, including on energy products. However, it appears to be insufficient to achieve the stated goals (EC, 2018a; OECD, 2019c).

Revenue from environmentally related taxes is high by international comparison.2 In 2016, it accounted for 12.6% of total tax revenue and 3.8% of GDP, the second and third highest levels in the OECD (Figure 3.1). Like all OECD countries, Latvia collects most environmentally related tax revenue through taxes on energy products (82%) and motor vehicles (14%). Pollution and resource taxes account for the remaining revenue. They are all part of the natural resource tax, in place since 1991. It includes a carbon tax and levies on air emissions, water abstraction, water/soil pollution, waste and packaging materials (Section 3.3.5).

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Figure 3.1. Revenue from environmentally related taxes is high by international comparison
Revenue from environmentally related taxes, top OECD countries
Figure 3.1. Revenue from environmentally related taxes is high by international comparison

 StatLink http://dx.doi.org/10.1787/888933969392

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Figure 3.2. Vehicle sales and diesel use have driven environmentally related tax revenue
Figure 3.2. Vehicle sales and diesel use have driven environmentally related tax revenue

 StatLink http://dx.doi.org/10.1787/888933969411

There is room to further increase the rates of environmentally related taxes while reducing the tax burden on labour and providing targeted support to low-income households. A 2016 study suggests that, in a best-case scenario, environmentally related taxes could generate additional revenue equivalent to 1.07% of GDP in 2020 and nearly as much in 2035. At the same time, they could generate environmental benefits equivalent to 0.3% of GDP by 2030. Raising fuel tax rates would add revenue of EUR 100 million in 2030 (at 2015 prices) or 0.25% of GDP (EC, 2016). Additional revenue could also come from further raising the natural resource tax rates (Section 3.3.5), introducing taxes on pesticides and fertilisers, including environmental costs in road tolls for heavy goods vehicles and extending them to passenger vehicles (Section 3.3.4).

Latvia needs to raise more revenue to finance its high spending needs (including for infrastructure investment, education and health) while further reducing the tax burden on low-income households (OECD, 2019c). Expanding the use of environmentally related taxes could help achieve both goals, in addition to their main objective of encouraging more efficient use of energy, materials and natural resources.

3.3.2. Taxes on energy use and carbon pricing

Like many other EU countries, Latvia puts a price on CO2 emissions via a carbon tax, energy taxes and participation in the EU ETS (Section 3.3.3). However, the carbon price signal is weak. Most CO2 emissions are priced relatively low or not at all. Increasing the carbon price signal would help Latvia move towards the EU common goal of reducing GHG emissions by between 80% and 95% by 2050 from the 1990 level.

Carbon tax

A carbon tax applies to energy used at stationary facilities outside the scope of the EU ETS, i.e. primarily small heating, industrial and commercial facilities. The carbon tax is part of the natural resource tax (Section 3.3.5). The rate of the carbon tax increased from EUR 2.85 per tonne of CO2 (t CO2) in 2014 to EUR 4.5/t CO2 in 2017. However, it remains well below a conservative estimate of the social cost of CO2 emissions, EUR 30/t CO2 (OECD, 2018a). Emissions from peat combustion are exempt. The exemption is not justified from an environmental point of view and should be removed, as peat is a non-renewable fuel with high carbon content. Emissions from biomass combustion are also exempt; the rationale is that biomass is a carbon-neutral renewable source over its lifecycle, but there is increasing scientific and policy debate on this (OECD, 2018a).

Latvia should gradually raise the rate of the carbon tax on smaller heating, industrial and commercial facilities. It could consider extending the tax to petrol and diesel so that transport fuel taxes explicitly include a carbon component, as in other OECD countries (e.g. France, Ireland and the Nordic countries). It could also consider extending the carbon tax to emissions from biomass combustion after assessing the economic, social and environmental impact of such a move.

Taxes on energy products

Latvia applies an energy tax on road fuels (petrol, diesel, liquefied petroleum gas) and on fuels used at stationary facilities (e.g. natural gas). All tax rates are above the minimum rates required by the 2003 EU Energy Tax Directive, but rates on electricity and fossil fuels used at stationary facilities are among the lowest in the EU. In terms of energy content of fuels, Latvia applies higher tax rates on transport fuels than on those for heating and process purposes. This is common to all OECD countries, and is justified by the higher environmental and social costs of road transport (OECD, 2018b).

After several years of constant rates, in 2015 the government launched a series of tax rate increases to take effect in 2016, 2018 and 2020. These adjustments are part of a broader tax reform and are in line with the rates recommended by the World Bank’s review of Latvia’s tax system (World Bank, 2016). However, the rates for heavy fuel oil and marked mineral oils for heating have remained unchanged since at least 2010.

Tax rates on energy products do not fully reflect the estimated environmental cost of energy use, including CO2 emissions. The excise duty on diesel is still well below that on petrol, despite diesel’s higher carbon content and local air pollution cost. Even after increases, the energy and carbon tax rates are relatively low and fossil fuel use in some sectors is partially or fully exempt (Section 3.4.1). Effective tax rates on CO2 emissions from energy use in road transport are the lowest in OECD Europe, and those on emissions from other energy uses are among the ten lowest in OECD Europe (Figure 3.3). These effective rates, however, do not take into account the effect of the EU ETS on carbon pricing (Section 3.3.3).

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Figure 3.3. Effective tax rates on CO2 emissions are low
Average effective tax rate on CO2 emissions in the road and non-road sectors, 2015
Figure 3.3. Effective tax rates on CO2 emissions are low

 StatLink http://dx.doi.org/10.1787/888933969430

The carbon price signals delivered by carbon and energy taxes and the EU ETS are weak. OECD (2018a) estimates that, accounting for both energy taxes and the emission allowance price, 55% of CO2 emissions from energy use face some kind of carbon price signal in Latvia. This share is the fifth lowest in the OECD, after Australia, Chile, Turkey and the USA. One reason is the high share (34%) of energy sourced from biofuels (mainly fuelwood), which are mostly not taxed.3 In addition, only about a quarter of CO2 emissions from energy use face a carbon price of EUR 30/t CO2 or above. They include nearly all emissions from road transport and 1% of emissions in the residential and commercial sectors. All emissions from electricity and heat generation and from industry face a lower carbon price or are not priced at all.

Latvia should consider reducing tax exemptions and further raising the energy tax rates to reflect environmental and climate damage from energy use. A higher price on carbon emissions would help the country increase efficiency of energy use, promote investment in renewables and expand the market opportunities of low-carbon technology, goods and services. It would also bring co-benefits, for example through reduced air pollution from energy use.

Higher tax rates on diesel and petrol would provide an incentive for drivers to reduce fuel consumption and hence CO2 emissions. To the extent that this happens through reductions in distance travelled, other social costs (e.g. local air pollution, congestion, accidents and noise in transport) could also decrease (Harding, 2014).4 Raising the cost of diesel would help counteract the progressive dieselisation of the car fleet and the gradual shift of freight from rail to road, with the associated potential increase in GHG emissions.

In raising petrol and diesel tax rates, Latvia needs to assess and address the potential for fuel tourism and smuggling. This is especially true for neighbouring non-EU countries (e.g. Belarus and Russia), which do not have to meet minimum energy tax rates (World Bank, 2016). Latvia should also consider the impact of raising taxes on lower-income households and other vulnerable population groups (Section 3.3.6).

3.3.3. Carbon pricing through the EU Emissions Trading System

The EU ETS covers a small share of Latvia’s emissions due to the country’s economic structure and biomass-based energy mix. The EU ETS allowance price covers more than a quarter of Latvia’s emissions in the industry sector and nearly two-thirds of emissions in the electricity sector. This compares, for example, to 33% of industrial emissions and 88% of electricity generation emissions in Estonia, or 74% of industrial emissions and 94% of electricity emissions in Poland (OECD, 2018a).

