The Inflation Reduction Act: How should the EU react?

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Joint Statement of the Council of Economic Analysis (CAE) and the German Council of Economic Experts (GCEE) and the Franco-German Council of Economic Experts (FGCEE)

Authors are:
Camille Landais, Sébastien Jean, Thomas Philippon, Aurélien Saussay, CAE
Monika Schnitzer, Veronika Grimm, Ulrike Malmendier, Achim Truger, Martin Werding, GCEE

Summary

The Inflation Reduction Act (IRA), enacted in 2022, aims at promoting the production and adoption of clean energy in the United States, fostering job creation, and effectively addressing competitive pressures from China. This ambitious response of the US to the issue of climate change is welcome. Yet, the IRA’s local content requirements have drawn criticism because they conflict with principles outlined by the World Trade Organization (WTO). Moreover, the IRA creates economic distortions in foreign direct investment

and might prompt European companies to relocate their operations to the United States. The IRA has stirred a strong debate about the future of European industrial policy because it poses new and fundamental challenges and demands careful rethinking of European industrial strategy. The conundrum is the following: how can Europe manage its Green Transition while strengthening its economic and strategic resilience, preserving jobs

and productivity growth, and maintaining European solidarity and international coordination?

The IRA in itself is small, and so will be its aggregate macroeconomic effects

Assessing the precise financial implications of the IRA poses a considerable challenge. Estimates range from $390 to $900 billion for the period from 2023 and 2031. At the same time, it is clear that

(i) the overall funding level of the various programs the EU has already initiated to meet climate targets and facilitate the green transition is comparable to the IRA, and

(ii) the subsidies under the IRA are expected to exert minimal overall macroeconomic impact on both the US and the EU.

While specific industries may have greater incentives to invest in the US rather than the EU under this new framework, a closer examination at the sectoral level fails to yield evidence linking the IRA to significant risks for the EU. In this context, a subsidy race should be avoided with the US as well as within the EU.

But the IRA should nevertheless force a rethink of European industrial policy doctrine

The IRA revolves primarily around providing production and investment subsidies, many of which are uncapped. We highlight that this strategy will be inefficient to address the challenges of decarbonization. The European policy mix, which involves both carbon pricing and dedicated industrial intervention, is clearly a superior approach. At the same time, Europe should learn from the simplicity and expediency of the IRA approach. It should be a priority to simplify and expedite European procedures. Aid should be concentrated on sectors for which EU countries either currently possess or can be anticipated to develop comparative advantages, resulting in substantial environmental and technological externalities.

Expand energy supply to reduce energy price differentials

Rather than the IRA itself, it is the existing and sizeable energy price differentials that are likely to substantially impact Europe's attractiveness and the competitiveness of its industries. Therefore, concerted endeavors to reduce energy prices within Europe are of paramount importance. It is key to accelerate the deployment of renewable energy sources in order to strengthen energy supply.

In the realm of conventional power generation, Germany and France have adopted different strategies. We advocate for mutual support, particularly by designating both nuclear power plants and hydrogen-capable gas power facilities as transitional technologies on the path to climate neutrality within the EU taxonomy. Moreover, both countries stand to gain from intensified collaboration in expanding Europe's electricity and hydrogen infrastructure. The reform of European electricity markets should also be a central tenet of any European Green Industrial policy, with the wholesale market as the main instrument for coordinating power generation dispatch.

Secure raw material supplies, strengthen trade agreements and international cooperation

Finally, we recommend securing raw material suppliers and strengthening international cooperation through trade agreements and incentives to build domestic capacities. Rather than a complaint to the WTO with little chance of success, we believe that it would be more efficient to cooperate with the U.S. on rules about subsidies linked to environmental protection, in a framework that might be shared with a number of partners, such as border adjustment agreements linked to environmental protection, on methane emissions for instance.

Joint Statement (PDF)

Press Release (PDF)