How can the EU reform its fiscal framework to meet its climate targets?

Executive Summary

The EU Commission’s European Green Deal (EGD) falls significantly short to mobilise the necessary investments to achieve its climate mitigation targets, leaving a green-investment-gap of approximately 3.35 trillion euros over the next decade. This threatens the EU’s economic performance, competitiveness, and long-term recovery outlook from the Covid-19 pandemic and political legitimacy. The EU’s rigid fiscal framework is the biggest obstacle to bridging the green investment gap by preventing member states from deficit-financing the required investments. To fix this, the EU Commission should adopt a new EGD specific fiscal framework delegating fiscal responsibility to independently operating public investment banks and holding companies with green investment targets that are sufficient to bridge the green-investment-gap. This framework is preferable to adjusting the existing fiscal framework with a green golden rule of investment or a green investment exemption clause, as it largely removes political pressures – thus allowing member states to balance their budgets in line with the ordinary fiscal framework, while sufficiently mobilising the necessary investments to bridge the green investment gap.

Situation Brief

The European Union (EU) has economically underperformed for years, as illustrated by Figure 1, facing difficulties in maintaining its economic competitiveness and investment rates (Fücks et al. 2015, p.53;  EIB 2019, pp. 8-12). The EU’s restrictive fiscal framework, the stability and growth pact (SGP), and fiscal consolidation have made matters worse by preventing member states from financing the investments necessary to escape the low growth and low investment environment, resulting in worsened socio-economic conditions (Storm and Naastepad 2016; Storm 2020). This underinvestment environment has translated into green innovation and investment underperformance, summarised by Figure 2. The EU has been a green investment laggard compared to its peer competitors with green investment growing at a slower rate than overall investment growth (EIB 2020, p. 171) and lacking diversification in new fast-growing sectors that will underpin the green transition (Claeys et al. 2019, pp. 12-13). This has already resulted in a decline of the EU’s relative share of environment-related technology patents, indicating a decline in its relative green innovation performance (OECD 2020).

The Covid-19 pandemic adversely impacts the EU’s economy. Thus, the EU requires a strong green growth strategy to mitigate the adverse economic impact of the pandemic, meet its climate targets, and restore its economic competitiveness (Pisani-Ferry 2020; Drzeniek et al. 2020). In 2019, the European Commission launched its European Green Deal (EGD) as a response, committing to increase its 2030 emission reduction target from 40 to 55% and achieve carbon neutrality by 2050 in line with its 2015 Paris climate commitments (Pianta and Lucchese 2020; Storm 2020). Green investment is crucial for the EGD because it replaces older non-green capital with green capital and encourage economic growth essential for a smooth and socio-economic successful green transition (Altenburg and Rodrik 2017). So, does the EGD deliver the necessary investments?

Figure 1. The European Union’s Economic Performance

Average annual economic growth rate (2000-2019)Average unemployment rate (2000-2019)
European Union1.56%9.19%
OECD Members1.89%6.91%
United States2.08%5.88%
Canada2.66%6.93%
New Zealand2.82%5.14%
Australia2.90%5.49%
World2.92%5.74%
Source: World Bank (2020)

Figure 2. The European Union’s Green Investment and Innovation Performance

Climate-related R&D investments in billion Euro (2018)Climate Change mitigation technology investments in percent of GDP (2018)
European Union7.51.2%
United States121.3%
China8.63.3%
Source: European Investment Bank (2020)

Relative Share of Environment-Related Patents, 2000-2016

Share of global environment-related technology patents in percent (2000)Share of global environment-related technology patents in percent (2016)Relative change 2000-2016 in percent
European Union34.51%26.41%-8.1%
United States22.65%24.08%+1.43%
China0.57%9.26%+8.96%
Source: OECD (2020)

To meet its 55% 2030 emission-reduction target, the required investments are estimated between 3-4 trillion euros over the next decade (Storm 2020, pp. 9-11; Claeys et al. 2020). But due to the highly uncertain and risky nature of green investments, 4 trillion euros is the more sensible estimate (Claeys et al. 2019, pp. 6-7). However, the EGD entails a total investment plan of 2.6 trillion euros over the next decade, with public funding equaling 1 trillion euros and 1.6 trillion euros in private investment (Storm 2020; Pekanov and Schratzenstaller 2020). Nevertheless, as Storm (2020, pp. 10-11) emphasises, only around ¼ of public investments are additional, as most public funds are reshuffled. At best, it would leverage in an equal rate of private investment and a total of 650 billion euros of additional investments, leaving a green-investment-gap of approximately 3.35 trillion euros or 83.75% (Figure 3). The current EGD under optimistic assumptions increases economic growth by 0.5% per year, thus falling significantly short to deliver the necessary investments and a genuine green growth strategy sufficient to offset the adverse socio-economic impacts of the green transition and the Covid-19 pandemic (Clayes et al. 2020; Storm 2020, pp.10-11).

