Europe faces few sure-fire policy options to combat the next recession. As previously discussed, monetary policy, fiscal policy, or their combination through "helicopter money" all face serious limitations in the eurozone. Could a "Green New Deal"—massive investment in the transition to a carbon-neutral economy—provide a more promising option?
Of course, the case for climate action is not driven by macroeconomic stabilization concerns. Achieving carbon neutrality will take at least 30 years. European leaders plan to set themselves ambitious targets when they meet on December 12. Should they agree to a concerted, sustained green investment program, the resulting increase in aggregate demand could be exactly what the eurozone needs to fight off secular stagnation and acquire the resilience it currently lacks. The current negative long-term interest rate environment provides an opportunity to front-load investment and to finance it by issuing debt.
A sustained rise in investment over projected levels by at least 1 percent of GDP annually over the next decade is required for the European Union (EU) to reach the new, more ambitious climate objectives proposed by the European Commission. Such an investment would also significantly contribute to strengthening the European economy and making it better able to fight off the next recession. But investors will not embark on new, risky projects if they doubt that the European Union will be able to set the price of carbon at a level consistent with its plans. Investment will only materialize if the EU finds ways to overcome the credibility handicap its climate strategy is suffering from.
The European Union's decarbonization plans
The EU has already embarked on an ambitious decarbonization path. In 2018, it set the goal of reducing greenhouse gas emissions by 40 percent by 2030 (with 1990 as the baseline). The new European Commission, which took office on December 1, proposes to revise these goals upward and speaks of a 50 to 55 percent emissions reduction by 2030 (36 to 43 percent with respect to 2017). It hopes that at their summit on December 12, European leaders will adopt the target of climate neutrality by 2050. This plan requires member countries to significantly accelerate their efforts (see figure below).
The questions this post sets out to address are:
- Is climate action good for growth?
- How much investment is required for the European Union to meet its targets?
- What are the available policy instruments, and can they be effective and credible?
The missing macroeconomics of climate action
For all the fuss over the need to choose between climate action and growth, the truth is that decarbonization is a condition to economic prosperity. A failure to mitigate climate change would inflict significant economic damage.1 But such benefits are long term and require significant action at the global level. For the European Union, what matters is how much growth its own action can trigger in the short and medium run.
At this horizon of 5 to 10 years, things are more complex. Because higher current and future carbon prices (or their regulatory equivalent) will render part of the existing capital stock obsolete, decarbonization will inevitably reduce economic potential. Current job cuts in the auto industry are indicative of this logic. Further layoffs and plant shutdowns will follow. At the same time, however, decarbonization will require investing in new processes and technologies that raise economic potential, because the pricing of carbon will value emission reduction and encourage new investment in energy efficiency and renewable energy. Overall, the joint growth effect of capital destruction and capital investment will be ambiguous.
Domestically, the transition to a carbon-neutral economy will destroy jobs in extractive, energy-producing, and manufacturing industries and create jobs in the service sector. It will therefore involve significant reallocation of labor across industries. The slower this reallocation, the higher the cumulated output loss.2
Finally, decarbonization will entail reducing the value of brown assets (from coal mines and oil fields to energy-inefficient housing). The recent scale-down of the initial public offering of the oil company Saudi Aramco indicates that the possibility of a range of assets becoming stranded is no fantasy. Some estimates assess the potential undiscounted loss on brown assets to be on a magnitude of $9 trillion globally at a 15-year horizon.3 Even assuming away adverse financial developments, this is a large enough number to affect aggregate demand.
On an international scale, decarbonization will obviously impose different costs and benefits on the relative income of fossil-fuel-producing versus fossil-fuel importing countries.4
Whether the transition to a climate-neutral economy will improve or hurt growth is a quantitative issue. Unfortunately, we know too little about it. Green New Deal advocates often minimize the damage to supply (or assume that it will be inconsequential because output is determined by demand). Projections by international organizations primarily rely on energy-specific and computable general equilibrium models that provide useful insights but are ill-suited to macroeconomic analysis. They often minimize the macroeconomic effects of decarbonization.5 Surprisingly, climate economics has developed into an active branch of applied microeconomics, but the macroeconomics of climate change mitigation remains relatively unexamined.6
Investment and climate mitigation in the European Union: A closer look
Can the EU decarbonization strategy trigger significant investment? Available EU estimates put the required additional effort at 1.5 to 2.0 percent of GDP annually.7 There are three problems with such computations, however. First, because part of the investment is taking place already, they overestimate the new investment that policy decisions could trigger. Second, these estimates do not take into account the upward revision of the EU objectives (and therefore underestimate the required investments). Third, they do not encompass other investments, especially those triggered by the need to adapt to higher temperatures.
