The European Green Deal. How can the EU reform its fiscal framework to meet its climate targets?

By Sebastian Kiecker, 13 January 2021

The European Union (EU) has economically underperformed for years facing difficulties in maintaining its economic competitiveness and investment rates (EIB 2019). 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 low investment environment (Storm and Naastepad 2016). This has translated into green innovation and investment underperformance. 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). 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). Given the economic fallout following the Covid-19 pandemic the EU urgently 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, 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). So, does the Green Deal deliver the necessary investments?

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 Green Deal entails a total investment plan of 2.6 trillion euros over the next decade, with public funding equalling 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. The current Green Deal under optimistic assumptions increases economic growth by 0.5% per year, falling significantly short to deliver a genuine green growth strategy sufficient to offset the adverse socio-economic impacts of the green transition and the Covid-19 pandemic (Claeys et al. 2020; Storm 2020, pp.10-11). 

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?

Policy Options

The first policy option is to amend the Stability and Growth Pact (SGP) by specifically expanding the investment exemption clause. Currently, it excludes investments with positive, direct and verifiable positive long-term effects on growth and fiscal sustainability (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; Clark and Nickels 2020, p.3).

The third option is designed to minimise and withstand these political pressures by delegating the European Green Deal’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:

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). However, one major drawback is that only a handful of member states have public investment banks. Setting up this new fiscal framework will thus take a considerable amount of time and effort.

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

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 European Green Deal’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 public investment banks 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 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 public investment banks (e.g. Germany and France) to increase their  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 public holding companies 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. 8-18; Beetsma et al. 2020).

Sebastian is a 4th year student on the University of Stirling’s PPE programme. This post was originally submitted as a policy brief assignment to the module POLU9GE Political Economy and the Global Environment.