Figure 3. European Green Deal Funding and Green-Investment-Gap

Current Commission Scenario – total additional investments650 billion euros
Required Investments4000 billion euros
Remaining green-investment-gap3350 billion euros
Source: Storm (2020)

Hopes that leveraged in private investments bridge the green-investment-gap are at best “wishful thinking” (Storm, 2020, p.10) Such investments are highly uncertain, long-term, and risky with substantial public good characteristics, leading to underinvestment by private markets which are unable to effectively operate under such conditions (Zenghelis, 2012; Laplane and Mazzucato, 2020). In fact, the scale, uncertainty and complexity of climate change requires a mission-oriented industrial and fiscal policy approach with significant public investments to co-create technologies and markets. Markets by themselves fall short to provide these services, as they are unable to develop new qualitatively different directions of development (Kattel and Mazzucato 2018, p.9; Mazzucato and Penna 2015, p. 30). The EGD and the Commission has not proposed reforms of the EU’s fiscal framework that would allow member states to bridge the green-investment-gap (Varoufakis and Adler 2020; EIB 2019). Thus, the EU’s fiscal framework is the biggest obstacle to bridging the green investment gap (EIB 2020; Storm 2020). Failure to do so would have adverse socio-economic and climate policy consequences that would undermine the EU’s political support and legitimacy (Pisani-Ferry, 2020; Pekanov and Schratzenstaller ,2020). So, what are the policy options to fix its fiscal framework and bridge the green investment gap?

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Policy Options

The first policy option is to amend the SGP by specifically expanding the investment exemption clause. Currently, it excludes investments ranging from those with positive, direct and verifiable positive long-term effects on growth and fiscal sustainability to green investments (Pekanov and Schratzenstaller 2020, pp. 33-37; Claeys et al. 2019, p. 9). The second option is to legally change the SGP by adding a green golden investment rule (GIR), excluding green investments from fiscal rules (Pekanov and Schratzenstaller 2020, pp. 33-37; Claeys et al. 2019, p. 9). The green exemption clause (GEC) is an easier legal adjustment than the GIR, giving immediate fiscal space. However, exemption clauses are usually short-term exemptions for extraordinary time, entailing thorough reviews that could delay and reduce green investment rates, as they often require a long-term horizon to materialise. To facilitate green investments, the clause could be simplified and extended over longer periods. However, exemption clauses are meant to be applied in exceptional circumstances, not as the operating norm. This makes the option politically unfeasible, as the SGP would be even more complicated, inconsistent, and watered down than it already is. This is particularly troublesome for fiscally conservative states that demand clear rules thorough reviews and definitions, which attempt to minimise greenwashing and other shirking attempts by member states trying to gain fiscal space (Pekanov and Schratzenstaller 2020; Claeys et al. 2019; Barrett et al. 2020).

In contrast, the GIR is a permanent green investment enabling device allowing governments to bridge the green-investment-gap, thus being more effective than the GEC. However, similar to the exemption clause, greenwashing opportunities exist – especially if rules are simply defined to minimise bureaucratic hurdles which could result in comparable pressures by fiscally conservative states (Claeys et al. 2019, p.9; Pekanov and Schratzenstaller 2020, p.35). To safeguard the GIR against greenwashing and political backlash, two measures can be taken: 1. Clearly separate green investments from other fiscal expenditure by issuing green bonds exclusively financing green investments; 2. Limit the maximum amount of green bonds issuable to the annual country-specific green-investment-gap, regularly reviewed by the Commission as a neutral arbitrator (Claeys et al. 2019). However, if austerity pressures by fiscally conservative member states resurface successfully after the Covid-19 pandemic recovery, it will result in substantially higher public debt levels that could have an adverse impact on green investments if relied on the ordinary fiscal framework. This could occur even if the investments were separated from other expenditures, as policymakers may generally cut public spending or greenwash expenditures to gain fiscal space. As a result, it would undermine the GIR’s and GEC’s ability to sufficiently bridge the green-investment-gap (Barrett et al. 2020; DW 2020; Clarke and Nickels 2020, p.3).

