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The Real Reasons Why Europe Is Concerned by the US Inflation Reduction Act

15/12/2022

The Real Reasons Why Europe Is Concerned by the US Inflation Reduction Act

Author

Georgina Wright

Resident Senior Fellow and Deputy Director for International Studies

Inflation Reduction Act: Between Europe and the United States

US President Joe Biden told French President Emmanuel Macron that he would try to 'tweak' the Inflation Reduction Act to stop it discriminating against European companies. The EU knows it cannot rely on IRA exemptions to protect its industry from unfair competition - the problem is, it can't agree on what measures to take, argues Georgina Wright.

Most of Brussels was on holiday on 16 August 2022 when the Biden administration signed the Inflation Reduction Act (IRA) into law. A mammoth package of 280 pages, the IRA aims to drastically reduce US carbon emissions and strengthen its social security system, while also cutting the public deficit, fighting inflation and boosting energy production and manufacturing. Not everyone in the US likes it: the bill narrowly made it through Congress, with 220 voting in favor and 207 against.

The EU’s view of the IRA is also mixed. On the one hand, this is the first serious attempt by a US administration to combat climate change (the IRA plans to reduce carbon emissions by 42% by 2030 (compared with 2005 levels)). Although experts believe the US will need to pass more legislation to meet this target, the IRA is an important first step in US climate action - and undoubtedly a good move for the planet.

But it's the IRA's whopping subsidies package that is proving problematic. To cut down emissions, the US administration is hoping to boost its green technology industry. Through the IRA, it is pouring $369 billion worth of tax breaks and subsidies into energy production and manufacturing, in particular for electric vehicles, solar panels and batteries that are mainly produced in the US. That's almost half of the total of the NextGenerationEU, the mass investment plan the EU adopted in 2020 to relaunch the EU's economy after Covid-19. The EU is not alone: the UK, Japan and South Korea have all expressed similar concerns.

This poses both a short-term and longer-term risk for the EU. There is an immediate risk that the EU's 'green tech industry' relocates to the US to flee the bloc's high energy costs and low subsidies. It's also clear that tweaks to the IRA won’t be sufficient to ensure EU industry remains competitive in the long-run. The EU knows it needs to introduce some form of subsidy support but it is not sure how to do this without revising its free market principles and competition rules.

Europeans do not hate the IRA

The EU may not like everything about the IRA but it does support US ambitions to try and tackle climate change through it. For the US federal government, the IRA is "the most aggressive action we [US administration] have taken to confront the climate crisis". Some US companies have started to adjust their business plans and production sites. This has even benefited some firms inside the EU: German heavy industry firms saw their exports to the United States increase by more than 40% in September 2022 compared to the previous year.

The EU is also keen to preserve its good working relations with the US, which have significantly improved since Biden took office.

The EU is also keen to preserve its good working relations with the US, which have significantly improved since Biden took office. Both would rather resolve tensions over the IRA diplomatically: in October, the EU and the US set up a specialized task force within the US-EU Trade and Technology Council (TTC) to discuss the nine reservations the EU has about the IRA.

During Macron's state visit to the US, President Biden said that he would try to tweak the text to stop penalizing the EU's green industrial transition. In theory, any amendments to the bill would need to get the approval of Congress, but the EU's Commissioner for the Internal Market, Thierry Breton, is confident that a solution can be found.

The IRA confirms the US' protectionist tendency

For many Europeans, it’s not the IRA per se that worries them but rather the broader signal it sends about the direction of travel for US industrial policy.

For starters, even if the US did agree to grant exemptions to European or EU-located firms under the IRA, this would only be a temporary solution. Today, more than a quarter of the world's electric vehicle production is European, while US production accounts for only 10% of global production. Now under the IRA, electric vehicle (EV) companies can only benefit from the full subsidy scheme - $7500 per vehicle - if they meet two conditions: first, that at least 40% of the critical raw materials used in the electric battery are extracted in the US or in a country with which the US has a trade agreement (though this threshold will increase to 80% by 2026); second, that at least 50% of the battery components are made or assembled in the US, Canada and Mexico (although here too, the threshold will increase to 100% by 2029).

Realistically, if EV companies want to continue receiving subsidies beyond 2025, they would need to relocate to the US - or at the very least, have US-integrated supply chains. Similarly, US consumers can buy European EVs but they would only benefit from IRA tax breaks if they buy cars that are "Made in America". This prospect, combined with low US energy prices, probably explains why Tesla announced in September that it was opening a battery plant in the US, rather than Germany. Iberdrola, the Spanish energy firm, and Safran, the French multinational company specializing in aviation, defense and space markets, have also relocated part of their activity to the US.

