The industrial policy of the EU between the energy crisis and decarbonization

Europe is immersed in a deep and complex energy crisis. It is not limited to the gas sector as a result of the Russian invasion of Ukraine, but affects all sources of energy. The French nuclear power generation, for example, fell last year to its lowest level in thirty years due to maintenance works and corrosion. Due to the extreme heat of the summer, an unprecedented drought has reduced the hydroelectric generation, as well as the possibility of importing coal by river. Oil hasn’t been immune to turmoil either. The EU embargo on Russian crude finally started on December 5, 2022, which, together with the US$60 per barrel price cap, creates uncertainty about supply and future prices. In February 2023, the second phase of the embargo on refined products will enter into force, and the diesel oil could become the next chapter in the European energy crisis.

Until now, Europeans have coped quite successfully with these difficult events. As regards the gas sector, they have managed to fill their warehouses, reduce Russian energy imports and attract shipments of liquefied natural gas (LNG), as well as encourage demand reduction/destruction. However, all this has been possible at a extremely high cost (not only for Europeans) and also thanks to lucky (albeit precarious) circumstances. Among the latter, the lower Asian (mainly Chinese) demand for gas and milder temperatures stand out.

The energy crisis brings to the fore not only energy security, but also the role of industrial policy at international and European level. Since Covid-19, the role of the state (and also the EU) in the economy has been dramatically expanded through recovery plans and aid packages in response to the health, economic and energy crises. This is likely to remain the case in the medium to long term, as the global economy and industry face a change of era driven by the global energy transition.

Fragmentation, disunity and deindustrialization?

Although it is only the last stress test for the EU, the energy crisis represents a decisive moment for the Union and its future. It is still unknown how that future will be shaped. Much will depend on how governments and citizens react to the crisis and its consequences, gauging their resistance capacity. What is certain is that uncoordinated and nationalist responses would reduce European resistance and unity, causing fragmentation of the EU single market and stoking intra-European competition, which would aggravate the energy crisis.

The crisis puts significant pressure on European industry. In fact, the development of a number of sectors and companies was based on access to cheap Russian energy. So the European industry needs to find new solutions to navigate the uncharted waters of a (potentially) complete shutdown of Russian energy supply and high energy prices over the next two to three years. So far, EU companies have managed to reduce gas consumption while preserving production. However, if energy prices remain high and the EU does not have a clear industrial vision consistent with its climate goals, Europeans risk finding themselves in an industrial wasteland at the end of the energy crisis. Since the main European gas consuming industries generate an economic value of more than 600 billion dollars a year and employ almost 8 million workers, a European deindustrialization in these sectors could trigger an economic recession and social instability, ultimately threatening to derail the energy transition.

European industry on the path of net zero

Europe has not reduced its climate ambitions, quite the contrary, as demonstrated by the REPowerEU plan, aimed at decoupling Europe from Russian energy imports and promoting decarbonisation, or the decision to end the sale of new cars that emit CO₂ in Europe from 2035. The automotive sector, still mainly based on internal combustion engines, employs some 13.8 million people in the EU and represents more than 7% of its GDP. The industrial transformation of this strategic sector requires a compelling roadmap and political vision towards a net zero emissions future.

In this context, Europe will face greater industrial competition at a global level. China today enjoys a dominant position in key clean energy technologies and global supply chains. Meanwhile, the US has launched its ambitious Inflation Reduction Act (IRA) –aimed at reviving domestic industry while promoting decarbonisation–, which allocates some US$370 billion in subsidies and tax breaks . Other Asian countries, such as South Korea and Japan, have worked on similar strategies and plans in various sectors.

An EU industrial plan?

Against this backdrop, Europeans are called upon to consider how to protect and develop their industrial sectors in the light of not only high energy prices and decarbonization efforts, but also attempts by other economies to gain competitive advantage. The voices are getting louder urge the EU to have an industrial plan. This is key.

