The Green Deal is intended to help the UK meet its climate targets by allowing cost-effective renovations and refurbishments of energy-inefficient homes, which can be recouped through energy bill payments.
But Brussels has ruled this illegal because the VAT exemptions apply to all UK citizens - and lack a redistributive element – and so cannot be considered part of a ‘social policy’.
“There is no provision in the  VAT Directive to allow a reduced VAT rate on ‘energy saving materials’ specifically and the universal application of a reduced rate for energy saving materials is therefore not allowed,” a statement by the Commission said.
If the European Court rules against London, the UK will be obliged to change its law or face a mounting series of weekly fines.
British Conservative MEPs reacted with horror to the news. "This is a typical case of jobs worth bureaucrats who lose all common sense when they enter their Ivory tower," said Martin Callanan MEP, the Conservatives environment spokesman.
"The commission cannot propose stringent and growth-hampering environmental legislation on one day, and then demand we drop a major scheme aimed at reducing energy use the next."
Earlier this week, Callanan defied the UK prime minister David Cameron to vote against proposed reforms to the EU's Emissions Trading Scheme aimed at raising carbon prices.
The timing of the court announcement surprised some as two weeks ago, EU regulators approved the Green Deal, saying that it would keep competitions in distortions to an “acceptable minimum”.
But the EU’s tax directorate has consistently argued that the UK’s VAT exemptions fall outside of a strict list of goods and services eligible for the reduced rate agreed on by EU ministers in 2009.
“We have taken measures against other EU states when the UK has complained about rules being breached and there has to be level playing field for everyone,” Emer Traynor, a spokeswoman for the taxation commissioner, Algirdas Šemeta, told EurActiv.
Flouting the law
“This is certainly not an attack on UK efforts to promote energy efficiency, which the Commission itself supports and promotes strongly,” Traynor added. “But we don't reach our objectives in the EU by flouting the law.”
The Commission believes that reduced VAT rates are less effective at promoting energy efficiency than direct subsidies because of difficulties in precisely defining relevant product lists, and targeting the most vulnerable sectors of the population.
For businesses, which will likely represent a large proportion of the Green Deal’s uptake, VAT is tax-deductible anyway, officials say, and studies suggest that reduced VAT rates to business are not passed on to consumers in the form of lower prices.
More than that, Brussels sees itself as a leader in green taxation, having proposed revised energy tax rules to support environmental and efficiency goals, and having urged EU states to shift taxes away from labour to the environment.
But in the UK, clean energy advocates urged David Cameron to stand firm on what is the environmental flagship of a government often seen as reluctant to act on its professed green credentials.
Fighting tooth and nail
“We are disappointed that the Commission has not seen sense at the 11th hour and we shall be continuing to do all we can to encourage the government to fight tooth and nail in defence of the reduced VAT rate,” said Jenny Holland, the head of parliamentary affairs for the UK Association for the Conservation of Energy.
The Commission contends that ‘social policy’ should only refer to measures such as government action to provide and improve housing for low-income and vulnerable people. Holland though, argues that seeking to limit CO2 emissions from buildings of itself should itself be considered a form of ‘social policy’.
“It can also be about ensuring that fuel bills are not punitive for the population at large, or the most vulnerable sectors,” Holland told EurActiv. “If you have a reduced rate of VAT on fuel suppliers, there is a strong argument that having a reduced rate of VAT levels the playing field on demand management measures.”
As well as in the as yet unscheduled court case, the infringement spat between London and Brussels could potentially be resolved in the EU’s backrooms.
Later this year, Commissioner Šemeta will propose a review of reduced VAT rates - in order to improve tax efficiency. “It's too early yet to say what changes this review will bring but we will be looking to see if there is any real added value to the various reduced rates on the table,” Traynor said.
No British officials were available to comment.