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* New needs, new prices, same money›
Policy
NEW NEEDS, NEW PRICES, SAME MONEY - WHY THE EU MUST RAISE ITS GAME TO COMBAT THE
WAR’S ECONOMIC FALLOUT
Policy Brief
DOWNLOAD
* New needs, new prices, same money by Nils Redeker and Phillip Jäger PDF 826
KB
Russia’s invasion of Ukraine puts EU economic policy making on the spot. At the
beginning of the war, there was some uncertainty whether the combination of
dampening growth, rising energy prices and new investment needs would warrant
new common EU spending. However, in recent weeks the fog has cleared. It is now
evident, that without additional common expenditures the EU risks undermining
its common position towards Russia and that new money is needed to finance
necessary investments in energy independence.
1. Introduction
Russia’s invasion of Ukraine puts EU economic policy making on the spot. Acute
uncertainty and spiraling prices are dampening growth. Inflation has hit new
highs. Energy bills at record levels. And the need to wean Europe off Russian
energy and achieve climate targets as well as to boost defense spending will
require massive additional EU-wide investments when shared resources are already
scarce.
At the beginning of the war, there was some pushback against the idea that these
issues would require more common EU spending. Given the large uncertainties
surrounding the economic impact of the war, the price tag of additional
investment needs and remaining resources at the EU level, this skepticism was
legitimate. However, in recent weeks the fog has cleared substantially.
For one, it is now evident that the war will have very different economic
impacts across member states. This matters not just economically but also
politically and the disputes over the sixth round of sanctions proved how
difficult it will be to maintain a united front on Russia without some
short-term burden sharing. Moreover, the Commission has now presented a detailed
plan, REPowerEU, with a clear price tag on how to end Europe’s energy
dependence. However, the financing side of the agenda consists of little more
than rejigging existing funds and hoping that member states will take out EU
loans that so far, they did not want. This simply will not do.
The question of more common expenditures therefore needs to get back on the
agenda. Specifically, the EU will need joint spending in two areas:
* First, external unity demands internal solidarity. These huge differences in
economic fallout and costs of dealing with higher energy prices will
undermine the support for sanctions in the long-run and will make any
broadening of the regime politically almost impossible. The EU therefore
needs some short-term burden sharing. The best approach is a temporary and
targeted instrument to support vulnerable households in specifically exposed
member states.
* Second, common investments in energy independence are required to increase
energy security, curb energy price inflation, and reach the EU’s climate
goals. However, this would often require member states to spend large sums on
projects that may have substantial European benefits but yield few direct
national gains. Especially when national budgets are already under a lot of
pressure, this is unlikely to happen without additional common resources.
Short-term challenge: cushioning rising energy prices in a downbeat economy
For the EU, the war’s most immediate economic impact is slowing growth and
rising inflation. In its Spring forecast, the Commission has cut its EU-wide
growth projections for 2022 from 4% to 2.7% with much of the remaining upswing
stemming from statistical carry-overs of the strong rebound in the second half
of 2021. Importantly, this is the most positive scenario. According to the
Commission, a further escalation of the war or higher energy prices could bring
the EU very close to a recession.
At the same time, the war is driving up prices. In May, year-on-year inflation
in the Eurozone reached a historic high of 8.1%. While much of it is caused by
higher energy and food costs, other prices are also picking up and core
inflation (excluding energy and unprocessed goods) stood at 3.5% in May. Given
that nominal wage growth is expected to be significantly below inflation, real
wages are expected to decrease, and so is real disposable household income.
The EU’s response to this, so far, has been to grant member states more wiggle
room to design national compensation policies. First, it has relaxed European
state aid rules. In April, the Commission updated its guidelines to give
national governments more leeway in temporarily supporting companies that suffer
from exceptionally high energy prices. These rules are already active and will
be in place at least until the end of 2022. Then, in early May the Commission
proposed suspending the EU’s fiscal rules for another year. The so-called
“general escape clause” was already active since the outbreak of the pandemic.
Now the Commission wants to keep the main fiscal rules on hold until the end of
2023.
The short-term economic costs of the war differ dramatically across the EU
These steps are helpful in the short-run but they mean that the direct economic
costs are borne exclusively by national budgets – and these costs differ
enormously across countries. Early signs of this are already evident in the
current projections. Figure 1 plots changes in projected growth rates for 2022
across EU member states. While the war has left growth projections for countries
like the Netherlands, Belgium, or France almost untouched, it will likely cause
a sizeable slowdown in Germany and Italy and some Eastern European member
states. Again, these are the more optimistic projections. In more severe
scenarios, recessions would be likely in several member states.
