Why the EU must reset its Green Deal – or be left behind

Through its Green Deal, the European Union shows its ambition to be a world leader in the fight against climate change. Approved in early 2020, this comprehensive package of policies — spanning clean energy, buildings, farms, transport, industry and more — aims to achieve ‘net zero’ for EU greenhouse-gas emissions by 2050.

Since then, further goals have been bolted on. The 2021 European Climate Law stipulates that, by 2030, EU greenhouse-gas emissions should be at least 55% lower than 1990 levels¹. The Nature Restoration Law passed in February this year aims to restore 20% of the EU’s degraded ecosystems by 2030 and at least 90% by 2050, to reduce emissions and achieve biodiversity objectives.

Yet, changing political and economic winds risk blowing the Green Deal off course. This year’s elections to the European Parliament saw gains by populist parties that are opposed to the Green Deal. And trends in the global economy have shifted markedly since the package was agreed — before the COVID-19 pandemic and wars in Ukraine and the Middle East.

Here, we highlight what these changes mean and call for a reset of this crucial green policy package. The Green Deal can be saved if the EU adopts a fresh mindset and realigns its policies to work with global trends.

Carbon taxation is not global

The Green Deal was predicated on three presumptions, each of which has not been borne out.

First, it was widely expected that a global carbon tax would emerge, and it has not. Most economists view carbon taxation as the optimal policy for pushing carbon-intensive industries to lower their emissions². Carbon taxes also bring in revenue to help finance the green transition. Yet Europe now stands alone in implementing carbon pricing on a large scale.

The EU Emissions Trading System has introduced sizeable carbon prices. But big polluters are still offered exemptions. For example, free permits for emitting carbon dioxide have been granted to the EU’s domestic steel, aluminium and oil-refining industries. These are intended to avoid importing more carbon-intensive products from outside the EU (known as carbon leakage) and to support the bloc’s global competitiveness.

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However, most countries worldwide do not levy carbon taxes. And those that do put a relative value of at most a few dollars on each tonne of emitted carbon dioxide equivalent, once they have corrected for the many firms that are exempted. That low value doesn’t reflect the real damage done, now and in the future — the ‘social cost of carbon’³.

Why has carbon taxation not taken off? International coordination of climate policies has fallen victim to geopolitical fragmentation and technological rivalry. The United States and China are competing fiercely over green technologies — each has issued massive subsidies for research and development (R&D) and manufacturing in areas such as batteries, solar panels and wind power.

To protect itself from unfair competition, in 2023 Europe began to institute a Carbon Border Adjustment Mechanism, which will be fully in place by 2026. This mechanism aims to ensure that imports that have not been subjected to a carbon tax (or have paid one that’s too low) will be taxed at the EU border. It effectively widens the coverage of EU carbon pricing and will eventually enable free permits for the biggest polluters to be scrapped. However, this would be achieved by hitting exports from low- and middle-income countries, slowing their economies.

Such offshore policy impacts might yet be exacerbated by another law — the EU Deforestation Regulation law. This was adopted in 2023 and was set to come into effect by 2025, but has been delayed. In some circumstances, it would ban imports of particular commodities if they were found to be linked to deforestation — including coffee, cocoa, soya, palm oil, rubber and wood. The aim is to induce partners to stop deforestation in their territories by submitting their imports to stringent EU verification processes and mechanisms.

Through such policies, the EU is, in effect, promoting global environmental regulations and standards through instruments that will mainly penalize its trading partners. It is perilously abandoning its conventional position as a defender of free trade and emerging economies. This stance might be perceived as insensitive and unfair, especially by low- and middle-income countries, and could result in conflicts and even diplomatic isolation.

The financial climate has cooled

Second, the Green Deal was designed and adopted at a time when long-term interest rates were historically low or even negative in real terms, and when levels of public debt were moderate. These economic conditions were conducive to financing the massive investments necessary to accomplish the transition to net zero, especially electrification. The aim was also to extend financial support to help European populations to bear the early costs of the green transition⁴.

However, the post-pandemic environment is very different. Public debt as a percentage of gross domestic product (GDP) has soared in most advanced and European economies to more than 80%, on average. Greece, Italy, France, Spain and Belgium have public-debt-to-GDP ratios of more than 100%. This will limit the possibilities for helping households to absorb the costs of the transition, and will force careful selection of public and green investments.

International cooperation is fragmenting

Third, geopolitical trends challenge the Green Deal. As currently designed, the deal impedes European competitiveness by increasing the cost of energy substantially, mainly to cover the cost of building infrastructure around renewables and decommissioning those around fossil fuels. Europe also depends heavily on external suppliers for ‘critical minerals’ — sources of elements such as lithium and cobalt — for renewable energy and other green technologies.

Like the United States, Europe is facing challenges from China — which has control of 60–80% of the world’s production and processing of critical minerals. China is also the biggest emitter of CO₂, the largest producer of coal-based electricity and the world leader in batteries and electric vehicles. China’s strategy is to act as a monopolist with low pricing, undercutting others.

