The US’s Inflation Reduction Act (IRA) counts on massive direct subsidies to its private sector to stimulate a green transformation of the economy. The EU has opted largely for carbon pricing and other taxes to make the same transition. The two approaches are in no way mutually exclusive – and both have benefits. Paul Hockenos looks at the European answer to the IRA in the second installment of the two part series. Read part one here.

---

While Europeans do a fair share of subsidizing themselves – like in renewable energy production and battery manufacture – they’ve bet on carbon pricing and tariffs to do the hard work in reducing net greenhouse gas emissions by at least 55% by 2030 – compared with 1990 levels – and hitting climate neutrality by 2050. The EU carbon trading system puts an upscaling price tag on carbon emissions by the ton.

Until recently this applied only to some industrial sectors, aviation, and energy generation; soon it will also include road transport, maritime transport, and buildings. The concept is that the climbing carbon prices – an upshot of fewer freely allotted “allowances” to emitters – will steer consumers away from fossil fuels and generate revenue to help industry make the shift. Experts say it’s the best way to go as the market-based system ensures that emission reductions take place where it is cheapest to do so. This is why most emission reductions until now have happened in the energy sector.

A necessary companion to carbon pricing is the Carbon Border Adjustment Mechanism that will, as of 2026, penalize trade goods entering the EU from countries that don’t price emissions. This should level the playing field and earn the bloc more revenue for its industries, disadvantaged by way of carbon pricing.

The two systems, the US and the EU’s, shoot for the same goal: fewer emissions. “The EU is dramatically increasing the cost of emissions,” explains Michael Mehling, Deputy Director of the Center for Energy and Environmental Policy Research. “The U.S. is doing the opposite: no meaningful cost on emissions, outside of a few states, but a program of fiscal and other subsidies that will lower the cost of means to abate emissions.”

Chris Stark, chief executive of the UK’s Climate Change Committee put it another way: “Rather than making the black stuff expensive, Biden said ‘Let’s make the green stuff really cheap’. That’s far more politically saleable.”

Although the EU has slashed its emissions by 32 percent between 1990 and 2020, carbon prices are thus far only responsible for a share of the drop: indeed emissions in those sectors covered by the ETS plummeted by 41 percent but other sectors, like road transportation, were unaffected. Many experts agree, however that until recently, the complicated system has not logged particularly impressive results in light of its 18-year lifespan. Innovation and support policies have spurred technology breakthroughs in renewable energy, electric mobility, and battery storage that have contributed immensely to emissions’ reductions.

There were kinks in the pricing system from the start that shielded the big emitters – and to a degree still do today. But if in the future the price the per ton of carbon jumps – as it did between 2021 to 2022 from €53 to €80 – and the number of free emissions allowances fall further  – far too many were originally allotted to industry – experts say that coal plants don’t stand a chance of remaining on the market beyond 2030. Gas and oil’s exit would follow, almost certainly faster than will happen in the US. In late February, the EU ETS price passed the threshold of €100 per ton of CO2 for the first time since its creation in 2005.

Two-pronged approach

A key insight is that the carrot and the stick methods are not mutually exclusive: The former constitutes a more direct means of stimulating investment, the latter of slashing emissions. In response to the IRA and Chinese subsidies, EU chief Ursula von der Leyen’s proposal of a Green Deal Industrial Plan with public and private investments of hundreds of billions over a decade wouldn’t supplant the carbon pricing system but rather complement it. A first move, the Commission has proposed dramatically simplifying cumbersome regulations for “net-zero products” products in the EU to encourage public procurement, investment, and rollout. Tweaked single market regulations would enable tax breaks for green industries and allow more state aid to flow into clean tech.

For its part, the US has limited sub-national carbon pricing mechanisms on both coasts, which could one day expand – to push emitters out of the market. Currently, though, for political reasons, a carbon pricing system like Europe’s is unthinkable in the US: it’s just not going to happen. The lever that the Biden administration has is spending.

Still, a two-pronged approach could cull the best of both, and Europe is moving in this direction: “Further raising the cost of emissions while subsidizing that of decarbonizing more will accelerate the necessary investments,” contends Martin Sandbu economic analyst for the Financial Times, referring to Europe. “That means expanding the carbon pricing and tariff policies. But it also means boosting public money for research, capacity, and production… Europe’s embrace of carbon pricing means such subsidies can have a greater effect than on the other side of the Atlantic.”

Imperative is that animosities don’t escalate and trade wars ensue – neither across the Atlantic nor beyond it. Smaller EU states and those in the Global South cannot hope to keep up should a full-fledged subsidies race break out among the heavyweights. A joint EU-US task force is building exceptions for European companies into the IRA.

The Biden administration has already backpedaled on eligibility for a commercial-vehicle tax credit, opening the way for European firms to benefit, according to the US magazine Undark. As part of a newly proposed  trans-Atlantic initiative on sustainable trade, the US and Europe’s common approach to measuring the carbon footprint of steel and aluminum could extend to other products.

In setting a new benchmark, the IRA has stolen the EU’s thunder, not doomed it to the margins. The ball is now in Europe’s court: it has to match or better the IRA’s aspirations, which the EU shows itself entirely capable of doing.