Paying for the European Green Deal—Fiscal and social challenges

Climate action is expensive, and European budgets will be even more constrained in the coming decade by the fallout from covid-19. A key question for governments will be how to pay for climate-related reforms.

This blog reports on the second session of a virtual conference, European Climate Action: Political Economy Challenges, hosted by the European Studies Centre of St Antony’s College Oxford, on January 21, 2021, which tackled this difficult question.

The panel included Jean Pisani-Ferry, Senior Fellow at Bruegel and PIIE, Professor EUI; Dora Iakova, IMF, Assistant Director leading IMF work on European Climate Policies; and Linus Mattauch, Martin School, Oxford; it was chaired by Professor Tim Vlandas, St Antony’s College. Click here for the podcast of session 2.

 

Jean Pisani-Ferry            Dora Iakova         Linus Mattauch          Tim Vlandas

Background: challenges both for the EU and for national governments

For European governments, operationalizing the European Green Deal will require finding ways to pay for it—somehow accommodating new spending for climate action within budgets already stretched by the impact of COVID-19. There are partial solutions (grants from the Recovery Fund) and additional planned solutions (new taxes on plastic waste and sharing of Emissions Trading System (ETS) auction receipts). But mainly, governments are likely to be offered easy-term loan financing—meaning that their deficits will worsen until they take offsetting action.

This creates new dilemmas for fiscal policy both at European and national levels.

• At the EU level, Europe will have to decide whether other spending will be sacrificed for climate spending, or whether its fiscal rules can be relaxed (perhaps a more conceivable prospect in a post-covid world?). The Green Deal envisages a review of the European economic governance framework. The review will need to answer the question of how far fiscal rules should be modified to accommodate climate investment. This will require striking a delicate balance between investing in resilience and protecting debt sustainability.

• At national levels, governments will have to chart a fiscal strategy that allows them to respect the EU fiscal framework while delivering on their NDCs—making difficult choices between cutting other spending and raising taxes.
  

There is wide agreement that higher carbon taxes should be a key component of paying for climate action, since they create efficient incentives for transformation away from polluting activities. A revision of energy taxation is a key element of the European Green Deal and is also under review in Britain. However, the political feasibility of carbon taxes is still to be tested: hydrocarbon price increases can be politically toxic, as demonstrated by the gilets jaunes’ backlash. A main challenge to social scientists is to design carbon price hikes in a way that makes them tolerable to the public. This may require greater reliance on non-tax approaches to increasing carbon prices, notably by strengthening emissions trading schemes (which attempt to impose an economic cost of carbon).

Jean Pisani-Ferry opened the discussion of ‘How Will Governments Pay?’ by looking at the likely EU bill. His broadbrush estimate of the annual cost of decarbonization for the EU (with expenditure on infrastructure, renewables, research, etc.) was “perhaps a 2 percent of GDP increase in total private and public investment each year”. While substantial, this would imply a government share of between ½ to 1 percent of GDP p.a. (meaning a cost that need not terminally distort the EU fiscal framework).

Moreover, not all of this extra spending will increase fiscal deficits, since some will be funded by grants, from the 30 percent of the Next Generation EU Fund assigned to climate transition. This is an estimated 127 billion euro (0.9 percent EU GDP), which, spread over five years, will fund an average 0.2% GDP extra spending a year. Pisani-Ferry cautioned that it will be important to make access to these funds subject to conditionality: for instance, the EU should require countries to align their national policies with its overall strategy for cutting fossil fuel subsidies.

For the EU, the main question is whether the SGP fiscal framework can continue to be applied or will have to be reformed. It has been suspended during the pandemic, leaving open the question of what rules to go back to. Studies suggest that the SGP has been associated with considerable dampening of investment, especially in high-debt countries. The SGP does contain a clause allowing deviations from the medium-term objective to finance growth-supporting investment, but only two countries have ever applied for this exemption because requirements are too onerous (the country must be in recession but with its fiscal deficit still on track and must have co-financing) and the exemption too small (less than 0.1 percent of GDP).

Pisani-Ferry made it clear that discussion of the SGP is at an early stage, but offered two anchors for furthering the debate. In his view:

• SGP rules should be amended to accommodate climate-related investment. Indeed, the rules need to be amended in any case, since the protracted low interest rates and high covid debt mean that the benchmarks no longer make sense. Any reform should include a broader definition of sustainability and a sustainable corrector for growth. It would be preferable to do the reform before the General Escape Clause is deactivated (currently programmed for end-2021). The amendment should not just exempt climate-related investment from deficit-accounting, since it would be too hard to define the exclusion (the investment needed is non-traditional, and some undesirable investment would be difficult to ringfence). A preferable approach would be to have a qualification process for investments, subject to a list of defined priorities.

• This type of reform alone would not solve the problem that highly-indebted countries will be reluctant to invest. There is no easy answer to this, but Europe’s financing for covid expenditure may be seen as an experiment that could be extended to climate spending: national investments are for the first time being financed by the EU via the Recovery Fund, and not treated as part of Maastricht debt. Pisani-Ferry was careful not to suggest that centralized financing would be a panacea—in the end, countries will end up having to cover the cost through their contributions to the EU budget—but it does illustrate how a larger climate budget could co-exist with continued discipline to maintain sustainability in national fiscal frameworks.
  

