Hailed as a major step toward addressing climate change, the Inflation Reduction Act (IRA) of 2022 provides $369 billion in green subsidies and tax credits aimed at cutting carbon emissions in half by 2030. But the IRA set off alarms in Europe over its violation of trade rules, forcing its governments to respond with plans for their own tax incentives and spending to keep green technology investments from relocating to the United States.
In response, President Emmanuel Macron of France and a range of Germany ministers are warning of a trade war over green subsidies. In fact, their fears are overwrought. The European Union appears likely to add very little to its already extensive policy support for Europe’s green transition. If Europe wants to engage in a green competition, it should realize that the problem is not a lack of funding resources and abilities but the obstacles of its own rules and rivalries among EU member countries.
This new transatlantic competition to develop new technologies—including electric vehicles (EVs), batteries, solar and wind energy, green production of steel and cement, hydrogen and other products—may be damaging to global trade rules, as critics say, but it may also be good for the quest to forestall global warming.
For now, there is little doubt that the IRA is discriminatory, protectionist, and against World Trade Organization (WTO) rules. Because its tax credits are uncapped, it could well cost far more than $369 billion. US private industry is rapidly scaling up its green production before the IRA expires in 2032. European concerns that EU industries will shift their green investments to the United States come at a time when European industry is already hurt by much higher energy prices and the rising cost of the European Union’s emissions trading system (ETS), which currently trades CO2 at around €90/ton.
On February 1, the European Commission proposed an EU Green Deal Industrial Plan for the Net-Zero Age, a plan pushed by France and Germany to loosen the European Union’s tight restrictions on state aid so that EU member states can match the tax credits and subsidies in the IRA, and potentially match aid offered to a European firm by a non-EU government. But such measures offered by individual EU countries are tightly controlled to avoid giving unfair advantage to richer member state governments. (Subsidies and credits routinely offered by US state governments to lure investments to their states are illegal in the European Union.) To deal with this problem, the Commission also proposed a common “EU sovereignty fund” to finance state aid directly from EU sources to avoid fiscally stronger member states like France and Germany having an unfair advantage over poorer and debt-burdened members like Italy and countries in Eastern Europe.
This proposed political link between easing the ability of France, Germany, and other wealthy states to offer state aid on the one hand, and establishing new common EU funding mechanisms for the benefit of poorer states on the other hand, met with criticism at the EU summit earlier in February. Many smaller members joined Germany in refusing to offer new money for a new common EU fund, likely limiting its implementation. As an alternative, EU leaders agreed to tap common funds left over from the pandemic recovery, repurposing them for green projects to be monitored by the Commission. The European Council also called for “simpler, faster and more predictable” procedures to facilitate “temporary and proportionate support” for tax credits and subsidies to help them fight “foreign subsidies or high energy prices,” especially for small and medium businesses. The Council declared further that “the integrity of and the level playing field in the Single [European] Market must be maintained.”
According to leaked documents, the Commission intends to limit state aid to a narrow set of “green industries,” including the production of “batteries, solar panels, wind turbines, heat-pumps, electrolysers and carbon capture usage and storage (CCUS) as well as related critical raw materials.” National state aid is defined as not exceeding €100 million (or €300 million for a poor region) per project. More restrictive rules will apply at the end of 2025 (i.e. seven years before the expiration of the IRA). In short, far from matching the tax subsidies in the IRA, Europe will limit them to a narrow set of industries, cap their scope, and allow them only for a few years.
Some critics have derided the European response to the IRA so far as a “policy mouse.” But in many ways, it has delivered a good outcome for the EU. First, the plan safeguards the integrity of the internal market from the general watering down of state aid restrictions sought by France and Germany. Second, limiting state aid subsidies in the EU, compared to the United States, reflects the highly overlooked fact that the EU has already implemented many public support measures for the green transition. In the United States, the IRA is the only major federal government spending bill promoting decarbonization. By contrast, the EU has its Green Deal, RePowerEU, pandemic Recovery Fund, and a host of member state–level support measures already in place.
For all the outcry on the continent, European governments do not lack public funding for the green transition to match the IRA. In addition, the EU’s expanding and increasingly expensive emissions trading system—with prices around €90/ton—offers strong incentives not available in the United States for the private sector economy to decarbonize.
Still, the IRA probably offers US-based investments one particular advantage over the plethora of often complex EU green policies—namely speed and simplicity. This is a message EU leaders in the summit conclusion noted implicitly, stating:
…Simple, predictable and clear framework conditions for investment in the European Union are essential. Administrative and permitting procedures should be simplified and fast-tracked, including to ensure manufacturing capacity for products that are key to meet the EU’s climate neutrality goals, taking into account the whole supply and value chain across borders.
Accordingly, the European Union will not try to match the IRA largely because doing so would jeopardize core EU economic policies in the internal market, and because the European Union arguably doesn’t need to match it euro for dollar. Still, America’s new climate policies are having an effect in Europe. The European Union leaders’ focus on securing the “whole supply and value chain” for green industries similarly has clear national security undertones arising from the dominance of China in many of these sectors. This motivation also reflects Washington’s influence in Brussels. Despite the damage done to trade rules, this transatlantic competition is a good thing for the fight against climate change.
Author's note: I thank my colleagues Maurice Obstfeld, Cecilia Malmström, and Cullen Hendrix for inspiring discussions of this topic.
This publication does not include a replication package.