The IRA also challenges other areas of EU industry. It includes new tax credits to promote carbon capture, clean hydrogen and investment in clean energy technologies and to mitigate greenhouse gas emissions - all areas in which the EU is either already a global leader or wants to deepen its industrial expertise.

The IRA includes new tax credits to promote carbon capture.

This is also why many Europeans label the IRA a protectionist move. Protectionism started when President Donald Trump slapped tariffs on steel and aluminium imports in 2018. Biden may have removed these tariffs but trade lawyers maintain that the bill breaches World Trade Organization trade rules by conditioning subsidies on local manufacturing and tight supply chain rules. A US-EU trade agreement could help but won't suddenly change US preference for products that are "Made in America".

This poses a key challenge for the EU. With the US, but also China, placing national preference at the heart of their industrial policies, and with the World Trade Organization at a deadlock, the EU needs to find new ways to support industry and ensure it remains competitive on the global stage. Unless it does, more EU businesses will move to the US.

Getting real about industrial support

Clearly, more needs to be done. "We need our European IRA" added von der Leyen this week in front of the European Parliament.

The EU is exploring several options, including simplifying EU rules and state aid procedures and setting aside more resources for Europe's competitive sectors.

1. A new European Sovereignty Fund

One option being discussed - and the most popular - is to create a new European Sovereignty Fund to support EU innovation and industrial programs that are "Made in Europe". This new European Sovereignty fund was first mentioned in von der Leyen’s State of the Union speech in September, an annual event where the European Commission president sets out the Commission’s priorities for the coming year. It is now up to Breton to turn this fund into reality.

How much funding will be a matter of debate. Breton has floated a figure of €350 billion, i.e. 2% of the EU’s GDP. Several Member States, including Germany, would prefer to meet that target by repurposing unspent EU funds.

The EU could choose to redirect some funding from the European Stability Mechanism or EU structural funds.

For example, the EU could choose to redirect some funding from the European Stability Mechanism or EU structural funds. This would be relatively straightforward. Every seven years, the EU negotiates a seven-year EU budget (in Brussels jargon: the multifinancial framework or MFF) - but Member States and the European Parliament can tweak funding streams during yearly MFF reviews. This has proven particularly helpful in times of crisis when the EU has needed more money to support humanitarian or health initiatives, for example.

The advantage of redirecting existing funding is that the money has already been budgeted for. It is the Member States that have the final say over how it is spent. The downside, however, is that it would mean fewer resources for other EU policies, like regional support in countries like Poland and Italy.

Another problem is timing. If the EU is really serious about responding to the IRA, it can't really afford to wait until next year's budget review. In the meantime, the European Commission has proposed to use resources from the RePowerEU plan, the EU's instrument to help the EU lessen its dependence on Russian fossil fuels. However, as EU industry expert Nils Redeker points out, it's hard to see how the Commission can change the funding allocation when RePowerEU has only just been adopted by the European Parliament.

2. More subsidies please!

For other Member States, including France, redirecting existing EU funding will not be enough to face the scale of the challenge. Instead, they would like to see additional funding put on the table - ideally in the form of subsidies. Interestingly, Katherine Tai, the US Trade Representative, also said that this was something that the EU should consider. Two options are being floated in the EU. Both carry risks and would require a relaxation of the EU’s competition rules.

The first would be to introduce a new EU-wide subsidy scheme to support EU industry and innovation, while making sure the EU remains an attractive place for investment. This scheme would be financed the same way as the NextGenerationEU: the EU would borrow on financial markets by using the EU budget as a guarantee. The EU Commission would then look at other ways to raise resources to pay the debt off.

It's easy to see why some Member States are ruling this option out. Some Member States - especially "frugal" countries like Austria, the Netherlands and Sweden, for example - are reluctant to take on more common debt, especially given that they still don't know how they are going to reimburse the €750 billion NextgenerationEU plan. The recent decision by Germany's constitutional court, the Karlsruhe, also shows the political difficulties of adopting new major EU fiscal plans.

As EU constitutional experts Thu Nguyen and Martijn van den Brink point out, the Court wouldn't automatically rule out a new EU fiscal instrument, but it would want the duration and volume of assistance to be limited. In other words, an EU subsidy scheme would be complicated. Other EU countries are worried about how the EU subsidy scheme would work. For example, who inside the EU grants the subsidies? In the case of the NextGenerationEU, it is the European Commission that decides when - and crucially, when not - to allocate the funding. The Commission only hands over tranches of funding once EU governments have made sufficient progress in passing reforms in line with their national plans. EU governments are then responsible for redistributing the funds.