Figure 1: Change in growth projections in EU Commission forecast
Critically, these differences are likely to grow the longer the war and the
energy crisis it induced linger. Figure 2 illustrates this point. The left-hand
side plots the increase in average wholesale electricity prices between April
2021 and April 2022 in each member state (as a proxy for overall energy price
increases), against the share of overall spending of low-income households on
energy related goods such as electricity, heating, and transport. The higher
this proportion, the more vulnerable poor households are to higher energy bills,
and the more governments will have to spend to shield them from hardship and
energy poverty as a result of the common sanctions. To illustrate differences in
vulnerability in the business sector, which governments would partially also
need to support, the right-hand side plots rising electricity prices against the
overall energy intensity of the economy.
Figure 2: Differences in vulnerability to rising energy prices
Figure 2 shows two things. First, the vulnerability of member states to rising
electricity prices differs dramatically for both households and the overall
economy. And second, the costs are concentrated in some Central- and Eastern
European countries such as Bulgaria, the Czech Republic and Romania which suffer
from a doubling of electricity prices as well as high spending on energy in
low-income households and by relatively energy intensive industries.
The metrics used here are far from perfect. They ignore the fact that energy
consumption mixes differ across and within member states and that the prices for
oil and natural gas do not match the development of electricity prices
perfectly. However, recent analyses by Steckel et. al (2022) that are based on
more fine-grained data and take these differences into account reveal similar
patterns. European citizens in Central and Eastern Europe will suffer a lot more
from the common sanctions and the rise in energy prices than citizens in many
other member states.
External unity requires internal solidarity
So far, the picture does not amount to a full-blown economic crisis. However,
the uneven distribution of the economic fallout matters politically. The lengthy
negotiations and spotty implementation of the latest sanctions package revealed
that countries hard-hit by sanctions will be increasingly reluctant to bear the
brunt of the costs for the rest of the EU. Without some burden-sharing at the EU
level, it will become increasingly hard to sustain the current sanctions against
Russia and almost impossible to reach a consensus on more broad-based energy
bans that hurt some member states much more than others.
To remain politically united and implement forceful policies against Russia, the
EU therefore needs to balance some of the short-term economic burden of its
common policies. Importantly, it needs to be ensured that such support does not
result in broad-based fuel subsidies that are not just fiscally costly but also
undermine the very goal of ending EU’s reliance on fossil fuels. The most
targeted way to achieve this would be to focus EU level support on low-income
households that are specifically exposed to the economic hardship wrought by the
energy crisis.
An appropriate instrument would need to meet four criteria. First, it would need
to be redistributive and support member states in proportion to their
vulnerability towards spiraling energy prices. Support needs to be based on
objective criteria such as energy mixes, dependencies, wholesale energy prices
and indicators of social vulnerability.
Second, support needs to be targeted. The main goal would be to support member
states in cushioning economic hardship. The chosen instrument should therefore
be geared exclusively towards vulnerable households and ideally take the form of
direct transfers that keep price signals intact. Third, the instrument should
come with strong strings attached regarding accompanying national policies. For
example, EU support should only be disbursed to member states whose domestic
measures do not undermine common European goals, such as directly subsidizing
energy bills. And finally, the instrument needs to be temporary by setting a
clear expiration date in order not to stand in the way of necessary adjustments
to permanently higher energy prices.
Critically, an instrument along these lines would be financially bearable.
Steckel et. al (2022), for example, put the overall costs of targeted support
for vulnerable households in all member states in the EU at about €90bn per
year. Given the measure’s redistributive goal, relatively unaffected countries
would not receive funding, and hence only a part of this sum would have to be
borne at EU level. The required volume would also be relatively contained since
effective tools, such as direct transfers, are a much cheaper way to support
those in need, compared to e.g. subsidizing petrol for the entire population. To
finance these expenditures, the EU could either rely on more common borrowing,
or raise funds through possible tariffs on Russian energy imports. Most
importantly, an instrument needs to be up and running before the coming winter
when rising energy prices are going to bite especially hard.
1) Ending energy dependence on Russia by speeding up the green transition
Besides cushioning the direct economic impact of the war, the EU needs to tackle
current economic issues at the roots: its dependency on Russian energy imports.
Done right, substituting Russian fossil energy, chiefly by accelerating the
shift to renewables, will increase energy security in the bloc, decrease
imported energy inflation and help achieve the EU’s climate goals by reducing
emissions. While a lot of hard economic choices have to be made in the current
context, there is no choice but to double down on energy independence by
speeding up the green energy transition.
In May, the Commission put forward a roadmap to achieve this goal. REPowerEU
aims to reduce natural gas imports from Russia into the EU by two thirds by the
end of this year and substitute all Russian energy imports by 2027. This rests
on three pillars: first, the Commission wants to accelerate the rollout of
renewable energies, raising the headline 2030 target from 40% to 45%. Second,
the Commission wants to reduce energy consumption by increasing energy
efficiency and campaigning for behavioral changes. And third, it aims to
diversify energy imports through new energy partnerships, facilitated by common
procurement.
