Zero carbon supremacy

Why governments are looking to secure their green industrial sovereignty

War in Europe has pushed its governments to pursue any measure necessary to extricate itself from Russia’s geopolitical sphere of influence.

In the short term that has meant sourcing natural gas from other suppliers (e.g. from the US and Qatar), and overriding, at least temporarily, long standing political commitments to phasing out nuclear and thermal coal power.

The longer term aim to increase the percentage of energy from renewable sources and decarbonise its economy remains. Indeed, it’s political leaders have sought to accelerate this process as it is seen as being completely aligned with cutting Europe’s exposure to Russia’s fossil fuel exports and the geopolitical vulnerability that dependence entails.

However, reducing dependence on fossil fuels does not mean that geopolitical risk simply goes away. The zero carbon energy transition means that countries will still seek to exert geopolitical influence.

One way to do this is by controlling the flow of energy, e.g. the high voltage power lines exporting zero carbon electricity. Another is to control access to the raw materials essential to the zero carbon energy transition, e.g. lithium, cobalt, copper, etc.

The third and arguably the most important way in which countries may seek to exert geopolitical influence is by gaining an edge in zero carbon technology. Just as the US ascent to global supremacy in the 20th century was inseparable from oil, countries are now vying to control the key energy technologies of the future: not just hydrogen, but also solar, batteries, digital networks, electric vehicles, and so on. Countries have a strategic interest in being technology makers, not technology takers in these critical areas (see The impossible trinity at the heart of net zero).

Leaders in North America and Europe do not want their economies to be left to be the latter, as China takes the lead role of technology maker. The risk of a green industrial arms race to take back and secure a lead in zero-carbon technology is increasing. The battle could have important implications for market based approaches to tackling climate change, both in Europe and elsewhere.

The first salvo in this race for zero carbon supremacy comes from America’s Inflation Reduction Act (IRA), which came into force from 1st January 2023. Signed into law in mid-August 2022 and coming into effect at the beginning of 2023, the IRA includes almost $370 billion of funding aimed at unleashing a boom in clean energy deployment and related technologies. The IRA employs generous subsidies and tax credits while also restricting competition to domestic US companies - the so-called “Buy American” clauses.

Although the impact on carbon emissions from the second largest global emitter is welcome, the IRA could have adverse unintended consequences elsewhere. As I outline in A 'green' unicorn, investment in European climate tech could suffer unless its governments unleash similar levels of government support. European climate tech start-ups could be starved of capital relative to their North American peers - many of the former might now be lured across the Atlantic.¹

How might Europe respond to this threat?

The EU do not want to repeat the mistakes of the past, relying on a limited number of countries to supply them with green energy and technology. It is not enough to simply achieve their climate targets if the cost is relying on a limited number of external suppliers - however reliable they might appear right now.

The carbon price is the cornerstone of the EU’s climate policy. But in the race for zero carbon supremacy some may see price signals as being unable to deliver progress until its too late, or only after other economic powerhouses have already achieved a commanding lead.

That’s why Europe might pivot to a much more interventionist industrial policy. Before the Christmas break, German and French economy ministers, Bruno Le Maire and Robert Habeck, extolled the virtues of a green industrial policy enabling Europe to lead the climate transition, calling on the continents political leaders to match US subsidies for green industry:

“We Europeans seek leadership when it comes to climate transition. We have come a long way in changing our regulations to comply with the Paris Agreement. We reaffirm our political ambition to boost all instruments to retain leadership in this major shift. In the difficult situation of the Russian War against Ukraine, we have to pursue European efforts to secure the industrial base in Europe, in particular critical green industries. Markets of the future are green and we all need to invest heavily in the development and roll-out of the technologies needed for the transition towards a climate neutral society.”

In terms of regulatory momentum, the greatest step-up in incentives from the IRA has come for hydrogen, carbon capture, energy storage and energy efficiency technologies. If Europe responds in kind then it’s likely that those sectors will also receive special attention (see Carbon's shifting anchor, The carbon capture superpower, AND Money to burn).