In the first two trading periods (2005-12), Latvia was consistently granted more emission allowances than actual emissions (Figure 3.4). The supply of allowances dropped in the third period (2013-20), with the tightening of the EU-wide emission cap, the extension of auctioning and the backloading of allowances. As in most other countries, companies in Latvia have since experienced a deficit of allowances in the energy sector and a surplus in manufacturing (Figure 3.4).

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Figure 3.4. The surplus of EU ETS allowances has dropped since 2013
Freely allocated allowances to Latvia’s installations and verified emissions
Figure 3.4. The surplus of EU ETS allowances has dropped since 2013

 StatLink http://dx.doi.org/10.1787/888933969449

As in all countries, Latvia’s manufacturing sector continues to receive a share of allowances for free to address carbon leakage concerns (EEA, 2016). However, the impact of carbon pricing systems on competitiveness is generally limited. It does not substantially differ between firms that benefit from preferential treatment (such as free allocations) and those that do not (Arlinghaus, 2015). In addition, free allocations can create windfall profits for carbon-intensive industries and can skew investment decisions towards carbon-intensive technology (OECD, 2017a). Dechezleprêtre, Nachtigall and Venmans (2018) found that the effect of the EU ETS had been limited on European installations that received generous allocation of free allowances. These installations had reduced emissions little if at all.

Oversupply of allowances, free allocations and low carbon prices in the market have limited the effects of the EU ETS on low-carbon investment in Latvia’s energy and manufacturing sectors. Since 2010, energy use and related CO2 emissions in industry have been growing faster than prior to the 2008-09 recession. Emissions from power and heat generation have declined since the mid-2000s, with a shift to renewables, namely biomass and waste. However, factors other than the EU ETS have likely played a major role in this fuel switch, notably support to renewables (Section 3.5.3).

Latvia has been a seller of international carbon credits. The government has collected revenue from these sales, as well as those for auctioning EU ETS allowances, in green investment funds. The Climate Change Financial Instrument collected the proceeds of the sales of the assigned amount units (AAUs) under the Kyoto Protocol. Latvia received an excess of more than 40 million AAUs. Revenue from auctioning EU ETS emission allowances feeds Latvia’s Emission Allowance Auctioning Instrument (EAAI). Both funds support investment in climate change mitigation and adaptation. In particular, the EAAI focuses on energy efficiency in buildings, a choice common to many countries participating in the EU ETS, such as Estonia, France, Greece and Italy. Earmarking allowance auction revenue for funds devoted to climate mitigation can help build support for stronger carbon pricing and secure reliable, sufficient resources. However, constraints on revenue use should be transparent, broad and flexible to ensure efficiency of revenue allocation in the long term (Marten and van Dender, 2019).

3.3.4. Transport-related taxes and charges

Vehicle taxes

In 2017, Latvia restructured the annual tax on cars and linked it to CO2 emissions. The tax rate increases with CO2 emission levels per kilometre.5 In association with this change, the vehicle registration tax, paid upon registration of a vehicle in the country, was removed. The new system applies to cars registered since 2009. Older cars pay the tax according to the old system, i.e. based on weight, engine volume and power. The tax on heavy goods vehicles increases with their weight and does not consider environmental parameters.

The new car taxation system is a step forward, as it aims to encourage renewal of the car fleet with more fuel-efficient vehicles. The previous system had not been effective in this respect: the vehicle fleet is particularly old and energy intensive. Close to 80% of the passenger vehicle fleet is over ten years old. Newly registered cars in Latvia are the second most carbon-intensive cars in the EU, after those registered in Estonia (Chapter 1).6

Road transport is a major source of GHG and air pollutant emissions (Chapter 1). The number of cars per capita is among the lowest in the OECD, but is expected to grow with rising income levels. Vehicle registrations have increased in line with economic recovery since 2010, and are expected to increase further (Figure 3.2). Vehicle taxes and road charges (see below) could foster renewal of the fleet with more fuel-efficient and less emitting vehicles. However, a vehicle tax based exclusively on CO2 emissions, without consideration of local air pollutants, can stimulate further dieselisation of the fleet, with adverse effects on urban air quality (EEA, 2018), as happened in Ireland (Ryan et al., 2019). Chile and Israel have implemented vehicle tax systems that consider both fuel economy and air pollutant emissions (OECD, 2016; OECD/UN ECLAC, 2016). The taxation of heavy goods vehicles should also take these aspects into account.

Tax treatment of company cars

Latvia is among the few EU countries not taxing benefits from personal use of company cars. This results in an estimated annual subsidy of about 35% of the company car price, the second highest in the EU after Bulgaria (EC, 2017a).7 Therefore, it is attractive for employees to be paid part of their salary in the form of company cars. In addition, fuel costs paid by the employer do not increase the employee’s taxable income. As a result, there is no incentive for employees to limit the use of company cars.

Since 2011, a company car tax based on engine capacity has applied at the company level. Electric vehicles benefit from a reduced rate. This does not provide sufficient incentive to companies to choose less emitting vehicles for their fleets. A tax based on CO2 emissions, as in Hungary, would provide a better incentive (OECD, 2018c).

In addition to burdening the public budget, the favourable tax treatment of company cars tends to encourage private car use and long-distance commuting. It can result in increased fuel consumption, GHG and local air pollutant emissions, noise, congestion and risk of accidents (Roy, 2014). This adds to problems related to disorganised suburbanisation around Riga and difficult access to public transport in many peripheral areas (Section 3.5.4). The policy runs counter to Latvia’s objectives of climate mitigation and air quality improvement in major cities and should be reconsidered.

Road pricing

A system of road pricing has been in place on main roads since 2014. The road user charge (Eurovignette) is paid only by commercial vehicles with gross weight exceeding 3 tonnes. It is partly based on test-cycle engine emission levels (Euro standards), although the differentiation is not very pronounced. The charge is time-based (with daily, weekly, monthly and annual tolls) and does not change with distance travelled. The Eurovignette does not apply to passenger vehicles. The road charge revenue is used for maintenance, upgrade and extension of the road network.

Latvia should adjust road tolls for heavy goods vehicles to take account of distance travelled, in addition to the emission standards applied. It should also extend road tolls to passenger vehicles. In addition, introducing congestion charges in major cities would help put a cost on travel during peak periods and encourage a shift to public transport. A seasonal charge is in place in the seaside resort city of Jūrmala (Box 3.2). Where concerns over equity arise social transfers could be used to partly compensate for road charges.

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Box 3.2. Seasonal local charge in Jūrmala

The seaside resort of Jūrmala applies a seasonal local charge of EUR 2 on vehicles entering the so-called special zone from April to September. The special zone includes the city centre, with cultural and historical buildings, as well as recreational and resort infrastructure. The charge aims to limit transit through the city and promote public transport use. The estimated 2018 revenue was nearly EUR 3 million. The revenue is used for a variety of purposes, including tourism promotion and environmental protection.

3.3.5. Taxes and charges on pollution and resource use

Latvia has applied a broad-based tax on pollution and natural resource use, the so-called natural resource tax, since 1991. The tax applies to a wide variety of pollution, goods and activities, including water and natural resource extraction, water and air pollution, CO2 emissions, waste disposal, packaging materials and environmentally harmful goods such as oil, tyres and electric appliances.8 Similar wide-ranging pollution taxes have long been in place in other countries in Central and Eastern Europe, such as Estonia and Hungary (OECD, 2017b; OECD 2018c).