While one can quibble about the details of the plan, REPowerEU does contain a
wide array of sensible initiatives, including for instance a platform for common
procurement of gas, LNG and hydrogen, a new solar initiative, an urgently needed
simplification of permitting procedures for renewable energies, and a strategy
on how to engage internationally to secure energy imports from elsewhere.
Figure 3: EU Commission estimation of additional spending needs for REPowerEU
However, big question marks remain regarding the financing of the plan. Overall,
the Commission estimates additional investment needs at about EUR 300 billion by
2030. EUR 210 billion would have to have been spent already by 2027, that is, in
the EU’s current budget period. Figures 3 provides some more details on where
funds would be earmarked in the Commission’s thinking. While the plan contains
some additional investments in fossil fuel infrastructure, the bulk of the money
would need to be spent on solar and wind energy, investment to increase energy
efficiency and upgrading the European power grid to make sure that electricity
gets to the places where it is needed. Crucially, these investments come on top
of sums already required to achieve a 55% cut in EU emissions by 2030 under the
FitFor55 package.
Figure 4: Proposed funding sources for REPowerEU
The new plan comes with a price-tag but almost no additional money attached to
it. Financing the necessary investments would in large part rely upon rejigging
existing funds. The Commission proposes to “mobilize” some €34bn by allowing
member states to funnel money they would receive under the EU’s Cohesion- and
Agriculture funds into the Recovery and Resilience Facility (RRF) to allow for
more flexible usage. The EC also wants to raise EUR 20bn of fresh money from
auctioning additional CO2 allowances through the Emissions Trading Scheme, which
is a highly problematic approach, mainly for two reasons: it would tamper with
the rules of the Market Stability Reserve, eroding trust in the whole CO2
market, and it would finance the green transition by allowing companies to emit
more. For this and other reasons, selling additional CO2 allowances as proposed
will face heavy resistance in Parliament and from member states. Either way, the
bulk of the necessary investments (€225bn) would need to come out of national
budgets, or by taking out untapped loans under the RRF – loans that so far most
member states show no sign of wanting. For some member states, these loans do
come with better financing conditions than national borrowing. However, they are
fully repayable, are only disbursed if milestones are fulfilled, and count
towards debt – consequently, so far, only seven member states have requested any
loans from the Recovery Instrument.
Financing energy independence requires joint investments
In its current form, REPowerEU is unlikely to work. It largely rests on the hope
that member states will take out interest-bearing, repayable loans to finance
common energy independence. Critically, these investments in many cases would
need to happen in places where the direct benefits are limited. To give one
example, additional solar energy investments would (according to the
Commission’s own estimates) be most useful in Spain. However, Spain does not
rely on Russian energy imports and would not only have to finance investment in
renewable energy plants but also into the necessary electricity grid
infrastructure to allow this energy to flow to other, less sunny member states.
Member states would also have to make these investments for common EU objectives
when their budgets are already strained by the pandemic and they are confronted
with rising spending needs for their armed forces and humanitarian aid as a
result of the war. In short, individual member states might not be willing to
invest enough of their own money, given a lack of incentives.
To have a realistic shot at achieving the goals set out in REPowerEU, the EU,
therefore, needs additional common financing. Crucially, funds are needed before
2027, or still within the current budget period, since putting off this
financing to the next budget period would come too late for investments to be
initiated now. Given that any wiggle room in the MFF is generally limited and
already largely depleted by the unforeseen spending needs for humanitarian
action and costs of supporting Ukrainian refugees, having recourse to the
existing budget is no option. The grant component of the RRF is already used up,
hence using the existing RRF grants for REPowerEU projects would depend on
member states’ willingness to forgo planned investments for the recovery, many
of which are already destined for the green transition.
This leaves the EU with two options to finance the additional investment needs.
Either member states will have to increase their contributions to the current
MFF, or more money will need to be raised through additional common borrowing.
The latter could be achieved through topping up the RRF with additional grants
or transforming parts of the remaining loans in the RRF into grants. In any
case, the political hurdles for all these options are high. However, if the EU
serious about the goals set out in REPowerEU it will need to face them. Without
common financing, funding will come up short and the EU runs a serious risk of
failing to achieve green energy independence any time soon.
Conclusion
The deepest geopolitical crisis the EU has faced in the last 30 years requires
common spending to address common challenges. Accepting this reality will
understandably cause discomfort to many: the borrowing at EU level to tackle the
pandemic fallout was designed to be a one-off. However, the bad timing of world
crises cannot be an excuse for inaction. Without additional measures the EU
could seriously undermine its geopolitical status and underfinance efforts to
reach its most important economic and ecological goals in the years ahead. The
risk of inaction is now much higher than that of action.
Image: CC Daniel Sorokin, Source: Unsplash
AUTHOR
* Nils Redeker, Deputy Director, Jacques Delors Centre
* Philipp Jäger, Policy Fellow, Jacques Delors Centre
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