A Green Fiscal Pact for the EU: increasing climate investments while consolidating budgets

ABSTRACT

To ensure sufficiently rapid decarbonization to meet the Paris Agreement goals, investments in green infrastructure will have to increase by an estimated 2% of world GDP annually, according to the International Energy Agency. A significant part of that investment will need to be funded with public resources – raising major tensions between consolidation needs after the high deficits during the pandemic and the need to increase investments. We consider this trade-off in the European Union, which has set itself one of the most ambitious climate targets in the world. The additional public investment required to meet the European Union’s climate goals is around 0.6% of GDP annually during this decade, which might increase if the green transition is accelerated due to Russia’s invasion of Ukraine. Budget consolidation can be done at a moderate pace in line with EU fiscal rules if those rules are interpreted flexibly, but past consolidation episodes resulted in major public investment cuts. A ‘green golden rule’ –excluding net green investment from the fiscal indicators used to measure fiscal rule compliance– is proposed as the most promising option to address this tension and would provide a positive incentive to undertake such investments. However, the uncertain growth impact of green public spending and the risks to growth from climate change create difficult trade-offs in fiscally weaker countries. Better regulatory policy and a higher price on emissions should in parallel incentivise private green investment and reduce public costs. These ingredients should be combined to form a ‘Green Fiscal Pact’.

Key policy insights

• Public investments tend to be cut in fiscal consolidation episodes by vote-maximising politicians and thus need to be treated differently in fiscal rules. Increasing green public investments will be difficult in the upcoming consolidation period.

• A ‘green golden rule’ –excluding net green public investment from the fiscal rule indicators– is proposed as the best option to incentivise public climate investment.

• Policymakers need to underpin such a rule by clearly defining what constitutes emission-reducing climate investments and monitoring compliance.

• Fossil fuel subsidies should also be eliminated, and private climate investment should be incentivised through appropriate taxation and regulation.

• Climate change may tighten budget constraints in countries with already high debt levels because of its negative growth effects, so these countries should delay the introduction of the green golden rule.

KEYWORDS:

• climate policy
• climate change and growth
• fiscal policy
• fiscal rules
• public investment
• Stability and Growth Pact

Acknowledgements

An earlier version of this paper was prepared for the informal Economic and Financial Affairs Council (ECOFIN) meeting in Ljubljana on 10/11 September 2021. The authors thank Jan Corfee-Morlot, Climate Policy Editor, three anonymous reviewers, Grégory Claeys, Maria Demertzis, Joanna Depledge, André Sapir, Jean Pisani-Ferry and Simone Tagliapietra for comments and suggestions, and Klaas Lenaerts for excellent research assistance.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 https://ec.europa.eu/commission/presscorner/detail/en/ip_22_1511

2 Tagliapietra and Wolff (2021) argued for a climate club to incentivise non-EU countries to accelerate their climate efforts in line with the EU.

3 There is an ongoing EU economic governance review, including fiscal rules: https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A52020DC0055

4 https://www.imf.org/en/Topics/climate-change/energy-subsidies

5 Dataset on national policies to shield consumers from rising energy prices: https://www.bruegel.org/dataset/national-policies-shield-consumers-rising-energy-prices

6 The French number refers to the actual public share in 2018. The Dutch number is for 2018–2030 and underestimates the true public share, because it does not include all investments of energy infrastructure companies which are 100% public owned. For Spain, the 20% public share is specified in the NECP, but the European Commission noted that ‘it is not clear how these amounts were calculated’. For other two large EU countries, Italy and Poland, proper information about the public share is missing from the NECP.

7 International Renewable Energy Agency’s (2021) 1.5°C scenario estimated a somewhat lower public share at the global level: 22% in 2019, which share would decline to 17% beyond 2030.

8 https://ec.europa.eu/info/strategy/eu-budget/performance-and-reporting/mainstreaming/climate-mainstreaming_en

9 https://ec.europa.eu/info/sites/default/files/economy-finance/rrf-factsheet.pdf

10 While the EU fiscal framework includes four numerical rules, various factors can be considered to set the pace of fiscal consolidation. The 2018 detailed manual explaining the practical application of EU fiscal rules is 220 pages long (European Commission, 2018), suggesting there is room to interpret the rules.

11 Corporate accounting rules treat current and investment spending differently: the cost of an investment is not charged to a single year when the investment is implemented, but distributed over the service life of the capital good.

12 https://ec.europa.eu/sustainable-finance-taxonomy/

13 Accordingly, national fiscal rules that may be more binding would need to be adapted to allow for green investment in line with EU goals.