Europe Must Tax Brown and Subsidize Green
The US Inflation Reduction Act is a landmark legislative package that should be welcomed around the world, despite its putatively protectionist features. Owing to the positive learning-by-doing spillovers that follow from green subsidies, Europe and the rest of the world ultimately will benefit, too.
NEW YORK – After years of global climate-policy leadership, the European Union is looking warily at the United States’ sudden embrace of ambitious clean-energy subsidies. Ultimately, America’s entry into the clean-energy race is good news for both the planet and Europe. But will US generosity toward its own companies under the recent Inflation Reduction Act (IRA) hollow out Europe’s industrial base even further? Will dirty industries continue moving east and south as clean ones move west across the Atlantic?
Europe must prevent this outcome. But how should EU leaders proceed?
Unlike in the US, European policymakers have long heeded the economists who suggest that carbon pricing is the best strategy for tackling climate change. That means making dirty energy more expensive, in line with the external costs that it imposes on society. Though the EU’s Emissions Trading System is far from perfect, it now prices roughly half of Europe’s carbon pollution at around €100 ($109) per ton; and several national governments in the bloc have introduced their own carbon taxes. None of this is sufficient on its own. But Europe’s carbon-pricing policies are clearly much better than America’s incomplete state-level patchwork and its complete lack of a federal carbon price.
Now, US policymakers have seemingly taken the easy way out, subsidizing clean energy instead of pricing dirty energy. But while giving handouts is politically easier than imposing taxes, there is in fact a strong economic argument for subsidies in this case. Yes, Economics 101 calls for pricing negative externalities, but Economics 102 calls for subsidizing positive externalities that arise from learning by doing. The argument is simple: installing the thousandth, and especially the millionth, solar panel will be much faster and cheaper than installing the first, owing to all the efficiencies and improvements that have been developed along the way.
The same logic extends to research and development more broadly. Innovators deciding on how much to invest in R&D will generally spend less money than is socially optimal, because their decisions typically do not include the possibility that the result will create shoulders for others to stand on. That, too, calls for subsidies.
Policymakers from California to Germany have embraced the learning-by-doing logic with solar subsidy schemes that start high in the first year and decrease almost immediately thereafter. Germany’s feed-in tariffs (payments to solar-energy producers above the market price) started as high as €0.40 per kilowatt-hour for small rooftop solar units, but have since been scaled back to under €0.15. That tapering is appropriate, given how cheap solar power has become in recent years. It also demonstrates that the subsidies worked.
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While solar feed-in tariffs have decreased, EU carbon prices have risen some tenfold, from as low as €10 per ton. It is here that the EU’s climate policy shines. European policymakers recognize that carbon pricing is crucial, and they have acted on that insight.
But neither carbon pricing nor subsidization is enough on its own. Just as the US ought to take a page from Europe’s book on carbon pricing, Europe should follow the US in pursuing green subsidies. Early economic analyses of the IRA calculate that the legislation’s provisions, like its various tax credits for clean energy, create an implicit carbon price of around $12 per ton – scarcely one-tenth of Europe’s explicit one.
Whatever reasons Europe had for avoiding green subsidies in the past, European competitiveness and energy security demand that they be reconsidered in the context of the IRA. China currently produces the vast majority of the world’s clean-energy technologies: including three-quarters of all solar panels and batteries sold globally, well over half of all wind turbines, and around half of all electric vehicles. In some clean technologies, like heat pumps, Europe is behind not only China but also North America, which produce 39% and 29%, respectively, compared to Europe’s 16% share.
This import dependency translates into significant geopolitical vulnerabilities. Relying on China for solar panels may be less dangerous than depending on Russia for gas; but that hardly makes it prudent. The EU urgently needs to create new incentives for domestic manufacturers and invest in a more resilient clean-energy supply chain.
The IRA should be welcomed around the world. Of course, its immediate effect will be to boost US clean-energy investments, and it will inevitably rankle some foreign manufacturers and governments as it generates headlines around the world about companies being lured to the US. But it is important to remember that just as economic growth is not a zero-sum game, neither is clean growth.
In a recent paper, Costas Arkolakis of Yale University and my Columbia Business School colleague Conor Walsh show that the IRA’s subsidies will pay for themselves through increased global GDP, owing to the positive spillovers from learning-by-doing dynamics. The implication is that the EU and the rest of the world will ultimately benefit from the US subsidies. And Arkolakis and Walsh’s analysis does not even account for the positive welfare effects of helping to address climate change. Add those in, and US clean-energy subsidies (or future European ones) look like a win-win-win.
The massive costs of unchecked climate change are already mounting and should be sufficient to show that much more needs to be done on both sides of the Atlantic, as well as around the world. For their part, US policymakers should recognize that their long-awaited clean-energy push would be strengthened enormously by additional measures to make polluters pay for the costs of their pollution.
The EU, meanwhile, must take the arguably easier step of ramping up its own clean-energy subsidies. It can and must afford to do so. The result will be a race to the top, with the global economy and the planet as clear winners – a truly rare occurrence in the annals of global economic competition.