The green transition: shifting from “tax & subsidy” to “tax & investment”

European Commission President, Ursula Van der Leyen, announced an even more ambitious “decarbonisation target” for the EU last week, rising from 40% to 55% by 2025. This confirms the EU’s refusal to sacrifice the fight against climate change to the struggle of restarting the economy.

Public authorities – at least in Europe – have come to regard supporting the green transition as a way to spur economic growth, in contrast with a popular approach purporting an inconsistency between the two objectives. There is a measure of political expediency in this decision. In many EU “core countries” where public opinion is traditionally hostile to fiscal activism, environmental concerns are high on the agenda. This can be “leveraged” to elicit support for otherwise unpopular fiscal federalisation projects.

Still, beyond political expediency, we think reconciling economic growth and the green transition is better achieved when the policy instrument shifts to investment projects, rather than the usual combination of tax and subsidy. We believe combining the EU’s green agenda with concrete schemes to fund an investment surge – as per the “Next Generation” programme - would support both a decline in CO2 emissions and the recovery from the pandemic.

Textbook economics have called for tax to be the main green policy tool. The deterioration of the environment is a cost supported by all which is not paid by anyone through market mechanisms. Balance is restored by revealing this cost and charging those responsible for it, such as CO2 issuers, with a tax. The idea is that public authorities punish “bad behaviour” (such as brown energy companies) while remaining agnostic on how economic agents will react.

However, these “Pigouvian taxes” can be – at least temporarily – detrimental to economic growth. Producers can try to adapt to the higher cost of carbon by adopting less carbon intensive new technological solutions, but it is likely that those technologies will initially come with a higher price. Consumers are left with only unpalatable options: pay more for the Green product – if it is available – or pay more for the taxed Brown product.

Of course, as demand shifts to Green products, economies of scale kick in and their price can fall, gradually restoring aggregate output to its previous equilibrium, but the process can take time, and governments may not tolerate this temporary impairment to growth.

Engaging in active subsidisation of the Green alternatives becomes very tempting. The effect of the subsidy is to “precipitate” the shift to the right of the green product’s supply curve.

However, in this scenario the government needs to choose which alternative solutions “deserve” to be supported. Even assuming the government makes the right choice, it would still be faced with an information asymmetry: a difficulty to get an independent appraisal of the producer cost. The government – and society in general – can thus pay “too much” for the transition.

The cost of the subsidy can be “hidden” in final prices. A simple illustration of this is a “feed-in” approach in which producers of renewable energy get compensated for the difference between market electricity prices and their (higher) production cost, generating a surcharge for the final consumer. The costs are not trivial. As Germany was pushing ahead on its energy transformation process in the mid-2010s, the surcharge to final consumers amounted to EUR 20bn a year, 0.6% of GDP. In economics, there is no such thing as a free lunch.

Another stumbling block for production subsidy is that the government has no visibility on the time it will take for the price incentive to generate the capital expenditure which will make the pre-subsidy cost of the green solution competitive.

It would be rational therefore for investors to demand visibility from the government on a minimum duration of the subsidy before starting the projects, meaning that governments lose capacity to adjust fiscal policy over a long horizon. By focusing on investment however, governments regain control of their fiscal policy: the bulk of public sector expenditure happens at the beginning of the process, when capacity is built. This approach would accelerate the emergence of green capacity, and speed up the downward shift in the green supply curve.

Combining the EU’s renewed ambition on decarbonisation with the “Next Generation” programme provides a unique opportunity. The EU will issue EUR 750bn of debt - a third of the proceeds being directed to green projects – at a time when interest rates are extremely low. The acceleration in public green spending would occur at the least risky moment from a public debt sustainability perspective. The risk of conflict between supporting the green transition and managing the future cycle is thus minimized. The fact that issuance is “federalised” reduces the risk further by reducing the burden for the most fragile member states.

While the “devil is in the details”, some aspects of the Commission’s plans could bring further benefits. Ursula van der Leyen announced that 30% of the Next Generation debut issuance would comprise of green bonds. We see two positives to this. First, it creates a “double lock” on the benefit to decarbonization of the investment plan. Green bonds come with minimum traceability criteria which will make it difficult for national governments to engage in “greenwashing” when selecting projects for refinancing through the NextGen framework. Second, it will spur the development of this market.

Green investment at the current stage is hobbled by a very binary distinction between what is already green and what is not. An asset class representative of a transition to less carbon-intensive activities helps fill this gap.

Gilles Moec - AXA Group Chief Economist 

Contacts

Ellis Ford

+44 20 7003 1225

Ellis.Ford@axa-im.com

Jamie Wynn-Williams

+44 20 7003 2680

Jamie.Wynn-Williams@axa-im.com

Hélène Caillet

+33 1 44 45 88 06

Helene.Caillet@axa-im.com

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