The third option is designed to minimise and withstand these political pressures by delegating the EGD’s fiscal responsibility to a new fiscal framework – combining two independent institutions that tend to enjoy greater public confidence, trust and longer-term investment commitments (Skideksly 2018, pp. 355-356). This would allow member states to balance their budgets and bridge the green-investment-gap while freeing up fiscal space, allowing states to reduce debt ratios without pursuing socio-economically or politically harmful spending cuts (Skidelsky 2018, pp. 355-356; Mazzucato and Penna 2015, pp. 4-5). These two independent institutions are: 1. Commercially operating public investment banks (PIB) that issue publicly-guaranteed bonds to finance specific investments, which are potentially profitable but insufficiently undertaken by private investors due to the nature of these investments (Skidelsky, 2018, pp.355-356; OECD, 2017, p.15); 2. Commercially operating public holding companies (PHC) that issue publicly-guaranteed bonds operating and expanding in sectors that the private sector will insufficiently invest and expand in due to the nature of these sectors (Skidelsky 2018, pp. 356-357; Zachmann et al. 2018, pp. 45-46). Both are given clearly defined targets with operational independence left to them and are operating in a complementary manner. By networking with the private sector and policymakers, it would achieve horizontally-diversified targets in line with the EU’s subsidiarity principle to bridge the green investment gap on all levels (Skidelsky 2018, pp. 356-356; Bergamini and Zachmann 2020; CoR 2019). Furthermore, these institutions entail skillsets, which government bureaucracies lack to evaluate the economic feasibility of various projects in a well-coordinated manner  (Mazzucato and Penna 2015, pp. 4-5; Skidelsky 2018, pp. 355-356; Pollin 2020, pp. 13-14). However, one major drawback is that only a handful of member states have PIBs. Setting up this new fiscal framework will thus take a considerable amount of time and effort than adjusting the SGP.

The Commission has considered all three options but has not yet taken a clear stance (Barrett et al., 2020). So, what policies should it pursue?

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Policy Recommendations

The EU commission should adopt the third policy option because even though it may take longer to implement it, it allows member states to balance their budgets and mobilise the required investments to bridge the green investment gap – making the EGD’s success independent from the EU’s ordinary fiscal framework and short-term political considerations. To calm concerns of fiscally conservative member states, the lending allowances for PIBs should be limited to the country specific green investment gap and the Commission which – in cooperation with the European Committee of the Regions (CoR) and member states – should specify concrete and easily trackable targets for a reviewable green transition path (Lambertz 2019; CoR 2019, pp. 3-4). To immediately mobilise investments, the Commission should cooperate with member states to instruct the European Investment Bank (EIB) to increase its investments from currently 400bn euros to the maximum 600bn euro limit – channelling these into green projects with a greater focus on costly cross-border projects. Furthermore, the Commission should ask member states with PIBs (e.g. Germany and France) to increase their PIBs’ green investments in line with their green investment gap (Barrett et al. 2020; Claeys et al. 2019). Similarly, the EU already entails a wide-ranging PHC framework that needs to be reviewed, partly repurposed, refinanced, and extended to the pan-European level (Zachmann 2015, pp. 5-7; Creel et al. 2020, pp. 11-14).

The EU Commission should cooperate with member states to deliver well-coordinated targets for regional and national PHCs and PIBs, with a particular focus on sectors in which the EU has been an investment laggard, as well as in new frontier markets. As a result, new PHCs may need to be established and investment efforts concentrated to gain competitive advantages. Here it is essential to closely cooperate with the CoR to align targets with regional industrial and development policies to smoothen the structural transition and utilise regional comparative advantages (Lambertz 2019). The EU should focus on new pan-European lighthouse projects around which the European political economic society can rally behind (Creel et al. 2020, pp. 8-14). For instance, the EU’s high-speed railway network is mostly outdated and lags a true pan-European network. Transport remains a national affair focused on national transport interests, falling short to effectively coordinate and deliver pan-European projects as nation states fail to internalise the positive cross-border spillovers of pan-European projects. The EU could create a European ultra-rapid train network connecting all EU capitals at an operating speed of 250-350 km/h, complementing national railway systems and delivering concrete benefits to citizens by presenting a credible alternative to inter-European aviation transport. Simultaneously, it would bridge the sectoral technology gap that EU companies currently have vis-á-vis South Korea, Japan and China – meeting the aims of the EU’s new transport oriented industrial policy (Creel et al. 2020, pp.13-16). An EU level public holding company would be founded to raise the necessary funds and build and run the network. This would cost around 7.5% of the EU’s 2019 GDP and stretching over a decade, with the necessary funds raised off budget in close cooperation with the EIB that targets complementary investments (Creel et al. 2020, pp. 16-18; Beetsma et al. 2020). As a concluding remark, the EU needs to invest significantly more to better meet its climate targets.

Featured image credit: “Greta Thunberg urges MEPs to show climate leadership” by European Parliament is licensed under CC BY 2.0

Disclaimer: This policy paper is a revised version of a policy paper originally written in November 2020 and submitted to the POLU9GE module at the University of Stirling.

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