Revenue from the natural resource tax has hovered around 3% of environmentally related tax revenue over the last five years. Part of the natural resource tax revenue is redistributed to the municipalities where the resource extraction, landfilling or polluting activity take place, and is allocated to special environmental protection budgets. This may help improve local acceptability of potentially environmentally harmful facilities and help municipalities fund environmental protection expenditure. However, this arrangement can also reinforce regional inequality, and earmarking can create budget rigidity.

Latvia has regularly increased the rates of several components of the natural resource tax, but the rates are still relatively low to encourage change in consumption and production behaviour (Jurušs and Brizga, 2017). The latest major revisions took place in 2014 and 2017, when most rates were raised by between 20% and 25%. However, some tax rates have been stable for several years: for example, those for extraction of several natural resources, including peat, and for water pollution and emissions of most air pollutants. Latvia should consider raising the rates on ammonia and nitrogen oxides, for which the country is not on track to reach the 2020 and 2030 targets (Chapter 1).

Several exemptions have hindered the environmental effectiveness of the natural resource tax and reduced its revenue to about one-tenth of what it could be. An exemption applies to packaging materials and environmentally harmful goods for companies that join extended producer responsibility systems and meet their recycling and recovery targets. The exemption has helped expand participation in such systems to over 90% of regulated companies and improve recycling and recovery (Chapter 4). However, it does not stimulate companies to go beyond the targets, nor does it sufficiently encourage waste prevention. An ongoing review of the natural resource tax legislation aims to link exemptions to stricter performance requirements.

The impact of the natural resource tax has been generally limited (Jurušs and Brizga, 2017). The tax mainly acts as a fine. Standard rates apply where best available techniques are used or operations are in accordance with licensing conditions. Until 2018, rates increased tenfold in cases of non-compliance. Then, however, the penalty was reduced to twice the standard rates, due to persistent monitoring and enforcement problems: operators would go bankrupt rather than pay (Chapter 2). Overall, the natural resource tax has been used mainly as a revenue source rather than an incentive to reduce pollution and use resources more efficiently.

3.3.6. Distributional implications of environmentally related taxes

Particular consideration should be given to the potential adverse impact of tax increases and exemption removals on low-income households and other vulnerable groups. Households bear a third of the burden of environmentally related taxes, contributing 31% of fuel tax revenue and nearly half of vehicle tax revenue, though they are less exposed than businesses to pollution and resource taxes (Figure 3.5).

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Figure 3.5. Households bear most of the environmentally related tax burden
Revenue from environmentally related taxes by sector, 2016, EUR million
Figure 3.5. Households bear most of the environmentally related tax burden

 StatLink http://dx.doi.org/10.1787/888933969468

Affordability of household energy is still an acute issue in Latvia, as in other Central and Eastern European countries. A relatively large share of the population may be vulnerable to energy tax and prices increases. In 2017, 12% of households were in arrears on utility bills (including electricity and heat), more than in the other Baltic states and above the EU average of 7%. In 2018, 7.5% of households were unable to heat their homes adequately. This is in line with the EU average, but more than twice the shares of most other northern European countries.9 The low thermal efficiency of pre-1990 apartment buildings and lack of metering contribute to energy affordability risks. Often there is no possibility of regulating indoor temperature and heat consumption, and apartments are overheated. Heat supplied to each building is billed to individual apartments in proportion to their size. In addition to being a disincentive for energy savings (Section 3.5.3), the lack of metering leads to unnecessarily high heating bills (Flues and van Dender, 2017).

Retail transport fuel prices are among the lowest in the EU in nominal terms, but among the ten highest when adjusted for purchasing power parity. Nevertheless, increasing transport fuel taxes could help make the tax system more progressive in Latvia, as in other countries with relatively low GDP per capita (Flues and Thomas, 2015). This is because a certain level of income is needed for a household to afford a car, and poorer households are less likely to use a car. In 2018, 17% of Latvia’s population could not afford a personal car – one of the highest shares in the EU. In Estonia and Lithuania, the corresponding share is 10%.10

Any adverse impact of tax increases on energy prices and vulnerable groups should be addressed through targeted social benefits not linked to energy consumption, such as income-tested cash transfers. Currently, however, reduced electricity tariffs apply to “protected users”, such as those at risk of poverty, families with three or more children and people with special needs. The government could use budget savings from removing energy tax exemptions and subsidies (Section 3.4.1), or additional revenue from increased fuel taxes, to address energy affordability risks (Flues and van Dender, 2017).

copy the linklink copied!3.4. Removing potentially perverse incentives

Like other countries, Latvia provides subsidies that could harm the environment. These subsidies, in the form of direct support or preferential tax treatment, exist primarily in the energy, transport, agriculture and fishing sectors. Latvia’s support to agriculture and fisheries follows the EU frameworks. As in all EU countries, agricultural support is largely decoupled from production or input use, and 30% of the direct payment envelope under the Common Agricultural Policy is allocated to agricultural practices that are beneficial in terms of climate change and the environment. However, Latvia also provides direct support to some sectors and payments based on production volumes and animal numbers. Such support distorts resource allocation, harms long-term agricultural competitiveness (OECD, 2019d) and can encourage overproduction, with a potentially negative environmental impact (Chapter 5). Agriculture and fishing companies also benefit from fuel tax relief. In the energy and transport sectors, most subsidies are provided implicitly through tax reductions.

In general, such subsidies contravene the polluter-pays and user-pays principles. They distort competition, lock in inefficient technology, lead to inefficient allocation of resources and weigh on public finances. The Ministry of Finance has estimated the fiscal impact (revenue losses) on the state budget from environmental tax exemptions and relief since 2011. Latvia could build on this to establish a process for systematic review of environmentally harmful subsidies. It could consider introducing a mechanism to screen all current subsidies and new subsidy proposals against their potential environmental impact. This would improve the transparency of the tax and public expenditure system. It could be the basis for reforms of subsidies and special tax treatment that are not justified on economic, social and environmental grounds.

3.4.1. Fossil fuels subsidies and subsidies for energy use

Latvia provides a high level of support to fossil fuel consumption. When measured as a share of energy tax revenue, the level of fossil fuel consumption support is among the ten highest in the OECD (Figure 3.6). It hovered around 25% of energy tax revenue in 2006-16 except in 2011, when it reached 38.5%. The 2011 peak was associated with a one-off total exemption from the excise duty on natural gas for all users from September 2010 to July 2011. Fossil fuel support has increased since 2005, especially in the form of transfers to producers (Figure 3.7).

The government has made some progress in reducing total exemptions from energy taxes. For example, diesel partially blended with biodiesel has been taxed at the standard diesel rate since 2015; the exemptions on natural gas used in industry and fuels used in agriculture and fishing were replaced by reduced rates. The reduced value added tax on natural gas used by households was discontinued in 2011.

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Figure 3.6. Fossil fuel consumption support is among the highest in the OECD
Fossil fuel consumption support as a percentage of energy tax revenue, top 10 OECD countries, 2016
Figure 3.6. Fossil fuel consumption support is among the highest in the OECD

 StatLink http://dx.doi.org/10.1787/888933969487

However, many other exemptions and reduced rates remain. They include total exemptions on biodiesel fully obtained from rapeseed oil and on fuels used to generate electricity. Reduced tax rates apply to, among others, petroleum, fuel oil and diesel used for heating, natural gas used in industry and diesel used in agriculture (up to a volume that depends on crop type and cultivated area).11

Fuel tourism results in considerable revenue loss (estimated at EUR 23 million in 2016). Oil products that individuals import for their own consumption from non-EU countries are exempt, within the limit of one vehicle standard fuel tank and another 10-litre tank. Since 2012, individuals have been able to benefit from this exemption only weekly instead of daily as before. This is a step towards better controlling fuel tourism, but it needs to be strictly enforced.

