Europe’s answer to the Inflation Reduction Act should be global cooperation

A green industrial program of some $400 billion in federal funding, the IRA has caught Europe wrong-footed.

The fallout of Russia’s Ukraine war – strained public budgets and an ailing economy – have shifted policy priorities and temporarily put climate policies into the backseat. What is more, whilst the EU is traditionally good at fostering market competition, also in clean energy, it is less so in nurturing green champions.

In response to the IRA, EU Commission President Von der Leyen announced relaxing state aid rules, for European governments to counter US fiscal sweeteners for green investment.

However, this measure misses the point. It pits the EU against the US and fosters a subsidy race within the Union, which those with the deepest pockets will win. It also falls short of what is needed to advance the European economy, and clean energy policy globally.

Europe’s selling point has always been a rule-based and reliable policy framework, which made domestic and international investors advance cutting-edge technology in telecom, automotive or green energy.

The EU’s energy and climate policy outline a coherent and commonly agreed vision for the future European economic model. Joined-up policy action should build on it in response to US clean tech reshoring efforts.

Rather than a lopsided focus on state-aid rules, a number of key policy files will need to be linked, so as to ensure sufficient investment at the EU scale and to remain an attractive partner internationally.

First, policies aimed at incentivising industrial production in high-carbon price environments need to be redesigned. Clearly, the merit of the carbon border adjustment mechanism (CBAM), the EU’s protective levy targeting carbon-heavy imports, lies in raising global attention to emissions pricing.

Yet, it fails to generate similar pay-offs and financial support for EU-level industrial decarbonisation as the IRA. As a result, countries like Germany, Netherlands, France and Sweden will likely scale up their national carbon contracts for difference to support green investment, notably in basic materials, which risks balkanising the EU market.

An effective CBAM to fund and incentivise EU industrial modernisation will require a different design option: a climate contribution specific to the type of product, not the location.

What sounds overly technical, essentially amounts to a carbon levy on both domestic production and imports. Industrial competitiveness is ensured by waving the levy for exports.

At current carbon prices, such a levy would yield some 40 billion every year, and – unlike the IRA – offer a long-term investment outlook. This sets incentives for industrial emission reduction across the EU by at the same time creating revenues and addressing concerns about carbon leakage. 

Second, Europe needs to focus its public funding strategy on fully unlocking its wind- and solar potential across the continent. Appropriate financial arrangements are central here. The EU Commission has announced a review of the market design to include contracts for differences and locational pricing.

Both elements will be essential to protect investors against regulatory risk and energy users against financial risks of power purchase agreements. Already by 2030, this will lower financing costs for renewable energy deployment, thus reducing energy costs for industry and households to the tune of 8 billion per year while enhancing protection against price hikes.

Third, Europe needs to adjust its gas market model and make it fit for purpose. As the world’s largest importing bloc, Europe is – unlike the US – overly exposed to geopolitical and market uncertainties, which also throw up transition risks on the way towards clean fuels.

Going back to long-term gas contracts barely is an option, also given the spectre of carbon lock-in. Contractual changes and price controls alone will not do the trick.

Instead, the EU needs to complement price-based market adjustments with effective security of supply protocol. As recently outlined by 18 European economists, such a protocol could combine national gas saving targets and a gas allocation mechanism with a price cap by mandating gas transmission system operators to pay a limited price for supply shortfalls.

The benefit lies in establishing clarity on regulatory choices during emergency situations, thus reducing costs and risks for gas producers and consumers during the transition period.

It will also keep global LNG prices in check, benefiting consumers with lower purchasing power, e.g. in East Asia. Such measures could save EU gas customers – or the governments currently funding gas price relief programs – during the crisis more than 200 billion per year that can instead be invested into the energy transition.

Finally, Europe will need to build on cooperation. It is a combination of fair and predictable rules, funding for solidarity and an attractive shared vision that have determined the success of the European Union as well as its latest grand project, the EU Green Deal.

Globally, it is likely to do so also when it comes to cooperating with pivotal emerging economies like India, Brazil, Indonesia or South Africa on the green transition.

These nations will sign off on a joint climate and industrial policy if built on a robust framework. A Climate Alliance can then reward ambitious action at home by sharing in financial flows; breakthrough alliances can transform select sectors such as steel or cement; energy transition partnerships can set out joint areas of technology cooperation.

To this end, EU policy frameworks need to be aligned with the needs of such global cooperation. The funding backing up global climate alliances and partnerships, including for industrial transition, can be secured by climate contributions raised among participating economic blocs.

Rather than joining in a global green race that is exclusive and targeted at industrial reshoring, Europe should take smart choices aimed at accelerating the domestic energy transition, mobilising funds and strengthening global rules-based cooperation.

The ultimate effect will be a more sustainable and lasting transformation and one that coopts rather than antagonises the future economic powerhouses in the Global South.

This article is also published on Euractiv. illuminem Voices is a democratic space presenting the thoughts and opinions of leading Sustainability & Energy writers, their opinions do not necessarily represent those of illuminem.