The European Union’s ambitious climate targets will not be met with the current fiscal policies, as we concluded in a recent study published in Climate Policy. To overcome this problem, we proposed a new ‘Green Fiscal Pact’ to ensure that climate targets are met while ensuring that public accounts remain sustainable and consistent with fiscal rules.
The European Union’s Climate Targets and Investment Needs
The EU has very ambitious climate targets. Its ‘Fit for 55’ package aims to reduce net greenhouse gas emissions by at least 55% by 2030 relative to their level in 1990, while the ‘European Green Deal’ aims for no net emissions of greenhouse gases by 2050. Achieving these targets will require substantial additional investments and major regulatory and tax measures.
Several studies have concluded that the additional investment requirements for energy and transportation sectors to achieve the objective of net-zero greenhouse gas emissions by 2050 are approximately equivalent to 2% of the gross domestic product (GDP) annually. The public sector must fund a significant share of this additional investment. The burden on public budgets could be reduced by appropriate government regulation, taxation policy and, in particular, a higher carbon price. These instruments would create obligations and incentives for the private sector to invest in the green transition, but each of these instruments has limitations.
For example, a significant increase in gas and electricity prices related to the Russian war in Ukraine should be welcomed from the perspective of green transition as it creates strong incentives for the private sector to move away from fossil fuel consumption. However, governments throughout the EU provided billions of euros to support households and firms to cope with high energy prices. There are political limitations to energy price increases, and the same applies to tighter regulations and subsidy elimination.
Our research estimated that the public sector should finance approximately one-third of the required additional green investment, about 0.6% of GDP annually. This funding could be either direct public investment or subsidies and guarantees to incentivize private investment. It will require a substantial fiscal commitment, particularly as most EU nations will be obliged to reduce budget deficits according to the European Union’s fiscal regulations starting in 2024. Increasing green public financing while consolidating budgets will be the major fiscal challenge of this decade.
The European Union’s Fiscal Rules
Fiscal rules are numerical constraints on fiscal policy, typically defined as a summary indicator of fiscal performance. The two most well-known EU fiscal rules are that the budget deficit must remain below 3% of GDP and public debt below 60% of GDP. When this is not the case, EU countries must reduce their budget deficits. The EU’s fiscal architecture also includes other rules in a complex system, which is currently under review. The European Commission recently proposed to reform fiscal rules. Nevertheless, the basics will remain the same: countries with large budget deficits and public debts will have to reduce their deficits.
EU fiscal rules were suspended during the COVID-19 pandemic but will be reintroduced in January 2024. We concluded that except for three countries, Denmark, Luxembourg, and Sweden, which meet all EU fiscal rules, the other 24 EU countries will have to implement fiscal consolidation from 2024. In the past, fiscal consolidation resulted in cuts to public investments. This time, public investments must increase to meet climate goals.
Politicians often prefer cutting investment over current spending, partly because future generations’ interests have less electoral support, especially in ageing societies. Additionally, fiscal rules treat investments as current expenses, which puts them at a disadvantage, despite their long-term benefits. Green investments, in particular, have a long-term payoff that may take time to materialise, making it tempting to scrap public green investments instead of implementing unpopular tax increases and social spending cuts.
While the European Commission’s recent proposal to reform fiscal rules mentions green transition and public investment multiple times, it does not provide a good framework to incentivise public green investment when budget deficits must be cut.
Our Call for a ‘Green Fiscal Pact’
To address the conflicting needs of fiscal consolidation and more green public investment, we recommend a ‘Green Fiscal Pact’ composed of the following elements:
- Introduction of a ‘green golden rule’ that excludes net green public investment from the fiscal indicators used to measure compliance with the EU’s fiscal rules;
- A requirement that fiscally weak countries should not immediately benefit from the green golden rule, but rely on the EU’s pandemic recovery fund for their green investment up to 2026 and not ignore risks to public debt sustainability;
- Incentivising private green investment through appropriate reform of taxation and regulatory policies; and
- Ensuring that subsidies for fossil fuels are removed as quickly as possible to save fiscal resources and accelerate the green transition.
If a ‘green golden rule’ is implemented, green investments could be financed through budget deficits without being subject to fiscal rules. This would eliminate the need for politicians to cut other expenses or raise taxes to fund green investments. Consequently, the green golden rule would encourage investment in environmentally-friendly projects by removing the need for unpopular fiscal measures. A key challenge is how to define ‘green investments’: we propose that those investments could be classified as green that achieve large carbon emission reductions.
While a green golden rule could incentivise countries to increase green investments without resorting to expenditure cuts or tax increases, it may not suit countries with high public debts. Climate change and carbon taxation could lead to reduced economic growth and higher inflation, necessitating labour relocation to different jobs and places, ultimately resulting in a smaller GDP. This could lead to reduced consumption and income tax revenues and increase all ratios relative to GDP, such as the public debt to GDP ratio. Thus, countries with vulnerable fiscal positions should not use the green golden rule. The good news for these countries is that they receive large amounts from the EU’s pandemic recovery fund, the Recovery and Resilience Facility. About 40% of this funding is used for green investments.
Private investment should also be incentivised through appropriate taxation and regulation to reduce the bill to the public sector. This would be unpopular, but without these measures, decarbonization will become more expensive, and the negative growth effects of the transition will possibly be larger. In our view, the proposed Green Fiscal Pact is the most promising option to address the tension between the conflicting needs of fiscal consolidation and increased green investments. The ongoing review of the EU fiscal rules offers a good opportunity to discuss and decide on the Green Fiscal Pact.
Darvas, Z., & Wolff, G. B. (2022). A Green Fiscal Pact for the EU: increasing climate investments while consolidating budgets. Climate Policy, 1-9. https://doi.org/10.1080/14693062.2022.2147893