Latvia also supports electricity produced using natural gas in energy-efficient combined heat and power (CHP) plants through annual guaranteed payments per megawatt of installed capacity and mandatory procurement of electricity, depending on plant size. The mandatory procurement is financed through electricity bills. The same benefit applies to renewables-based electricity and CHP plants (Section 3.5.5), but natural-gas CHP plants have attracted most of it. Both forms of support have risen sharply over the years (Figure 3.7), raising concerns about the economic sustainability of the support system. The system was put on hold in 2016 and was being revised at the time of writing.

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Figure 3.7. Fossil fuel consumption support has increased
Figure 3.7. Fossil fuel consumption support has increased

 StatLink http://dx.doi.org/10.1787/888933969506

copy the linklink copied!3.5. Investing in the environment to promote green growth

Large amounts of investment helped extend and upgrade infrastructure for transport, energy, water supply, wastewater treatment and waste disposal in the last decade. The public sector has been the main driver of environment-related investment, with major contributions from EU funds.

Latvia needs to upgrade ageing infrastructure and extend access to water, waste and transport services, especially in rural areas. At the same time, a steady population decline means some infrastructure and services will need to be downscaled (EC, 2018a). Low population density makes it costly to provide widespread access to public services and infrastructure, thus contributing to persistent regional disparity. Sprawling urban developments in municipalities that are within commuting distance of Riga add inefficiency to local service provision (OECD, 2017c). Enhancing cost-effectiveness of public spending is essential to ensure access to high-quality services for all.

3.5.1. Public expenditure for environmental protection

Public environmental expenditure (current expenditure and investment) decreased over the last decade. In 2017, it was 0.6% of GDP and 1.5% of total government expenditure, about two-thirds of their levels prior to the global financial crisis (Figure 3.8). Central government expenditure dropped sharply in 2009, due partly to the recession and partly to the allocation of EU ETS allowances to new market entrants (which the national account statistics record as asset dismissal or negative expenditure). Disbursement of EU funds drove public expenditure trends.

As in many other countries, the waste and water sectors traditionally absorb most public environmental expenditure. Expenditure on air pollution abatement and biodiversity protection accounts for a minor share and has declined since 2005 (Figure 3.8).12 Expenditure on environment-related research and development (R&D) has increased in recent years, although from a very low level (Section 3.6).

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Figure 3.8. Public expenditure for environmental protection has decreased
Figure 3.8. Public expenditure for environmental protection has decreased

 StatLink http://dx.doi.org/10.1787/888933969525

Expenditure in the waste sector has considerably increased (Figure 3.8). It helped upgrade the landfill infrastructure and establish separate collection systems for municipal waste. More recent investment has focused on recycling and biogas recovery infrastructure (Chapter 4).

Investment on wastewater management has helped improve the quality of water services and infrastructure and extend access to wastewater treatment facilities (Chapter 1).13 It has decreased in recent years, although needs remain high. In 2015, water utilities of agglomerations with more than 2 000 inhabitants estimated that over EUR 200 million was still needed to renovate and rebuild urban wastewater systems. Water service infrastructure is ageing and in generally poor condition. Access to safe water and sanitation is an issue in rural areas (OECD, 2018d).

Local governments have major responsibilities in providing environment-related infrastructure and services, but their expenditure has hovered between a quarter and a half of central government expenditure (Figure 3.8). This masks significant transfers from the central government budget. Local governments’ responsibilities far outstrip their financial resources (OECD, 2019c). Municipalities largely rely on EU funds for their capital expenditure, as well as on national financial support mechanisms like the EAAI (Section 3.3.3), the Latvian Environmental Protection Fund (LEPF) and the Environmental Investment Fund (LEIF) (Box 3.3). Despite technical assistance provided by the central government, smaller local authorities continue to lack human resources and adequate skills to plan and manage large, complex infrastructure projects.

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Box 3.3. The Environmental Protection and Environmental Investment Funds

The LEPF provides financial support to local governments and non-government organisations for a variety of environment-related projects, especially on environmental awareness and nature conservation. It is funded by the state budget. During the recession, the government cut the LEPF budget by two-thirds, and has not yet restored its pre-recession allocation. The LEPF Administration manages the fund and is accountable to the environment minister. It launches calls for project proposals, assesses and selects them for financing, and monitors implementation of the environmental protection measures and projects funded by the LEPF.

The LEIF operates as a state-owned financial institution. It provides concessional loans for environment-related projects, conditional on the project generating enough income to cover all operating expenses, including repayment of the loan and interest. Projects can target drinking water quality, wastewater treatment, heat production, cleaner production processes, heat insulation of buildings and waste recovery, among other areas. In addition to providing finance, LEIF supports municipalities and companies in project implementation.

European structural and investment funds

Latvia has benefited from considerable financial support from the European Union in the framework of the EU cohesion, rural development and fishery policies. EU funding helped Latvia recover from the recession and comply with EU legislation in the water and waste sectors (Applica, Ismeri Europa and CEA, 2016). Between 2005 and 2017, EU funds financed two-thirds of investment in environmental infrastructure and services (waste, water, nature protection, climate, monitoring, remediation and flood risks).

Over 2007-13, funding allocated to Latvia from the EU Cohesion Fund and European Regional Development Fund averaged 2.6% of annual GDP and 50% of government capital expenditure. Latvia spent all the available funds on time. Investment in transport and environmental infrastructure received the largest shares.14 Most transport-related investment focused on the road network. Environment-related investment focused on the water sector and, to a lesser extent, waste management, with the aim of ensuring compliance with the related EU directives.

Latvia received EUR 5.6 billion under the European structural and investment (ESI) funds for 2014-20.15 This is equivalent to 3% of annual average GDP over 2014-18 and 65% of national public investment (EC, 2018a).16

For 2014-20, nearly 28% of the ESI funds target environmental protection, resource efficiency and climate-related objectives, including in agriculture and fishing. Investment focuses on energy efficiency, use of renewables in district heating, transport, and investments to ensure fulfilment of the EU environmental requirements. Disbursement of the funds in the water sector is conditional on river basin management plans being in place.

By implementing the 2014-20 EU-funded programmes, Latvia expects to reduce GHG emissions by 62 700 t CO2 eq per year. As of end 2018, the projects selected for funding allowed it to achieve a little over a third of the planned emission abatement. Latvia has made rapid progress in achieving several environment-related targets, such as those on improving energy performance of residential buildings and extending organic farming. Progress in other areas has been slower, including in increasing waste recycling and renewables capacity, extending connection to wastewater treatment facilities and improving energy savings in public buildings. There is a need to accelerate implementation of EU-funded investment in these areas.

Latvia should increase financing for public infrastructure investment to complement the EU funds, which will eventually diminish. It should use the funds more effectively to improve environmental performance. Large infrastructure investments should systematically undergo cost-benefit analysis, including environmental costs and benefits. Latvia should also improve the governance of state-owned and municipal enterprises, such as those in the energy, public transport, waste and water sectors, to ensure transparent and cost-effective project selection (OECD, 2017c). This would help improve competition and confidence of private investors. The use of private-public partnerships is in its infancy in Latvia and could be expanded, particularly at the local level, where municipalities face high financial constraints (OECD, 2015).

3.5.2. Business expenditure for environmental protection

Environmental expenditure of businesses has declined since the mid-2000s, especially in terms of investment (Figure 3.9). Business investment decreased by 55% over 2006-17. It accounted for a quarter of environmental expenditure in 2017, down from about half in the years prior to the financial crisis. Over 2005-17, private investment accounted for only 11.5% of Latvia’s total environmental investment. It mostly targeted water resource protection, waste treatment and air protection (Figure 3.9). Current expenditure has increased with economic recovery, especially for managing waste. This reflects progress in setting up extended producer responsibility systems and firms’ increased participation in them (Chapter 4).

