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The battle for Europe's industrial sovereignty
Energy molecules are moved by pipeline or tanker, from whence they came, to the point at which it is consumed.
The modern global economy was built on this premise. Industrialisation led to greater demands on resources, which led to the exploitation of faraway fields, which helped fuel further development, which in turn led to demands for even more resources. Germany in particular, stands out as an economy whose comparative advantage was built on access to cheap Russian fossil fuel molecules, securely transported thousands of miles.
"Germany built up a business model that relied on cheap Russian gas," said Economy Minister Robert Habeck during a speech in mid-August. "This model has failed and it's not coming back."
Does it still make sense to transport coal, natural gas and oil thousands of miles across the globe - crisscrossing oceans, navigating rivers and traversing mountains and farmland - only to convert that energy into products? Why not move the energy intensive manufacturing base close to the source of cheap energy and ship the high value product instead?
Politicians in Europe have always been concerned that carbon intensive industries would rebel against ever more onerous environmental regulations, and decide to move production elsewhere.
‘Carbon leakage’ as its known, occurs when firms located in the EU might lose market share to more carbon intensive products imported into the EU. This might prompt a carbon intensive firm (or even a whole industry) based in the EU to move their operations to jurisdictions where power generation is more carbon intensive and / or where there is less onerous environmental regulations.
In response the EU plan to introduce the Carbon Border Adjustment Mechanism (CBAM), an import levy on carbon intensive products imported into the EU. Scheduled to come into force in 2026 the CBAM should put EU firms on a level playing field with firms outside the EU that are not subject to the same carbon price (see Hedging the CBAM: What the EU's carbon border tax might means for carbon investors).
The CBAM idea was conceived when energy prices were much lower and the risk was that higher carbon prices would be the tipping point for European industry to up sticks as free emission allocations were cut. Now though it is high energy prices that may result in the gradual deindustrialisation of Europe.
For some industries the process could be quite quick. For others though the idea of moving production outside of the EU and closer to cheaper sources of energy are considered a non-starter.
Commodities derive a significant part of their value from network effects. For example, the value of oil is, at least in part, derived from the transportation and refining network that serves it (the pipelines, tankers, refineries and so on), which in turn enables end consumers to derive value from it.
The greater the value proposition of the incumbent energy network to its participants, and the higher the switching costs involved in moving to an alternative network, the higher the value of the incumbent network. Any new energy network must present a sufficiently high value proposition to justify the switching costs.
Energy intensive industries may have spent decades and billions of Euros building their network. The Ludwigshafen Verbund site, 100km south of Frankfurt is the world’s largest integrated chemical complex. The facility is a highly optimised agglomeration of chemical facilities, held together by nearly 2,850km of pipes. Those kinds of economies of scale are impossible to replicate elsewhere.
However, by only focusing on past investments instead of our present and future costs and benefits, many industries may be committing to decisions that are no longer in their long-term best interests. Indeed, strong, reliable gas supply from Russia - the basis on which the initial investments were made - is unlikely to come back.
In economics this is known as ‘the sunk cost fallacy’. Being wedded to past investment decisions becomes increasingly irrational, leading to suboptimal outcomes. For much of Europe’s heavy industry this could mean being undercut by fleet-footed domestic competitors not encumbered by such a fallacy.
European industry is already mitigating some of the impact of high energy prices through import substitution. For example, as aluminium smelters have closed due to high energy prices, imports from as afar as China have surged. That could turn into a torrent if industry fails to respond and reduce its energy costs.
Energy intensive industries producing highly-tradable products are more vulnerable to the risk of energy leakage. Indeed, industries initially expected to be caught by the CBAM including cement, iron and steel, aluminium, fertiliser and electricity generation are also ones where firms may seek to relocate production. This is more likely if they have plant that is near the end of its lifecycle, and the decision to invest in a new, more efficient facility is drawing near (see Stranded asset, or last mover advantage?)
However, industrial energy migration is more likely to occur downstream, at least at first, in the manufacturing activities that depend on a range of raw materials, yet are also highly energy intensive.
An example of industrial energy migration beginning to happen is Germany’s expanded partnership with Morocco. The bedrock of the German-Moroccan economic partnership are the automotive manufacturing value chains. Automotive products comprise Morocco’s largest category of exports to Germany, constituting about one-fifth of overall exports to Germany prior to Russia’s invasion Ukraine. Manufacturers benefit from cheaper energy and labour costs and a network of manufacturing facilities, especially electrical wiring.
