The European Commission has told the UK Treasury that it must quadruple its 5% VAT rate on insulation materials and installations to match the standard 20% rate applied to other products and services. The Treasury is likely to oppose the request, ENDS understands.

The warning has caused widespread concern in the energy efficiency market ahead of the launch of the government’s flagship Green Deal home energy efficiency upgrade scheme (ENDS Report, March 2012). However, the commission has also hinted at a possible compromise.

The commission’s publication of a reasoned opinion on 21 June is the second stage in an infringement procedure. It gives the UK two months to comply or face referral to the Court of Justice of the EU.

The action relates to UK legislation allowing reduced VAT rates on the supply and installation of 'energy-saving materials'. The commission claims this contravenes the 2006 VAT Directive, as the concept is not included on the list of goods and services on which reduced rates are allowable in annex III.

But in an apparent effort at reaching a satisfactory compromise, the commission has also said that reduced rates “may be allowed” under two articles within annex III.

The first of these – article 10 – covers “provision, construction, renovation and alteration of housing, as part of a social policy”. In a response to ENDS, the commission said: “Here it is crucial that the reduced rate applies as part of a social policy. Social policy in the field of housing would include governments' interventions to enhance housing opportunities for low-income persons.”

The other article, 10(a), deals with “renovation and repairing of private dwellings, excluding materials which account for a significant part of the value of the service supplied”. But this excludes materials that account for more than 50% of the total value of the services supplied.

The commission concluded that under these provisions “part of the goods and services that are granted a reduced rate as energy saving materials, may continue benefitting from the reduced VAT rate”.

It added that it had proposed a more general reduction in VAT rates in an amending directive in 2009, which would have applied to the supply and installation of green products. But it said that the European Council had held that reduced VAT rates as an environmental policy tool should be restricted.

The restrictions on green product VAT reductions proposed by the UK caused tensions in 2009 (ENDS Report, February 2009), and could now do so again.

The Treasury told ENDS: “We disagree with the position that they have taken. We obviously wouldn’t have put a reduced rate on energy-saving materials if we thought that the directive didn’t allow it.” It added that it would be studying the commission’s rationale before making a response.

Darryl Croft, senior researcher for the Association for the Conservation of Energy, noted that articles 10 and 10(a) could provide grounds for VAT reduction, but said detailed interpretation is complex.

The real question is whether the energy and climate department (DECC) can redefine its Greed Deal energy efficiency upgrade scheme as part of social policy, he said. The parallel Energy Company Obligation on energy suppliers applies to vulnerable consumers, so should secure a reduction more easily.

Croft also pointed out that if the value of materials accounts for more than 50% of the installation, “you can’t apply the lower rate”.

The implications of higher VAT duties on consumer uptake of the Green Deal and other energy efficiency policies could be serious. Higher duties would be bound to raise costs of measures, but quantifying this is far from straightforward.

The energy and climate department (DECC) has estimated the current market for installation of insulation at £700,000 a year. That would equate to an additional £105m a year in tax, but this takes no account of the potential drop in demand from higher costs and therefore a drop in VAT revenues.

The figure is also based on the current market, which is driven largely by the Carbon Emissions Reduction Target (CERT) obligation on energy suppliers. This ends in December, but once the Green Deal launches in October the market will be driven by consumer demand rather than targets.

Any additional cost would dampen demand and make it harder for measures to meet the Golden Rule, which dictates that monthly loan repayment should at least be matched by savings in energy costs. But any impact would be additional to the large drop in installations of loft, cavity wall and solid wall insulation that DECC has already anticipated from 2013 after CERT ends (ENDS Report, June 2012).

Croft took issue with the principle that energy efficiency products should be taxed at the same rate as energy consumption. He said that, while the commission’s stance may be correct in a narrow legal sense, it runs counter to the EU’s drive to raise energy efficiency.

Lorraine Parkin, head of indirect tax at law firm Grant Thornton, described the commission’s move as “a major blow to the government's Green Deal” if upheld. Energy law expert Peter Feehan, of law firm Pinsent Masons, described the move as “disappointing if not unexpected”.

He added that the company's work on the Green Deal “has shown that the margins on the affordability and viability of schemes is very tight and it will be interesting to understand how this plays out in the industry and the potential impact for Green Deal providers and their supply chain partners”.

Please note this article has been republished with the kind permission of the ENDS Report.