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Figure 3.9. Business environmental expenditure has declined and focuses on managing waste
Figure 3.9. Business environmental expenditure has declined and focuses on managing waste

 StatLink http://dx.doi.org/10.1787/888933969544

Latvia’s small and medium-sized enterprises (SMEs) have a low propensity to invest in improving their environmental performance. According to a 2017 Eurobarometer survey, 70% have invested in resource efficiency, in line with the EU average, but most have invested less than 1% of turnover. Latvian SMEs performed below the EU average in terms of actions taken to save energy, use renewables, minimise waste, save and reuse materials, and save water. Survey respondents said the main barriers to taking such actions were complexity of administrative procedures and lack of demand for resource-efficient products or services. Still, such actions helped reduce production costs in 46% of Latvia’s SMEs (EC, 2018b).

The public sector remains the main driver of businesses’ environment-related investment. This indicates that the current policy mix of regulations and market incentives (EU ETS carbon price, carbon tax, fuel taxes, pollution and resource use taxes) has not stimulated business investment effectively. Business investment largely relies on EU funding and national funds (Box 3.3). Businesses have an incentive to postpone investment and wait for funding opportunities. Hence there is a risk of national and EU funds being used for investment that would have been made without public financial support, rather than for financing additional, more productive growth-inducing investment. There is a need to reduce dependence on EU funds and to streamline the multiple fragmented financial support mechanisms available to encourage environment-related investment.

3.5.3. Investment in energy

Investment in renewable energy sources and energy efficiency improvement is at the core of Latvia’s strategy to reduce GHG emissions (Chapter 1). There are several forms of financial assistance for capital investment in renewables and energy efficiency, including through national funds such as the EAAI, LEPF and LEIF (Section 3.3.3 and Box 3.3) and the EU funds.

Renewables

Investment in renewables has increased in the last decade. Latvia is on track to meet its EU target of 40% renewables in gross final energy consumption by 2020.17 In 2017, renewables accounted for 39% of gross final energy consumption (Chapter 1). More use of biomass for heat and power production has been the main driver of growth.

However, Latvia needs to expand the use of renewables other than solid biofuels, especially solar and wind, to attain its 2020 target of nearly 60% of renewables in gross final electricity consumption, set in the National Renewable Energy Action Plan. Solar accounts for a negligible share of energy use. The country’s wind potential, which is considerable, has remained largely unexploited in comparison to other Baltic states, mainly due to public opposition to onshore wind farms and high installation costs of offshore capacity. The Baltic countries could invest in joint projects, including additional interconnectors through offshore wind power sites (Lindroos, T. et al., 2018).

In addition to financial assistance for capital investment, Latvia promoted investment in renewables and high-efficiency CHP plants through a mix of feed-in tariffs (mandatory procurement component or MPC) and guaranteed capacity payments, depending on the size of the plant and the fuel used.18 The difference between the price of electricity produced under the MPC programme and the market price is compensated by electricity users through a component of the electricity tariff.19 The support level depends on the type of energy source used, the installed capacity of the plant, the number of working hours and the natural gas price.

However, the support system was poorly designed, overly generous and not transparent. It resulted in high costs and windfall profits in some cases, mostly because of excess issuance of MPC licences and overcompensation of some beneficiaries (Dreblow et al., 2013; Rubins and Pilvere, 2017). In 2017, its cost totalled nearly 1% of GDP (The Baltic Course, 2018), weighing on business competitiveness and household income. In addition, energy-efficient natural-gas CHP plants were eligible for support and attracted much of it. This resulted in a perverse incentive to further expand fossil fuel use (Section 3.4.1).

These issues led to changes in the calculation of the support amount, the introduction of a tax on subsidised companies’ profits (the so-called Subsidised Energy Tax) and, finally, a moratorium on the support system until 2020. The system was being revised at the time of writing. Latvia needs to quickly restore investor confidence and launch a renewed support system. It should consider more cost-effective and transparent measures to support renewables-based generation, such as competitive tenders and procurement auctions (OECD, 2019c).

Energy efficiency

Latvia has made progress in reducing the energy intensity of the economy. However, final energy consumption per unit of GDP is still above the OECD average. Energy consumption in agriculture, industry and transport has increased, and that of buildings is persistently high. More work is needed to achieve the 2020 energy intensity and energy savings targets of the National Energy Efficiency Action Plan (Chapter 1).

The residential sector is the major energy user, accounting for 30% of total final energy consumption. Most of the building stock is over 25 years old and consists of multi-owner buildings with poor energy performance. Latvia has introduced minimum energy performance requirements for existing buildings and minimum thermal insulation standards. All new apartment buildings and public buildings should be nearly zero energy from 2021.

Since 2007, Latvia has used EU and national funds effectively to upgrade district heating networks and improve buildings’ thermal efficiency. This has contributed to remarkable energy savings, above the EU average (Odyssee-Mure, 2018). Heat consumption per square metre declined by 33% over 2005-16 in the residential sector.

However, investment is needed to expand and renovate district heating networks in some municipalities (PWC, 2016) (Box 3.4). Heat consumption per square metre is among the highest in Europe, well above that of most other northern European countries.20 Heat consumption in apartment buildings is generally metered at building level and allocated and charged to households based on apartment size. Charging for heat based on energy use is essential for achieving energy savings, as the experience of the Czech Republic shows (Flues and van Dender, 2017).21

There is a need to accelerate investment in residential energy efficiency and differentiate the financing sources. The government estimates it would cost EUR 6 billion (more than 20% of GDP) to thermally renovate all apartment building stock. Barriers to private investment include the large numbers of owners per building, the fact that many have low income and limited access to bank credit, the long payback and complexity of energy efficiency projects and a lack of energy efficiency specialists and energy service companies. Instruments such as subsidised loans, credit guarantees and energy performance contracts can help overcome some of these barriers and should be expanded.22 The Development Finance Institution ALTUM has provided these forms of financial support, as well as technical assistance, since 2014.

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Box 3.4. Energy efficiency of district heating

Centralised district heating networks cover nine of the largest Latvian cities. They deliver heat to residential and, to a lesser extent, commercial buildings. Solid biofuels (mostly woody biomass) have been progressively replacing natural gas in CHP plants that supply heat to the district heating networks (Chapter 1). This fuel switch has helped reduce the carbon intensity of heat generation.

Increased efficiency of CHP plants and investment in upgrading district heating networks helped reduce heat losses by 15% between 2010 and 2016, to below 12% of heat generation. This is lower than in neighbouring Estonia and Lithuania, but above the OECD Europe average of 9% and far from best performers such as Sweden (4%). The EU funds for 2014-20 have supported additional upgrade and extension of district heating networks.

Source: CBS (2019), Energy Statistics (database); IEA (2018), “Extended world energy balances (Edition 2018)”, IEA World Energy Statistics and Balances (database).

More work is also needed to improve energy efficiency in industry. The energy intensity of manufacturing industry is well above the EU average and has increased since the end of the economic recession, in contrast with the trends observed in the EU as a whole (Odyssee-Mure, 2019). Energy use in wood processing more than tripled between 2005 and 2016, to reach 60% of total industry use. The 2016 Energy Efficiency Law introduced an energy savings obligation and laid the groundwork for industrial energy efficiency measures, including industrial energy audits and voluntary agreements. Manufacturing companies have access to a wide range of financial assistance through national and EU funds. However, there is a generally low propensity to invest in improving environmental performance, including energy efficiency (Section 3.5.2). Pricing incentives are not strong enough. Industrial firms benefit from free allocation of EU ETS allowances (Section 3.3.3) and a reduced excise rate on natural gas (Section 3.4.1).