To start with, what matters from a macroeconomic standpoint is not the level of climate-friendly investment but the extra investment to be undertaken. A large part of existing investment flows will need to go green. For example, housing investment will need to meet much higher standards. What is macroeconomically relevant is the amount of additional investment necessary to meet a certain emissions target.
At present, there is no systematic survey of climate-specific investment, making it impossible to assess with precision if the European Union is on track to achieving its goal. A pilot project by the German Institute for Climate Protection, Energy and Mobility and the French Institute for Climate Economics (IKEM and I4CE 2019) has attempted to inventory these investments in France and Germany. The results are very imprecise because of the heterogeneity of methodologies. The study finds climate-specific investment flows to be €43 billion in Germany (in 2016) and €32 billion in France (in 2018)—in both cases 1.3 to 1.4 percent of GDP. For France, the shortfall in comparison to what it would take to achieve national climate policy objectives is reckoned to be €20 billion annually, or 0.8 percent of GDP. The proportion should not be that different for Germany. Overall, the Organization for Economic Cooperation and Development (OECD), the research association of the world's leading industrial economies, also estimates that the planned investments in energy efficiency and renewable power fall significantly below what is required to meet decarbonization objectives.
In addition, target investment must be revised upward to take into account the additional effort required to meet the 55 percent emission reduction by 2030 put forward by the European Commission. Higher emission reduction targets will require disproportionately higher capital expenditures as the marginal abatement cost curve is upward sloping (total abatement cost is typically a quadratic function of emissions reduction). On this basis, additional annual investment in the 2020–30 period consistent with the new EU target can be assessed to be 2.5 percent of GDP, if not more.8
Finally, investment over and above what is usually reckoned should also be considered. By their very nature, climate-centered models focus on the energy supply sector and the main energy demand sectors, such as housing and transportation. From agriculture to data centers, however, few sectors are in fact immune to the transformation implied by decarbonization. The current shock in the auto industry is indicative of the danger of underestimating this problem. By the same token, the costly investments required to adapt to even moderate climate change (such as levy construction for increased flooding and higher sea levels) tend to be overlooked.
Summing up, current decarbonization investment is probably 0.5 percent of GDP below what would be consistent with official policies in place. Another additional increase by at least 0.5 percent of GDP would be needed to reach the level consistent with the newly proposed goal of reducing emissions by 55 percent by 2030. Over the next 10 years the EU Green New Deal should therefore imply at least a sustained 1 percent of GDP increase in investment, in comparison to current trends. This is a cautious estimate, probably a lower bound.
Tackling the credibility challenge: What policies would be effective?
A 1 percent of GDP investment surge would be macroeconomically significant. It would exceed by far what can be expected from monetary and fiscal policies, given the constraints they are facing. The question is, what could trigger it?
To start with, most of this investment will have to come from the business sector. Public investment is also called for in fields such as infrastructure and the insulation of public housing and government buildings. Governments will also need to help low-income homeowners finance renovations. But estimates suggest that the bulk of investment would take place in the business sector. IKEM and I4CE (2019) put the public share at about 20 percent in Germany and 50 percent in France. Public investment schemes such as dedicated climate investment funds can help, but they are unlikely to be sufficient.
Several governments are putting faith in green finance. Labelling and other elements of responsible investment campaigns might direct savings toward climate-friendly investment while discouraging brown investment. All that will contribute to making investors wary of the risk of being left with stranded assets. Actually, there is already evidence of such behavior.9 At the same time dedicated funds, especially through the European Investment Bank, will help tackle the technological risk.
But such efforts may not be enough to elicit green capital expenditures. In a negative interest rate context, it is not the cost of credit that is hampering investment. Rather, it is the fact that as long as the price of carbon is not high enough to give a monetary value to reducing emissions, the rate of return on a range of socially beneficial investments is insufficient.
This brings us to carbon pricing. The price of carbon on the European Emissions Trading System (ETS), which covers 40 to 45 percent of emissions, is currently €25 per ton. Non-ETS sectors are often not covered by national carbon taxes: In 2018 only three EU countries (Sweden, Finland, and France) were taxing carbon at a level exceeding €30 per ton.10 These are very low levels, because the shadow price of carbon corresponding to the EU official objective is assessed to be around €50 per ton in 2020 and at least €100 per ton in 2030.11 As Jacob Funk Kirkegaard (2019) observes, an EU Green New Deal requires a far higher price of carbon.