The EU may feel between a rock (USA) and a rock (China). However, the Union must avoid the temptation to follow the path of other economies. Entering a grant race with the US seems economically unrealistic and politically counterproductive. On the face of it, however, a top-down approach like the one followed in China may seem attractive. Beijing’s “state capitalism” has produced remarkable industrial and economic growth. China has gained strategic influence in global supply chains across various sectors and technologies
such as batteries and solar panels. However, while some benefits are evident, this development has been driven by state-owned enterprises, direct subsidies, and technology transfers. This carries great risks: above all massive debt, corruption and possible inefficiency, as well as little innovation.

What alternatives does the EU have to become a motor of technological and industrial development? France and Germany called for a renewed boost to European industrial policy, while the President of the European Commission, Ursula von der Leyen, stated that the EU should “simplify and adapt” its state aid rules in light of the US IRA. In October 2022, the EU will already extended and amended its Temporary Crisis Framework on state aid to allow Member States to continue to benefit from some flexibility when it comes to state aid rules. However, since state aid control preserves the internal market, making it even more flexible may undo a level playing field in the European market, causing fractures between rich and poor member states. In addition, state aid may prove useless, as the industry thrives despite everything in countries where energy resources are relatively cheap (as is the case with solar photovoltaic energy production).

Others advocated by the introduction of industrial support schemes financed with new rounds of joint EU debt to overcome the divergent borrowing capacity between Member States. Although it has some merit, the debate on new funds at EU level may lead to lengthy (and probably inconclusive) discussions around the traditional divisions (frugal vs. non-frugal Member States). For the EU, it is crucial to make decisions without wasting time, as happened in the US with the IRA despite the polarized political debate. Furthermore, it is clear that there is no shortage of funds, especially in the aftermath of the Covid-19 pandemic; the constraints are rather in the ability to use these funds quickly and rationalize them with a coherent vision.

“Instead of replicating a top-down approach or entering a grant race, the EU should establish a clear framework through existing tools and funds to encourage investment”

The EU already has powerful tools to shape industrial decisions and investments. horizon europe, based on the experience of Horizon 2020, is the largest transnational program to support research and innovation, with a budget of around 95.5 billion euros for 2021-2027. Other noteworthy tools are the Important Projects of Common European Interest (PIICE), already applied to clean energy technologies such as hydrogen and batteries, or the European Investment Bank (EIB). In addition, the EU could also extend its contracting rules public for industrial purposes.

Rather than replicate a top-down approach or enter a grant race, the EU should establish a clear framework through existing tools and funds to encourage investment. It should not regard industrial policy as a substitute for competition policy, but rather reconcile the latter with a clearer and more common industrial policy. Competition policy produces innovation, which is crucial for industrial development and evolution. In this sense, Brussels should work to to complete the single market and its competition policy. While protecting competitive advantages and existing industries, the EU must encourage the creation of new industries and technologies. Undoubtedly, this can mean a loss for certain sectors and regions. For this reason, it is also crucial to promote compensation instruments aimed at reducing regressive consequences, such as the Just Transition Mechanism.

Cooperation with key partners

Finally, the drive for a European industrial policy must not fuel trade hostilities or undermine cooperation with key partners, such as the US or some Asian countries. While it is clear that the IRA poses a threat to European industry, the EU must not oppose other economies’ attempt to promote decarbonisation internally. The main challenges for European industry come not from US industrial policies, but from the collapse of the energy trade between Russia and the EU, which had provided cheap energy imports.

Some decarbonisation strategies, also in the EU, will inevitably affect other economies. The question is finding possible solutions that do not reduce decarbonization efforts, but rather include ways to reduce potential regressive or undesirable outcomes for others. This is also true for the US, which should take into account some of the European concerns and consider possible adjustments and exceptions for the EU. Washington and Brussels should encourage dialogue and try to find common solutions through adjustments on both sides. The US-EU Trade and Technology Council may be a suitable diplomatic platform for this purpose. Faced with these new challenges, the EU should join like-minded countries in climate forums to cooperate on technology and industry innovation, investment, regulation and economies of scale.

The evolution of the geopolitical landscape, characterized by increased industrial competition, requires industrial and strategic reflection on the part of the EU. At the same time, the Union should develop its approach on the basis of its own characteristics, ie focused on competition policy, in order to avoid distorting effects within its market and its borders. This would allow the EU to protect innovation, key to the development of the industry, and to become the engine of the transformation that the energy transition entails.

Article originally published in English in the IAI.