3.5.4. Investment in low-carbon transport

Transport accounts for more than a quarter of energy use and GHG emissions. It has traditionally played a large role in Latvia’s economy, thanks to the country’s position at the west-east and north-south crossroads. Transport and logistics account for about 10% of GDP and more than 40% of service exports. However, Latvia ranks last among the countries on the Baltic Sea in terms of perceived quality of transport infrastructure (Table 3.1).

Most transport-related investment in the last decade has focused on the road network. However, the quality of road infrastructure remains particularly poor, with Latvia ranking last among the Baltic and OECD countries (Table 3.1) (WEF, 2017). Most roads are single lane and many are unsafe. Road mortality is among the highest in the OECD.

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Table 3.1. Quality of transport and electricity infrastructure
Ranking of 137 countries, 2017.

 

Transport

Roads

Railways

Ports

Latvia

61

107

29

29

Denmark

20

13

22

10

Estonia

44

38

33

11

Finland

16

21

8

5

Germany

10

15

9

18

Lithuania

50

37

27

39

Poland

59

65

45

64

Sweden

22

18

21

15

Source: WEF (2017), The Global Competitiveness Report 2017-2018.

Latvia has the longest railway network in the Baltic states. It is largely not electrified and most trains run on diesel. In 2018, the government launched the electrification of the main east-west corridor, to be completed by 2030. Rail accounts for more than three-quarters of freight transport, the largest market share in the EU. However, the share has declined in the 2010s to the benefit of road. The role of rail in passenger traffic is low and declining, accounting for less than 5% of passenger travel (Chapter 1).

Latvia has been slow in implementing the recommendation of the 2017 OECD Economic Survey to invest more in upgrading existing roads to make them safer and improve their quality. While this is certainly needed, Latvia should ensure that transport investment priorities are consistent with long-term climate and environmental objectives, and systematically consider environmental costs and benefits in cost-benefit analysis of transport projects. It should accelerate investment in public transport, cycling lanes and pedestrian-friendly infrastructure in urban areas, as envisaged in Latvia 2030 and the Transport Development Guidelines 2014-20.

Public transport

Public transport, including trains and buses, accounted for 18.5% of passenger traffic in 2016. While the share is slightly above the EU average, it has decreased since 2005 in favour of private cars (Chapter 1).

The public transport network is dense in the Riga city centre, thinning out towards the city borders (Yatskiv and Budilovich, 2017). About 15% of the population of Riga proper has no easy access to public transport. In surrounding municipalities, the share can be much higher (OECD, 2017c). There is no integrated public transport system linking Riga to the sprawling municipalities in the surrounding region, where more than half the country’s population lives. People living in newly developed areas around Riga rely on work opportunities in the city. This leads to increasing congestion and pollution around the capital.

Transport planning between Riga and its surroundings is fragmented and does not reflect the metropolitan scale (OECD, 2019c). Latvia 2030 highlights the need for co-ordinated planning of transport infrastructure, public transport and urban development. Integrated route planning, pricing and ticketing across providers and municipalities would help increase public transport use and improve environmental outcomes.

Bus and rail services incur high costs serving sparsely populated areas, especially outside urban areas. Costs are expected to rise with a population that is declining and ageing, and thus has more limited mobility (OECD, 2017c). The state subsidises public transport by covering providers’ operational losses, including those due to reduced tariffs (e.g. for people with disabilities). The experience of some rural regions in other countries (e.g. France, Germany, Spain) shows that transport-on-demand systems could be an effective way to provide transport services in sparsely populated rural areas.23

Use of renewables in transport and electric mobility

Latvia is far from reaching the EU-wide target of covering 10% of energy used in transport with renewables by 2020 (Chapter 1). It exports most of its rapeseed-based biodiesel production. Domestic use is low, partly due to the old vehicle fleet and low mandatory blending requirement (4.5% by volume), which covers biodiesel sales during the warmer months (from mid-April to end-October). An in-depth assessment of the impact of biofuel production and use on the country’s net GHG emissions, biodiversity, water and soil is needed. No sustainability criteria are in place beyond those required by the EU. Latvia has not started to produce second-generation biofuels (e.g. from waste and residues).

There are opportunities to use electric vehicles (EVs) in Latvia, given the high share of renewables (especially hydro) in the electricity generation mix (Chapter 1). However, the impact on the electricity system and tariffs would need to be carefully assessed. The Electromobility Development Plan (EMDP) for 2014-16 and the Alternative Fuels Development Plan for 2017-20 envisage investing EUR 8.3 million (including EUR 7 million in EU funds) to install a network of 150 charging stations along main roads by 2020.24 The number of charging stations grew from just 13 in 2014 to 74 in 2018.

Incentives have encouraged EV sales. They include free parking and bus lane use, as well as economic incentives (EVs are subject to the lowest fee for the annual technical inspection and the lowest company car tax rate). The introduction of an annual vehicle tax based on CO2 emissions in 2017 also helped increase EV sales (Section 3.3.4). In early 2019, about 550 EVs were registered in Latvia, up from fewer than 200 when the EMDP was launched. However, this is still just 0.1% of the vehicle fleet, compared with the EU-wide rate of 1.5%.

EV costs are prohibitively high for much of the population, but the government should refrain from providing direct purchasing subsidies, a measure included in the Alternative Fuels Development Plan 2017–20. Such subsidies would likely benefit well-off people who could afford to buy an EV without public support. Rather, Latvia should continue to invest in extending the charging facility network to increase charging possibilities at night, as most people live in apartment buildings, and alleviate “range anxiety”.25

copy the linklink copied!3.6. Promoting eco-innovation and environmental markets

3.6.1. Innovation policy framework and performance

The innovation framework for 2014-20 comprises several policy documents and strategies, such as the National Industrial Policy Guidelines 2014-20 and the Guidelines for Science, Technology Development and Innovation 2014-20. Measures to foster innovation include grants, financial instruments (e.g. seed and venture capital) and non-financial incentives. Latvia established the Single Technology Transfer Centre as part of the Investment and Development Agency to foster industry-science co-operation and commercialisation of public research.

Despite an increased policy focus and gradual improvement, Latvia’s innovation system and performance are weak. The country has a low rate of public and private R&D investment. Gross domestic expenditure on R&D hovered around 0.5% of GDP in the last decade, about a fifth of the OECD average (2.4%). Government and business R&D expenditure levels have decreased since 2010 and are among the lowest in the OECD.26 The patenting performance is also low. The proportion of tertiary-educated people in the working-age population is below the OECD average (Basic statistics). This, along with workforce ageing and brain drain, limits innovation capacity.

The knowledge intensity of exports is lower than in many advanced OECD economies (OECD, 2017c). Exports are concentrated in industries and activities with relatively little room for quality improvement: largely raw materials and wood and food products, as well as transport services. Business innovation capacity is concentrated in a small number of firms. Latvia should further promote co-operation between firms and research institutions and devote more resources to higher education to improve the skill base (OECD, 2019c). This would help the country further diversify exports towards products and services with higher technology content and value added.

3.6.2. Promoting eco-innovation and green industries

Environment-related R&D, technology and innovation

As in other research fields, the state budget and EU funds are the main sources of funding for environment-related research. Latvia spends 9.5% of its government R&D budget on environment- and energy-related research. This puts it among the top ten OECD countries (Figure 3.10), although in the context of a low overall R&D budget. The share of government R&D outlays for environment- and energy-related R&D grew in the last decade, reaching 5.8% and 3.3%, respectively, in 2017, although the trends are volatile (Figure 3.10).