Longer-term, a stable cheap supply of ‘green’ hydrogen could be enough to incentivise heavy industry (steel, cement, etc.) to relocate. Here Morocco may also have an advantage over other regions close to the centre of demand in Europe. According to recent analysis from the International Renewable Energy Agency (Irena), Morocco could deliver green hydrogen at a levelised cost (LCOH) of just over $0.65 per kg by 2050, supported by an expansion in solar power generation.
That’s comparable to Chinese expected production costs - China is likely to be the cheapest place in the world to produce green hydrogen. In contrast, the cost of producing green hydrogen in Europe is projected to cost around 50% more, at close to $1 per kg by 2050.
While there is a ‘last mover advantage’ in waiting to see which decarbonisation technology has the highest chance of success, it is no good if by waiting you are put of business by high energy costs. High energy prices in Europe coupled with worries over long term security of supply may force industry to relocate. First mover advantage may enable them to retain market share, rather than being undercut by cheap imports.
A loss of industry from Europe would be a blow to European energy demand, cutting demand for carbon allowances. Some of the emissions will have been offshored elsewhere, but some will also have been abated, if for example many industries can take advantage of the growth in ‘green’ hydrogen in Morocco and other countries with have access to cheap and plentiful energy.
But, lets stop there for a moment.
All of this assumes that energy and carbon intensive industries operate in a vacuum, one where they are able to act on their interests without the intervention of the state. In reality governments will do everything in their power to avoid the hollowing out of their industrial base. On the contrary, with Europe at war and the potential for conflict elsewhere in the world, government policy is likely to pivot to the reshoring of industrial and manufacturing supply chains.
Our industrial sovereignty depends on it.
Two recent articles by respected economic thinkers seek to outline what an economy dominated by concerns over war could look like. The first article, ‘War and Industrial Policy’ by Credit Suisse strategist Zoltan Pozsar first outlines what he believes the global economic order has been built upon for the last three decades:
“The low inflation world had three pillars: cheap immigrant labor keeping nominal wage growth “stagnant” in the U.S., cheap Chinese goods raising real wages amid stagnant nominal wages, and cheap Russian natural gas fueling German industry and Europe more broadly.”
That economic order is now gone, possibly forever. And the reason? A loss of trust. Referencing Dale Copeland’s book, Economic Interdependence and War, Poszar outlines the ‘theory of trade expectations’:
“when great powers have positive expectations of the future trade environment, they want to remain at peace in order to secure the economic benefits that enhance long-term economic power. When, however, these expectations turn negative, leaders are likely to fear a loss of access to raw materials and markets, giving them an incentive to initiate crises to protect their commercial interests”
In simple terms, trade only works if there is trust.
To negate this mistrust the West will have to pour trillions into four types of projects according to Pszar: re-arm (to defend the world order), re-shore (to get around blockades), re-stock and invest (ensure the supply of commodities, especially energy), and re-wire the grid (the impetus behind the energy transition grows stronger).
In the second article, ‘The War Economy’ Noah Smith outlines why governments are likely to intervene in energy markets and industrial policy to a much greater extent than they have done for several decades:
“We are in a technological, economic, and arms-race competition with enemies with highly advanced tech capabilities, tons of production potential, and far fewer scruples than we have regarding the use of government power. We are not going to be able to deal with that problem by cutting taxes and opening our markets to more Chinese-made products and twiddling our thumbs and intoning quotes from Milton Friedman. Everyone except a few die-hard ideologues and vested interests realizes that on some level by now.
We are going to need to increase planning for one reason: National defense is a public good. Indeed, it is the most classic, most fundamental public good. Private individuals, left to their own devices, will simply not contract with each other to provide effective defense against Russian rockets or Chinese drones; we need a strong government to handle the threat from other strong governments. And since defense requires a huge technological and industrial supply chain in this day and age — you can’t just have a bunch of minutemen pick up their muskets and walk off to defend the country — the public good of defense-oriented planning is going to reach deep into many sectors of the economy.”
More fossil fuel investment in Europe, longer term contracts with reliable suppliers, the resumption of critical raw material mining on Europe’s soil, the reshoring of industrial supply chains including those vital for the buildout of renewable energy. These developments are likely to outweigh any movement by industry to move to places where energy is cheap and plentiful. In short, industrial sovereignty beats industrial energy migration.
In the long-term that means energy demand in Europe could be set to increase. That means that investment in low carbon power generation and industrial decarbonisation needs to accelerate. If not then carbon emissions could be set to rise, increasing demand for carbon allowances while also putting EU emission reduction targets in jeopardy.