Artificial intelligence is another emerging area of global competition. If the EU is to become competitive with the United States and China in this field, it will require vast amounts of cheap energy.

Western countries face a dilemma: how to accelerate their energy transition while preserving their economic security and technological autonomy. From a global perspective, the EU economy is flagging, as forcefully laid out in a September report by Mario Draghi, former president of the European Central Bank⁵. He notes that growth in per capita disposable income in the EU has been half of that in the United States since 2000. Despite having excellent research universities, Europe lags behind in terms of patents and innovation in digital and energy technologies. EU nations have a good track record in coming up with ideas, but less success in seeing them through to commercialization.

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Prospects are hampered further in Europe by populations that are declining and ageing, with the median age in 2022 being 44.4 years in the EU; for comparison, the US median age is 38.8 years. The EU is also losing the global race for talent against the United States, given Europe’s rigid labour and immigration laws.

Europe needs transformative policies to make it more productive and greener while maintaining equity and social inclusion. If nothing is done, European climate policies will slowly degenerate into more protection, taxation and coercive actions in an elusive attempt to promote more virtuous climate and energy policies in other countries.

Towards a new Green Deal

Although the EU should retain its high ambitions on the climate, it must reorient its policies to align with the new rules of the international game. The march towards net-zero emissions will be driven by the technology race, not by domestic taxes, regulation or carbon constraints on border trade and imports. Here’s what the EU should do instead.

Deploy incentives and subsidies. Massive encouragements to develop future green technologies should make up the bulk of the EU’s effort. For example, it could expand and relax criteria for tax credits for green investment, including for R&D.

A big push is required to move households and firms away from vehicles that rely on internal combustion engines to electric vehicles, and from coal- and gas-fired central heating to heat pumps. There must also be more impetus to switch the energy infrastructure from coal, oil and gas to renewables. This will increase ‘learning by doing’ in the renewables sector, building experience and bringing down costs, as well as boosting demand for renewables and green technologies such as electric cars. Once the economy has shifted from a dirty to a clean one, incentives and subsidies can be taken away.

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Phase in standards. Slowing the imposition of new environmental and climate standards would smooth the cost of the transition and avoid disrupting early stages of innovation. In practice, this means pushing deadlines back by at least a decade for the adoption of standards on heating, transportation and land restoration. This would allow consumers and corporations to cushion the costs of purchasing new equipment and create space for learning and innovation. Only when those clean technologies are ripe should stringent environmental standards be imposed.

Recognize nuclear energy. A new Green Deal should expand nuclear energy as a key contributor to decarbonization, together with renewables, and exploit its advantages. Nuclear energy provides a steady baseload of power; by contrast, renewables are intermittent and require energy storage.

Whereas conventional nuclear reactors have fallen out of favour, small modular reactors are cheaper, more versatile and safer. Interestingly, giant US digital platforms, including Google and Amazon, are investing in privately owned nuclear facilities to provide low-carbon energy for the development of artificial-intelligence technologies.

Grow domestic firms. As well as protecting and subsidizing nascent industry, the EU should seek to promote the competitiveness of European firms globally by allowing them to grow to reach greater economies of scale. The European Commission should ensure that anti-trust policy does not prevent strong European firms from merging when warranted, while still preserving the welfare of customers.

Build partnerships. The EU should also take steps to ensure it does not depend on China and other countries for access to critical minerals — and uranium. It can do so by developing partnerships with countries that are rich in such minerals, such as Chile, Indonesia and the Democratic Republic of the Congo, and by favouring trade and investment there.

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Restrict carbon taxes. Carbon taxes might have a residual role in sectors and activities that are not exposed to international competition, such as property, local transportation and public services. The EU should limit the Emissions Trading Scheme to such non-traded sectors for the foreseeable future to limit further loss in competitiveness, until an international system is agreed. In our view, the Carbon Border Adjustment Mechanism, which is premised on enticing others to adopt carbon pricing, should be dropped.

Donald Trump’s victory in the US presidential election will exacerbate trends towards slowing international coordination on climate issues. Down the road, as targets for emissions reductions become tighter, the price of emissions trading permits will rise rapidly. This will help to stimulate the green transition⁶.

Minimize social costs. Low-income households cannot afford to pay high carbon and energy taxes or to borrow funds to buy an electric vehicle or install a heat pump. Too often, that simple fact is neglected, allowing the populists to picture climate policies as an obsession of the elite. The Yellow Vests protests in France from 2018 to 2020 were a case in point.

More generally, policymakers should avoid imposing constraints that yield small benefits while imposing large costs on important segments of the population, such as small-property owners and farmers. Policies related to agriculture and housing renovation might need to be reassessed by pushing back deadlines for their implementation or offering compensation. For example, low-income households needing to switch from coal- or gas-fired central heating to heat pumps might need subsidies or loans to make the transition. Revenues from the EU Emissions Trading Scheme could be earmarked to compensate those on lower incomes.

There is no denying that the Green Deal needs resetting — socially, economically and politically. Doing so will make the Green Deal stronger, more effective and, importantly, supported by the population.