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Figure 3.10. A large share of public R&D spending goes to environmental and energy research
Government budget allocations for environment and energy R&D, percentage of total
Figure 3.10. A large share of public R&D spending goes to environmental and energy research

 StatLink http://dx.doi.org/10.1787/888933969563

With increased public R&D funding, Latvia has developed a specialisation in environmental technology in recent years. Patent applications for environment-related technology increased from 9% of all applications in 2000-02 to 13% in 2013-15. This is among the highest shares in the OECD, although the absolute number remains extremely modest. Applications related to environmental management and some climate change mitigation technology have increased since the mid-2000s, although not consistently (Figure 3.11).

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Figure 3.11. Green patent applications have grown since the mid-2010s, but the numbers are modest
Patent applications by environmental domain, 2007-15
Figure 3.11. Green patent applications have grown since the mid-2010s, but the numbers are modest

 StatLink http://dx.doi.org/10.1787/888933969582

Markets for environment-related products and services

The environmental goods and services (EGS) sector has grown moderately in Latvia, and seems less developed than in most EU countries. In 2015, environment-related products accounted for some 6% of total exports, about double the level in 2002. The EGS sector accounted for nearly 3% of total value added in 2015. Energy resource management (which includes renewables and energy efficiency) accounted for most EGS value added, followed by waste management, air and climate protection, and forest management (Figure 3.12). In 2015, businesses providing environmental products and services employed about 29 700 people, a 4% increase from 2014. Employment increased in environmental protection activities, particularly those related to air and climate, but declined in resource management sectors, except water management (Figure 3.12). Sectors continuing to develop include renewables, energy efficiency in buildings, forest-based industry, eco-cosmetics, and waste and water management (EC, 2017b).

Compared to the EU average, fewer SMEs design and produce greener products in Latvia. According to a 2017 Eurobarometer survey, 20% of the country’s SMEs offer green products and services, compared to the EU average of 24%. Only 16% of SMEs have taken steps to design products that are easier to maintain, repair or reuse (the EU average is 28%) (EC, 2018b). Only 13 products (all cleaning products) made in Latvia have been awarded the EU eco-label.

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Figure 3.12. The energy sector dominates green industry value added and employment
Figure 3.12. The energy sector dominates green industry value added and employment

 StatLink http://dx.doi.org/10.1787/888933969601

The policy mix for promoting eco-innovation

The main drivers of eco-innovation in Latvia are the energy and resource efficiency targets of the EU’s Europe 2020 strategy and the availability of natural resources such as forests, water and soil (EC, 2017c). Bioeconomy, “smart materials” and “smart energy solutions” are among the focus areas of the Smart Specialisation Strategy. The Bioeconomy Strategy 2030 aims to develop the production and use of bio-resources (such as forest-based products), including by fostering knowledge and innovation (Chapter 4). Some 8% of the EU funds allocated to Latvia in 2014-20 target R&D and innovation, including eco-innovation. The Rural Development Programme 2014-20 supports knowledge transfer and commercialisation in agriculture, forestry and wood processing.

As in most OECD countries, supply-side measures dominate the policy mix for innovation and eco-innovation. They include various forms of financial support to R&D and commercialisation of research results. EU-funded research projects and other donor-funded innovation programmes have helped stimulate production of new environmental technology.

However, innovation capacity of businesses remains generally low. The shortage of highly skilled workers and the small number and size of innovative companies hinder eco-innovation. The multiplicity of financial assistance mechanisms entails relatively high administration and transaction costs. Over-reliance on EU and other foreign financial assistance instruments holds back long-term national policy development (EIO, 2018). Latvia would benefit from streamlining and better targeting financial support for business environmental investment and innovation. It should systematically evaluate the cost-effectiveness of its eco-innovation policy and its contribution to improved environmental performance, resource productivity and energy efficiency.

Low public awareness of sustainable consumption and production results in low demand for cleaner products and services (EIO, 2018). Product price is the dominant driver of consumer choice (EC, 2017b), due to the population’s relatively low income. Thus more work is needed to stimulate demand for greener products and services, for example through green public procurement, eco-labelling, market incentives, awareness raising and better enforcement. Green public procurement amounted to 18% of total public procurement value in 2018. This is not far from the government’s target of 20% by 2020, but the target could be more ambitious (Chapter 2).

copy the linklink copied!3.7. Strengthening international environmental co-operation

3.7.1. Regional co-operation with the Baltic states and Baltic Sea states

Latvia has a long tradition of co-operating with the neighbouring Baltic states of Estonia and Lithuania. For example, an agreement signed in 2010 promotes co-operation in several environmental domains. Environment ministers and senior experts meet periodically. Within the framework of the Council of the Baltic Sea States, Latvia participates in regional activities devoted to SDG implementation under Realizing the Vision: The Baltic 2030 Action Plan. It has also actively participated in EU-funded territorial co-operation programmes, enhancing co-operation with neighbouring EU and non-EU countries.

3.7.2. Mainstreaming environmental considerations into development co-operation

Since 2004, when it joined the European Union, Latvia has substantially increased the volume of its official development assistance (ODA) to 0.11% of gross national income (GNI) in 2017. This puts Latvia at the lower end of OECD countries (second to last, before Israel). Its ODA/GNI ratio falls below the target of 0.33% of GNI by 2030 common to countries that have joined the European Union since 2002. Latvia should consider increasing its ODA volume in line with international goals, notably the 2030 EU target.

Latvia provides most of its ODA via multilateral channels, particularly the European Union (through contributions to the EU budget and the European Development Fund). Its bilateral assistance is concentrated in Eastern European and Central Asian countries (especially Georgia, Kyrgyzstan, Moldova, Tajikistan, Ukraine and Uzbekistan). Latvia’s projects focus on exchange of experiences and know-how.

Bilateral ODA commitments for general environmental protection, renewables and water represented 0.2% of ODA (sectoral allocable aid) in 2016, the lowest share in the OECD. By comparison, the share of committed bilateral aid for these sectors was 3.8% in Estonia and 3.5% in Lithuania. The environment ministry has its own bilateral co-operation agreements, which focus on exchange of best practices and experience on environmental policy and financial mechanisms, waste management, water management, green technology and energy efficiency. Latvia should increase the share of bilateral ODA devoted to environment, taking into account its areas of expertise.

Environmental sustainability, democracy, good governance and gender equality are the horizontal principles of Latvia’s development co-operation. These principles are required to be integrated in all activities financed from the Latvian bilateral development co-operation budget, regardless of sector. The level of integration of the horizontal principles is required to be evaluated in every project proposal.

Latvia is not a member of the OECD Development Assistance Committee (DAC). However, it reports ODA data to the DAC, and its Development Co-operation Policy Guidelines 2016-20 were designed on the basis of DAC recommendations and guidelines. Joining the DAC would help Latvia improve the effectiveness, visibility and coherence of its development assistance activities.

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Recommendations on green growth

Strengthening the strategic framework for sustainable development and green growth

  • Better align the post-2020 NDP, and sectoral policies at large, with environmental and green growth objectives; consider extending the 2030 horizon of development planning to 2050.

Greening the system of taxes, charges and subsidies

  • Implement a green tax reform to provide stronger incentives for sustainable resource use, increase overall tax revenue and reduce the tax burden on low-income households:

    • Continue to reduce tax exemptions and discounts (e.g. on rapeseed biodiesel, as well as on fuels used for agriculture, fishing, electricity, heating and industry production).

    • Further raise energy tax rates and close the petrol/diesel tax gap to adequately reflect environmental damage from energy use, while providing targeted support to vulnerable groups through social benefits not linked to energy consumption.

    • Consider raising the natural resource tax rates on air pollutants on the basis of a cost-effectiveness assessment.

    • Gradually raise the carbon tax rate; remove its exemption on emissions from peat combustion; consider extending the carbon tax to transport fuels and biomass.

    • Revise the vehicle tax to take into account air pollutants in addition to CO2; reform the tax treatment of personal use of company cars and link the company car tax to vehicle emission standards and fuel economy; link taxation of heavy goods vehicles to their environmental performance.