Moreover, tomorrow's price matters at least as much as today's, because decarbonization entails investing in fixed assets whose return depends on future prices. As things stand, private investors are unlikely to embark on risky projects whose return hinges on a €100 per ton price of carbon in 10 years. But on tax matters, agreement at the EU level requires unanimity, and individual governments find it hard to stick to their plans. The French government already backtracked twice on raising energy prices when confronted with violent opposition from the Red Caps (in 2014) and the Yellow Vests (in 2018). The German government released a rather unambitious climate program in 2019.
Insufficiently credible plans will not only slow down decarbonization. They will make it less efficient economically, because firms hesitate to undertake fixed capital investment as long as they are uncertain of its future return. They end up investing in neither brown assets nor in green ones, and the economy tends to get stuck in an inefficient equilibrium. Fried, Novan, and Peterman (2019) have quantified the cost of climate policy uncertainty in the US case. They find that US firms expect a carbon tax to be introduced sometime in the future. This anticipation acts as an implicit form of taxation that lowers the ratio of brown to green investment but also lowers aggregate investment. The consequence is that the output cost of decarbonization is found to be almost twice as high.
European policymakers must therefore tackle the credibility challenge that hampers both the effectiveness and the efficiency of climate policies. A credible forward path for the price of carbon would create the right incentive for business investment. Combined with adequate financing, and possibly budgetary support when externalities are not adequately covered by carbon pricing, it could unleash significant capital spending and help transform the EU economy.
There are several things the European Union can do to make its climate commitment credible:
- Reform the Emissions Trading System to include more sectors and give it the authority to define price corridors.
- Make decarbonization and competitiveness compatible through introducing a non-distortionary border adjustment mechanism.
- Put skin in the game and find ways to insure business investors against the political risk of policy reversals.
The stakes are high. A sustained rise in investment by at least 1 percent of GDP annually over the next decade is required for the European Union to reach its climate objectives. It would also significantly contribute to making the European economy stronger and better able to fight off the next recession. These are two good reasons for the European Union and its members to get their acts together.
Author's note: I am grateful to David Xu for research assistance and to Olivier Blanchard, Jacob Kirkegaard, Alain Quinet, Simone Tagliapietra, Xavier Timbeau, and Angel Ubide for comments on an earlier draft.
This post is the fourth in a PIIE series on how to confront the next European recession. View others:
The Euro Area Has Run Out of Pure Monetary Policy Options to Avert a Recession
The Euro Area's Fiscal Ability to Handle Another Recession Is Limited
The Euro Area Is Not (Yet) Ready for Helicopter Money
1. See for example the report of the European Commission's PESETA III study (2018), which focuses on Europe. The International Monetary Fund's October 2017 World Economic Outlook discusses the economic damages from extreme weather events.
2. Experience from natural disasters shows that by itself, capital destruction has a generally short-lived impact. The Kobe earthquake of 1995 destroyed capital worth 2.3 percent of Japanese GDP. Within 18 months, however, manufacturing output in the Kobe region had reached 98 percent of pre-crisis level (see Horwich 2000). This is because natural disasters do not permanently affect relative prices. The rebuilding of the capital stock does not involve any reallocation.
4. Mercure et al. (2018) compute GDP gains and losses at the 2035 horizon between a business-as-usual scenario and a scenario in which emission-reduction policies are adopted and fossil-fuel producers sell out their reserves in anticipation of their loss of value. They find that the United States and Canada are poised to lose significantly, whereas the European Union, China, and India are net winners.
7. See European Commission, A Clean Planet for all: A European strategic long-term vision for a prosperous, modern, competitive and climate neutral economy, COM (2018) 773, November 2018; and European Commission, In-depth analysis in support of the Commission communication, COM (2018) 773, November 2018. See also Claeys, Tagliapietra, and Zachmann (2019) and A. Gueret, A. Saussay, and X. Timbaud, On the Economics of a Green (New) Deal, forthcoming 2019, OFCE, Paris.
8. See Jean Pisani-Ferry and David Xu, "Macroeconomic investment requirements of decarbonization in the European Union," unpublished PIIE note, December 2019, accessible in the downloadable underlying data for this blog post.
The data underlying this analysis are available here [zip].