Chart 1: US IRA tax credits and other incentives as a % of coverage of the average total cost of each clean technology (%)

Nevertheless, there are two main obstacles preventing Europe from competing with the US on tax subsidies. First, fiscal policy remains a responsibility of individual member states, one that many member states are struggling to contain given the cost of the pandemic and now the energy crisis. Secondly, European Union member states are constrained by state aid rules. This prevent individual member states from supporting their domestic companies gaining a competitive advantage at the expense of companies located elsewhere in the EU.

The European Commission has indicated that it may look to loosen the rules as early as the beginning of 2023. However, given the parlous state of some EU states fiscal budgets, only the ones with the deepest pockets will be able to benefit anyway. That may open up the prospect of an expansion in the EU’s €300 billion RepowerEU plan. Published in mid-May 2022, RePowerEU outlines how the EU will rapidly reduce dependence on Russian fossil fuels and fast forward the green transition.

Any agreement on expanding the scope and size of the budget would require agreement on how funds could be allocated to parts of the EU unable to fund supporting climate technology out of their domestic fiscal budgets. Investors may then start to wonder where the funding will come from. For example, will some of it come from raiding the Market Stability Reserve (see Is the MSR sale really a 'win-win'? Calls grow for sale of emission allowances to fund Europe's energy transition).

Short sighted response raises the long term cost

State intervention became common after the First World War as European governments first directed the reconstruction of their countries, and then later as economies prepared for and responded to the threat of another war that was to emerge in the 1930’s.

However, the heyday of interventionist industrial policy in Europe was during the 1970’s and 1980’s. Back then many governments took large stakes or even completely nationalised companies deemed to be of future strategic importance. Industries such as steel, chemicals, communications and technology, aviation and nuclear power all experienced strong intervention by governments worried that they were being let behind by the USA and Japan.

However, history tells us that state directed industrial policy tends to result in capital misallocation on a grand scale. Governments typically over subsidise, incentivised by seeing to be doing something quickly. They pick winners, national champions that can be a source of national pride irrespective, rather than asymmetric bets on innovation. Once under government purview and isolated from domestic competition firms become flaccid, only responding to political signals, rather than those of the market.

History also tells us that it can be several years or more before the impact of that malinvestment comes to light. For politicians wishing to be seen to be doing something to protect Europe’s green industrial sovereignty, the risk that investments might not be efficient is a problem they hope to kick down the road for someone else to have to worry about (see The battle for Europe's industrial sovereignty).

Let the carbon market do its job

Over the past year I have argued that investors should think about the carbon price as ‘The Currency of Decarbonisation’. A strong carbon price is a signal that investors, businesspeople and citizens trust their government’s commitment to combat climate change (see Carbon is an emerging asset class, but what is it?).

High carbon prices signal a strong commitment to combating climate change, but it also signals whether emissions are declining fast enough to meet the target. The carbon price is also technology agnostic. It is irrelevant as to where investment is directed, only that it does.

An interventionist green industrial policy response can be seen in the context of politicians being unconvinced that the carbon market left to itself will deliver the correct signal as to what investment is required. Instead, investment is directed and channelled to whatever the government deems appropriate.

The experience in other carbon markets - California in particular - is that excessive reliance on other measures (e.g. mandates, subsidies, etc.) risks dulling the signal provided by the carbon price (see California's carbon market left to "fill the gap" in revised climate strategy). Undermining that price signal increases the cost of mitigating climate change. It also raises the prospect of further interventions in the future.

Instead of picking winners in the green energy transition, governments should focus their attention on enabling the carbon market to do its job. This may mean correcting those market failures that prevent emission reductions or investment in decarbonisation from responding to high carbon prices.

One of the defining themes of 2023 is likely to be a pivot towards a more interventionist approach to industrial policy. Governments, particularly in Europe, are likely to adopt more direct support for those industries seen as vital to securing their zero carbon energy transition while also securing their green industrial sovereignty.

Those industries receiving extra capital from government could see a strong tailwind as capital is directed at supporting research and infrastructure development. On the flipside investors need to be watchful for any sign that policymakers are undermining the carbon price.

1. Overall, the bill is likely to result in US emissions declining by between 7 and 9 percentage points by 2030 than the pre-existing policies would have enabled, according to Rhodium Group.