    • Link road tolls for commercial vehicles to distance travelled, in addition to vehicle emission standards; introduce similar road charges for passenger cars.

  • Build on the annual review of the tax exemptions’ fiscal impact to establish a systematic review process on environmentally harmful subsidies.

Investing in low-carbon infrastructure

  • Increase and enhance cost-effectiveness of public spending on environment-related infrastructure; streamline and better target financial support for business environmental investment.

  • Continue to improve residential energy efficiency by i) further scaling up public finance for energy efficiency renovation of buildings; ii) encouraging the use of energy performance contracts, subsidised loans and credit guarantees to foster private investment; iii) investing in training energy efficiency specialists; iv) assisting homeowner associations in the design and management of energy efficiency projects; v) accelerating retrofitting investment on the public building stock; vi) upgrading district heating networks; and vii) extending heat metering and charging heat based on actual use.

  • Review the design of the renewables support system at the earliest opportunity and consider introducing competitive tendering to improve cost-effectiveness.

  • Establish an integrated public transport system, with comprehensive route planning, pricing and ticketing, linking Riga to surrounding municipalities; promote transport-on-demand systems to provide public transport services in low populated rural areas; continue to extend the charging facility network for electric vehicles.

Promoting eco-innovation and green markets

  • Further increase public R&D funding for environment-related innovation and monitor the efficiency and effectiveness of its allocation; strengthen measures to stimulate demand for energy efficient and cleaner products, technologies and services, including green public procurement, eco-labelling, market incentives, awareness raising and better enforcement.

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Notes

← 1. The 2008 Development Planning System Law requires national-level policy initiatives to be in line with hierarchically higher goals and coherent with goals in other plans. Local development planning documents are subordinated to regional documents, and regional documents to national ones.

← 2. Environmentally related taxes are defined as any compulsory, unrequited payment to general government levied on tax bases deemed to be of environmental relevance. Taxes are unrequited in the sense that benefits provided by government to taxpayers are normally not in proportion to their payments.

← 3. Estimates in OECD (2018a) include emissions from biomass combustion in the emission base. This means CO2 emissions from biomass combustion are treated like CO2 emissions from fossil fuel combustion.

← 4. Fuel taxes can help account for local air pollution and other social costs directly or indirectly linked to energy use in transport (e.g. congestion, accident and noise costs). However, other instruments are theoretically more appropriate. Congestion, noise and accident costs are a function of the amount, location and timing of vehicle traffic. Thus they are only indirectly linked to fuel use, as greater fuel use generally reflects increased distance driven. The impact on local air pollution also partly depends on location of vehicle use or emitting facility. In remote or rural areas, for example, higher pollution may have lower health effects than in more populated or urban ones but a higher impact on natural resources and vegetation (Harding, 2014). Countrywide, time- and location-specific road pricing would generally be more cost-effective in addressing congestion, accidents and noise.

← 5. The rates range from zero, for cars with CO2 emissions per kilometre of up to 50 grams, to EUR 756, for cars with CO2/km above 351 grams.

← 6. In 2016, the average emissions of newly registered passenger cars in Latvia amounted to 128.9 grams of CO2/km, compared to the EU average of 118 g CO2/km (EEA, 2018).

← 7. The annual subsidy is calculated as the difference between the cost to the employer of providing a car and the benefit in kind on which the employee is taxed.

← 8. The natural resource tax applies to emissions of polluting substances into the air, including CO2, solid particles, carbon monoxide, heavy metals, volatile organic compounds, ammonia, hydrogen sulphide and other non-organic compounds, sulphur dioxide and nitrogen oxides; extraction of natural resources (e.g. peat, sand, clay, limestone, dolomite, quartz); water extraction, on the basis of the value (low, medium or high) of water; water pollution from non-hazardous and hazardous substances and phosphorus, with rates increasing with the hazard level; waste disposal, including municipal and hazardous waste and production, construction and demolition waste; goods harmful to the environment (e.g. tyres, batteries, electronic equipment); packaging of goods and products and disposable tableware and accessories, including plastic bags (with rates differentiated according to harmfulness of plastic type); radioactive substances; and coal, coke and lignite.

← 9. Denmark, Estonia, Finland, Norway and Sweden had shares below 3% in 2017.

← 10. Only Bulgaria, Hungary and Romania have higher shares of the population unable to afford a car.

← 11. Other total exemptions from excise duties include fuels used for domestic navigation and aviation, LPG used for residential and commercial heating, and electricity used for freight transport and public passenger transport. Other reduced tax rates apply to bio-gasoline, LPG for transport, and diesel, kerosene and fuel oil with at least 5% biofuel content.

← 12. The air pollution abatement category includes expenditure related to the EU ETS allowances. In 2009 and 2010, the government freely allocated emission allowances to new entrants in the EU ETS. The national account statistics recorded these operations as dismissal of assets or negative expenditure, which explains the negative bar in Figure 3.8.

← 13. About a third of the population was connected to clean drinking water supply and 90 000 people to new or upgraded wastewater treatment facilities as a result of EU-funded investment in 2007-13.

← 14. Investment in environmental infrastructure accounted for 20% of allocated funds, transport for 28.5% (roads 12%, rail 6.5% and other transport 10%) and energy for 3.5%.

← 15. For 2014-20, the EU structural and investment funds are the European Regional Development Fund, Cohesion Fund, European Social Fund, European Agricultural Fund for Rural Development, European Maritime and Fisheries Fund and Youth Employment Initiative.

← 16. When national co-financing is included, the 2014-20 regional development budget totals EUR 6.9 billion. There is one main operational programme (OP), the Growth and Employment OP, with an allocation of EUR 5.2 billion, of which EUR 4.4 billion is EU funds. In addition, there are three cross-border programmes (with Estonia, Lithuania, Finland and Sweden), one transnational programme for the Baltic Sea region, and two programmes for rural development and fisheries funded by the EU funds dedicated to these sectors.

← 17. Gross final electricity consumption includes total gross national electricity generation from all fuels, plus electricity imports, minus exports.

← 18. The MPC is granted to electricity generated from onshore wind turbines, biomass and biogas plants, small hydropower plants (installed capacity lower than 5 MW), high-efficiency natural-gas CHP plants and high-efficiency CHP plants using renewables as fuel. Guaranteed capacity payments are available to large CHP plants (installed capacity greater than 20 MW) fuelled by natural gas or renewables, as well as biomass and biogas plants.

← 19. The public electricity trader must purchase electricity from CHP plants under mandatory procurement, even if it is more expensive than the prevailing market price.

← 20. Latvian households used 14.12 kilograms of oil equivalent (kgoe) of heat per square metre in 2016. By comparison, heat consumption per square metre was 11.9 kgoe in Denmark, 15.3 kgoe in Estonia, 12.3 kgoe in Finland, 11.3 kgoe in Lithuania and 9 kgoe in Sweden (Odyssee-Mure, 2018).

← 21. After the introduction of consumption-based billing in 2015, average indoor temperatures dropped and heat consumption fell by between 10% and 20%.

← 22. Under an energy performance contract, an energy service company implements energy efficiency measures (e.g. thermal renovation of a building) and uses the income stream from the energy savings to repay the cost of the project.

← 23. With transport-on-demand systems, scheduled bus services are replaced by minibuses covering flexible routes depending on real-time demand.

← 24. Roads included in the Tran-European Transport Network (TEN-T) and regional roads connecting TEN-T roads and larger cities.

← 25. Range anxiety is the fear that an EV cannot drive the distance to destination on one charge.

← 26. In 2017, government R&D expenditure was 0.13% of GDP and business R&D expenditure 0.14% of GDP.

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Chapter 3. Towards green growth