Dora Iakova then turned to the national-level challenge for EU governments. She described an IMF exercise which explored whether/how national governments can pay for climate-related reforms while maintaining sustainability, by attempting to construct an affordable fiscal package consistent with preserving growth. But first she emphatically reminded the audience that the question (‘whether?’) is mis-posed: governments have little choice but to spend money to stem global warming, since failure to cap climate change would surely entail worse fiscal costs. That said, there is a real sustainability problem to be grappled with, since governments will not be able to foot a large bill indefinitely. To craft a feasible path between this rock-and-a-hard-place, any sustainable fiscal strategy will have to be as efficient as possible and focus on establishing enabling conditions for the private sector to fund the transformation.

• A key message from the IMF exercise is that there is no sustainable fiscal strategy that does not require raising carbon prices. Attempting to change private-sector behaviour through regulation or subsidies is much more expensive and less likely to work. Pre-announcing a gradual path of phased carbon price increases would give investors and consumers the strongest incentives to switch to ‘green’ behaviour, with minimum disruption to economic activity. Moreover, the IMF estimated that a gradual hiking of EU carbon prices to 100 euros per tonne would raise revenue by around 1 percent of GDP—significantly easing fiscal pressures.
  

For the EU, carbon prices could be raised by extending the Emissions Trading System (ETS) to additional sectors, rather than by explicit carbon taxation—although some countries such as Denmark, Ireland, and Germany have begun to complement the ETS with additional national carbon taxes. Fuel subsidies will need to be phased out, and measures like fee-bates (sliding prices for fuels or cars, depending on their emissions) would help strengthen the price signal to the transport sector—these are already being used in the UK.

• A second message is that government investment should concentrate on smoothing the path for the private sector—for instance, by upgrading electricity grids, providing public charging stations, funding research, giving low-cost loans to retrofit homes, etc. The more the frontloading of enabling investment, the better. Funds available through the Recovery Fund make this possible and are large enough to make a big difference: for instance, Spain can draw on 2 percent of GDP in grants. Obviously, it will be key to use the funds effectively; the EU envisages oversight to monitor this.
  

• A final message is the importance of a just transition. Since there will be clear losers, in the sectors affected by higher carbon prices (and by climate change itself), a strategy to help them adjust and compensate for losses will be a prerequisite for a politically-feasible transformation.
  

Linus Mattauch tackled the quandary that, although economists are adamant that climate goals cannot be reached without much higher carbon prices, politicians, citizens, and industry all have grave concerns about their impact. Hence, the main challenge for carbon pricing is how to get public support for the policy, because otherwise it will fail. There have already been several recent ‘spectacular’ political failures: Australia’s 2012 carbon tax had to be repealed in 2014; there have been two failed referenda in Washington State (2016 and 2018); and Germany’s Fridays for the Future movement is failing to generate support for higher prices.

Mattauch drew several lessons from his research on what worked to persuade citizens to accept higher prices, in countries which succeeded in raising prices:

• Focus on how the revenue will be used to alleviate the impact of the price change: all successful reformers used the revenue strategically to mitigate the domestic distributional effects.
  

• How the price is raised affects how the revenue can be used. Evidence suggests that revenue from carbon tax is returned to households and firms (a ‘fee + dividend’ approach), whereas ETS revenue has tended to stay with government and be used for green spending. Citizens’ preferences for tax versus ETS differ across countries. A survey showed that the French public distrust the fee + dividend approach (a tax followed by a cheque-in-the-mail), whereas Germans prefer this direct transfer to the more diffuse benefit from ETS earnings used for green government spending.
  

• A focus on how the revenue is used is also vital for maintaining positive communications about the reform. A main problem is that the public does not understand why the behavioural response to carbon tax is so important. Hence, if the revenue can be explicitly earmarked for a popular reform, it will win more public support. In general, to earn public support, the costs should be diffuse and the benefits as salient and concentrated as possible. This argues for upstream uniform price increases and earmarked spending. And still more generally, any reform will be more successful if it avoids calling the carbon price increase a tax!
  

• Finally, researchers find a positive relationship between pre-existing political trust in countries, and their capacity to raise carbon prices. This augurs well for Europe’s capacity to lead global efforts in carbon-pricing, given the relatively high level of political trust.
  

The offline discussion focused on why economists have kept losing the battle for carbon-pricing. So far, proposals for redistribution have tended to come too late and look too temporary; coupled with citizens’ limited trust in government, this has made the compensation side of the strategy inadequate. Hence the vital need to put the Just Transition at the centre of any future reform effort. Of course, the distributional issues are difficult and costly: for success, compensation probably needs to reach a combination of the vulnerable and the less-vulnerable-but-politically-powerful; broad coalition-building will be a prerequisite for success. Moreover, the international dimension of the need for compensation is only now beginning to be tackled (and will be very difficult). That said, the panel was in agreement that, in fact, the impact of the price changes will be relatively tolerable (e.g., a 25 percent increase in electricity spread over ten years), so the compensation should be affordable—the challenge will be how to design it so the right amount reaches the right people, and so that people feel the compensation is fair and adequate.

Adrienne Cheasty (Academic Visitor with EuPEP, St Antony's College, Oxford)