By tying subsidies and tax advantages to domestic production, the Inflation Reduction Act aims to make the United States the nation of choice for green investments. Karsten Neuhoff and Andreas Goldthau argue that for Europe to remain competitive, it must concentrate on what it does best: establish regulations and control its huge internal market.
Karsten Neuhoff is the head of climate research at the German Institute for Economic Research and an economics professor at Berlin’s Technical University. Andreas Goldthau is the director of the Willy Brandt School of Public Policy, a professor at Erfurt University, and the head of a research group at the Potsdam Institute for Advanced Sustainability Studies.
The IRA, a $400 billion federally funded green industrial program, has caught Europe off guard.
The repercussions of Russia’s war in Ukraine, including strained public budgets and a faltering economy, have temporarily pushed climate legislation to the back burner. Moreover, while the EU is traditionally adept at creating market competition, even in the field of renewable energy, it is less adept at fostering green champions.
In reaction to the IRA, EU Commission President Von der Leyen suggested a loosening of state aid regulations to enable European governments to counter US fiscal incentives for green investment.
Nonetheless, this measure misses the mark. It puts the EU against the United States and promotes a subsidy race within the Union, in which the winners will be those with the deepest pockets. Additionally, it falls short of what is required to improve the European economy and worldwide renewable energy strategy.
Europe’s selling point has always been a rule-based and dependable policy framework, which has encouraged local and international investors to advance cutting-edge technologies in telecom, automotive, and green technology.
The EU’s energy and climate policies offer a vision for the future European economic model that is consistent and widely accepted. In response to US initiatives to reshore renewable technology, coordinated policy action must be taken.
Rather than focusing just on state-aid laws, it will be necessary to link a number of critical policy files in order to maintain sufficient investment at the EU level and to remain an attractive foreign partner.
First, industrial production incentive policies in contexts with high carbon prices must be revised. Clearly, the value of the carbon border adjustment mechanism (CBAM), the EU’s protective tax on carbon-heavy imports, resides in its ability to draw worldwide attention to the price of emissions.
However, it does not generate the same returns and financial assistance for industrial decarbonisation at the EU level as the IRA. As a result, nations like as Germany, the Netherlands, France, and Sweden are likely to expand their national carbon contracts for difference to boost green investment, particularly in basic materials, which could fragment the EU market.
Effective CBAM funding and incentives for EU industrial modernization will require a new design option: a climate contribution specific to the product category, not the location.
What appears very complex equates to a carbon tax on both domestic and foreign production. The exemption of the export tax guarantees industrial competitiveness.
At current carbon pricing, such a tax would generate around $40 billion annually and, unlike an IRA, would provide a long-term investment prospective. In addition to generating cash and resolving concerns about carbon leakage, this establishes incentives for industrial emission reduction across the EU.
Second, Europe must focus its public funding approach on maximizing the continent’s wind and solar potential. Appropriate financial preparations are crucial to this situation. The EU Commission has announced a market architecture assessment that would incorporate contracts for differences and location-based pricing.
To safeguard investors from regulatory risk and energy users from financial risk associated with power purchase agreements, both elements will be needed. Already by 2030, this will reduce finance costs for the deployment of renewable energy, hence cutting energy costs for business and families by $8 billion annually and enhancing price stability.
Thirdly, Europe must modify its gas market model and make it suitable for its intended purpose. In contrast to the United States, as the world’s largest importing union, Europe is overexposed to geopolitical and commercial uncertainties, which also offer transition risks on the path to clean fuels.
Given the specter of carbon lock-in, going back to long-term gas contracts is hardly a viable choice. Contractual modifications and pricing limitations alone will not suffice.
Instead, the EU must supplement price-based market adjustments with an efficient framework for supply security. As recently proposed by 18 European economists, such a protocol might combine national gas conservation goals and a gas allocation mechanism with a price cap by requiring gas transmission system owners to pay a limited price for supply shortfalls.
Benefits include establishing regulatory clarity during emergency situations, hence decreasing costs and risks for gas producers and customers throughout the transitional phase.
It will also control worldwide LNG costs, which will assist consumers with reduced purchasing power, such as those in East Asia. During the crisis, such approaches might save EU gas customers or the governments now funding gas price relief programs more than $200 billion per year, which could be spent in the energy transition.
Ultimately, Europe will need to advance cooperation. The success of the European Union and its most recent ambitious project, the EU Green Deal, has been decided by a combination of fair and predictable laws, money for solidarity, and an appealing shared goal.
Globally, it is expected to do so when it comes to green transition cooperation with key emerging economies such as India, Brazil, Indonesia, or South Africa.
These nations will approve a cooperative climate and industrial policy if it is based on a solid foundation. A Climate Alliance can then reward bold action at home by sharing in financial flows; breakthrough alliances can alter certain industries such as steel and cement; and energy transition partnerships can identify areas of shared technological cooperation.
In order to accomplish this, EU policy frameworks must be aligned with the requirements of such global collaboration. Climate contributions from participating economic blocs can be used to ensure the finance for global climate alliances and partnerships, including for the industrial transformation.
Instead of participating in a global green race that is exclusive and geared at industrial reshoring, Europe should make intelligent decisions aimed at expediting the domestic energy transition, mobilizing funding, and enhancing global rule-based cooperation.
The final result will be a transition that is more durable and long-lasting, and which co-opts rather than antagonizes the future economic powerhouses of the Global South.