What's the future for EU climate policy?

While the EU has taken robust action to champion the transition there are fears of a backlash against ESG and security concerns impacting the priority given to climate protection. What can be expected going forward?

In recent years the EU has taken promising action to facilitate the green transformation but as investors know well ‘past performances do not guarantee future results’. Coming years are expected to be bumpy for EU climate policy making.

Geopolitical risks and member state protectionism might impact the speed of agreements and the implementation of new regulation which could hamper decarbonisation action and the fiscal support required. This is, for example, reflected in the discussion around the Energy Taxation Directive. The Commission tabled a revision in 2021, but postponed it, facing opposition from several member states. A second attempt in November 2023 again resulted in blocked negotiations.

While the trend continues to move in the right direction we should be realistic that hurdles are to be expected, with several regulatory developments being impacted by the elections and in the worst case, by the outcome of elections. Although challenging political times might lay ahead there is hope that EU interests will align around decarbonisation and EU competitiveness. The latter is a key priority of the largest EU party, the European People’s Party. One crucial pillar of the transition, essential in aligning these interests, is the Net Zero Industry Act. Key elements of this Act, such as fast-track permitting and the so-called ‘Net Zero Acceleration Valleys’ are essential to speed up the transition.

Further implementation of this Act supported by the right financial conditions and governance, needs to be decided on soon, by the next Commission and the member states, to competitively counter the US‘s Inflation Reduction Act and Chinese subsidies. This should strengthen the EU’s strategic, competitive positioning and ‘future-proof‘ the Act so the non-binding target of producing 40% of clean technologies in Europe, by 2030, is reached. Ultimately this comes down to rapidly expanding (subsidised) domestic manufacturing capacity by enabling the scalability of EU firms in relevant sectors such as batteries, heat pumps, electric vehicles or biomethane, in addition to subsidy-probing (Chinese) imports of new technologies. However the import of these products cannot be fully restricted as greenhouse gas reduction targets must be met.

To remain competitive member states will need to revise national subsidy and public procurement programs (and spending) by, for example, including non-price criteria in the auctioning of renewable energy to allow domestic parties to remain competitive with foreign ones. Also at EU public procurement level ‘a dedicated platform specifically for joint procurement’ is required, which would, for example, operationalise the Critical Raw Materials Act, as pointed out by Draghi in his report on the future of EU competitiveness.

The developments referred to above would mark the start of the next phase of the Green Deal, targeting 2040, and referred to by the Commission asthe ‘industry decarbonisation deal’. Tackling the next phase appropriately must ensure the ‘decarbonisation of the EU industry, while preventing the deindustrialisation of Europe’, as rightfully pointed out by a German MEP. In other words, Europe must decarbonise industry competitively. The current environment requires the next phase to be even more comprehensive and flexible, targeting diplomacy, trade and finance instead of solely focusing on industrial activities and consumers. The positioning of the issue within the European Council’s Strategic Agenda 2024-2029, to be adopted in June 2024, is crucial in ensuring the green transition is used to strengthen the EU’s industrial positioning and to gain sufficient buy-in from the European Parliament.

The special European Council meeting in April 2024, highlighted four major areas of action to deepen the single market and transform it into a true European market that embraces the green and digital transition: (1) improve access to capital for EU companies; (2) reduce energy costs; (3) improve workforce skills; and (4) strengthen trade with the rest of the world. The new Parliament is expected to focus more on member state sovereignty, which could hamper the latest Council communication. Will the strategic agenda for the next legislature remain intact?

The first point of these areas of action remains challenging – improving access to capital for EU Companies. According to I4CE there is an estimated annual investment gap of EUR 406 billion. The financing challenge for public and private markets is huge. The second phase of the Green Deal and the Net Zero Industry Act needs fresh money. While additional financing options such as the Emissions Trading System fund as well as the Strategic Technologies for Europe Platform funds are being explored, additional funding, aligned with social and distributional impacts, is expected to be a pivotal negotiation hotspot and battleground in the upcoming elections and in further negotiations, especially when capital flows from abroad and European private savings are being suggested.

There is also a lot of uncertainty around the role of fossil fuels (linked to carbon capture and storage expectations) which needs to be clarified in terms of financial and technical viability in order to keep certain EU fossil fuel nations on board.

Likely the biggest challenge in the short term is the buy-in of EU citizens and the political fear associated with it. One should not overlook the ‘just transition principle’ in this context. Social unrest, as shown by the Gilet Jaunes and agricultural protests, will continue to stir up debate and fuel pseudo-populists, particularly around elections, if the transition and associated policy making is not managed in an inclusive and brave manner. The complex debates around clean transportation and agriculture cannot be ignored as they represent approximately 25% and 11% respectively of the EU’s total GHG emissions, while for the latter, climate change effects also continue to drive up costs and productivity.

This raises the question of whether the new Council, Parliament and Commission will opt for the carrot or stick approach to reach GHG reduction targets and remain competitive in both the short and long run while ensuring buy-in from the electorate. In any case, climate change risks and associated mitigation efforts will continue to impact the market, in all scenarios and regardless of the asset class covered. Coming years are expected to be bumpy for politicians, citizens, corporates and financial institutions.

Weapons instead of climate protection?

There is concern that the EU’s current focus on defence will detract from climate protection. While it is true that geo-political unrest has put defence at the top of the EU’s agenda, considering the factors mentioned above it seems likely that green transition policies will continue to remain at the forefront of policy making and budget spending, as they can be aligned with a strengthening of the EU’s competitive, industrial positioning. Geo-political unrest will only increase protectionism, which will focus on the products and services of tomorrow (products and services that are at the forefront of facing climate change mitigation and adaptation).

Furthermore, the challenge of decarbonising the economy should be considered a united form of ‘climate protectionism’ as we will certainly not win the climate change battle under a hot-house scenario.

Due to extreme events, critical changes to earth systems and ecosystem collapses, risk factors such as inflation and adaption costs are expected to be much higher in a long term hot-house scenario, compared to a smooth transition which keeps global warming close to 1.5°C. Additionally, social unrest and migration are expected to rise under a hot-house scenario. This has already occurred, as the Center for Climate and Security has stressed, the Arab Spring was linked to the failure of governments to meet their citizens basic needs, address climatic issues like droughts, desertification and power shortage among other factors. Hence, investing in the transition will not only mitigate climate risks, but also, to an extent, socio-economic ones, notably by reducing migration and social unrest, ultimately freeing budget for other priorities.

Although many agree on the disastrous effects of a hot house scenario, short-termism continues to block tangible, rapid action. EU politicians must move away from the Ostrich Effect and keep an eye on potential biases in decision making, such as underestimating the probability of being directly affected alongside underestimating the likelihood and severity of disaster scenarios. This implies treating both security and climate protection as key risks requiring drastic action and funding while not forgetting they are interconnected. Should Europe consider a trade-off, or just double down on the mitigation of both risks?