In the case of the NextGenerationEU, it is the European Commission that decides when - and crucially, when not - to allocate the funding.

But in the case of subsidies, the Commission would - presumably - be handing assistance directly to EU firms. This poses three problems. First, it is too early to determine which industries have been most affected by the IRA. Second, there is a risk that subsidies go to those firms with powerful lobbies in Brussels and access to EU governments and institutions, rather than those firms that are most innovative. Privately, some officials also worry that subsidies would go straight into the pockets of shareholders, rather than to the companies themselves. Others are worried that subsidies will disproportionately benefit those countries with a high concentration of green tech industry. Third, under existing EU competition rules, state aid can only be made available for research - not manufacturing needs.

The second option would be to provisionally suspend EU state aid rules to support critical industries. The EU treaties limit the amount and kind of support EU governments can give their industries to protect the single market from unfair competition. But the EU can - and has - made exceptions in the past. For example, it suspended state aid limits at the height of the covid-19 pandemic to enable EU governments to provide exceptional support to national industries and companies. This option would give EU countries the liberty to choose how to allocate aid and who to support. It also means any debt would be national, rather than owned by all Member States.

However, this option also carries risks. Richer countries will find it easier to support their industries than fiscally weaker ones. Equally, those countries with a concentration of green tech technology industries may need more help than others. It's a tricky balance, which would need to be carefully coordinated by the European Commission. In the words of von der Leyen, "while it is critical that Member States have the flexibility to invest their budgets in strategic sectors, this approach cannot be self-standing. [...] It would favour deep-pocket states and lead to distortions that would eventually undermine the Single Market".

3. Simpler state aid rules for faster assistance

The other problem with subsidies is that it can quickly turn into a subsidy race - both between the US and the EU, and within the EU itself. Many EU politicians, including von der Leyen, EU Commissioner for Competition, Margrethe Vestager, as well as French Finance Minister Bruno Lemaire and Irish Minister Leo Varadkar have all voiced their concerns.

The question is not simply about making EU assistance available: it is also about how quickly that assistance reaches EU businesses.

To avoid this, the EU could look to simplify EU state aid rules to privilege certain sectors over others, for example to firms specializing in carbon-neutral technologies. However, the question is not simply about making EU assistance available: it is also about how quickly that assistance reaches EU businesses. Some EU capitals have called on the European Commission to speed up the process for approving grants for key industrial projects - which is significantly slower in Europe than it is in the US.

In their recent joint statement, French Finance Minister, Bruno Lemaire, and German Minister for Economy and Climate Action Robert Habeck called on the EU to "optimize and accelerate the notification process of Important Projects of Common European Interest" (IPCEI) like batteries, hydrogen and solar panels. On 14 December, the European Commission promised to set out a new framework to make state aid rules "simpler and faster to get access to investment aids and tax credits". This will presumably be discussed at the European Council this week.

4. "Made in Europe" production

Another idea put forward by France was to adopt a "Buy European Act" which would grant European preference in call for tenders that govern public procurement, while also keeping an open door to foreign investment, services and products. It's unclear how this proposal would work but privately, many EU officials in Brussels, but also diplomats from 'free-trade' enthusiastic countries, are ruling it out.

Industrial policy is becoming a top priority for the EU

None of these four options are simple - but they would, at least for now, avoid a transatlantic trade war.

The US and Europe have promised to build a common agenda to strengthen the resilience of supply chains and reform the WTO. This makes sense: if the US and EU governments want to become less dependent on Chinese and Russian imports, they need to improve bilateral trade, not restrict it by adopting measures that primarily favor national production.

The reality, however, is that governments all around the world are increasingly focused on how to prop up their industry while lessening dependence on "unfriendly" nations. The EU's recent decision to create a carbon border adjustment mechanism has been seen by some, not least the Americans, as a form of protectionism designed to penalize foreign imports.

The EU's industrial policy will become a key focus for 2023. EU capitals may not want the EU - and especially the European Commission - to take on more decision-making power in this field, but they may not have another choice.

It will be a heated debate. Still, at least that gives analysts like me plenty to work on.

The author thanks Camilla De Luca, Research Assistant in Institut Montaigne's Europe Program as well as Dr. Mathieu Duchâtel and Dr. Joseph Dellate in Institut Montaigne's Asia Program for their comments.

Copyright: Frederick FLORIN / AFP