Mind the Gap: Can Europe Afford Its Green and Digital Future?

Amid vast investment shortfalls, the European Union must rethink its funding strategy to achieve its ambitious goals.

Significant new investment is crucial if the European Union is to meet its decarbonisation and digitalisation targets, yet funding remains the Achilles heel of its green industrial policy. Amid a climate of austerity, policymakers’ attempts to subsidise and “crowd in” private investment, mainly through public guarantees, have failed to close Europe’s green investment deficit, which is estimated to be some €406 billion, or 2.6 percent of GDP, in 2024.

A recent report by the former Italian prime minister, Mario Draghi, calls for an additional €750 billion to €800 billion in yearly investments to meet further geopolitical and structural goals, a figure corresponding to around 4.5 percent of the EU’s 2023 GDP. Meanwhile, many relatively new programmes dedicated to green manufacturing, such as the Net-Zero Industry Act and the Sovereignty Fund/STEP, do not provide additional money from the EU level but mostly reshuffle funds from existing pots.

While these numbers may sound large, they are dwarfed by the costs governments have borne during wars and financial crises. Historically, public debt has almost doubled on average in the aftermath of domestic banking crises. As the climate crisis becomes increasingly critical, this article discusses ways to increase the EU’s funding of the green transformation beyond the prevailing approach of subsidising private financial intermediaries.

The Case for Permanent EU Bonds

As the centrepiece of the NextGenerationEU programme (2021-2026), the Recovery and Resilience Facility raised €723.8 billion through EU bonds to alleviate the economic hardships of the Covid-19 pandemic. Scholars have referred to the facility as a landmark agreement and an innovative European investment model. Poorer member states received proportionately larger sums dedicated to the green and digital transitions, among other ends.

Despite being a crucial step forward, the temporary nature of the Recovery and Resilience Facility has diminished the effectiveness of some of its resources. The smaller scale of borrowing compared to national governments has also increased its debt costs. Despite being triple-A rated, benchmark 10-year EU bonds have, for most of the last few years, traded at higher rates than their German and French counterparts. Conversely, the permanent issuance of EU bonds would decrease the cost of debt, improve the EU’s fiscal space amid the Stability and Growth Pact, and counteract regional imbalances within the Union.

A Permanent Investment Fund

Many current instruments, including the Recovery and Resilience Facility and InvestEU, have limited lifespans, expiring in 2026 and 2027 respectively. This finite approach is not conducive to the long-term planning required for both private and public actors to carry out the twin green and digital transformations.

Long-term financing mechanisms are therefore essential. A legally simple option to permanently summon public investments would be through the establishment of a permanent European investment fund, such as the “Sovereignty Fund” mentioned in Ursula von der Leyen’s State of the Union address in September 2022. Such a fund could provide, for example, “at least 1 percent of EU economic output per year” to enhance Europe’s energy independence and meet its climate investment needs. The fund could prioritise European public goods, such as continental railway infrastructure, pandemic prevention, integrated electricity grids, and an EU-wide 5G network.

Progressive European Taxation

Not only has the ratio of tax revenue to GDP decreased in recent decades, but the burden of taxation has also increasingly shifted from capital to labour. Competition for capital and investments in an era of free capital movement has led governments to successively decrease taxes on profits, capital income, real estate, wealth, gifts and inheritance. This has undermined the fiscal space that could have been used for necessary investments.

Although politically challenging, there have been increasing calls for common European taxation. Suggestions include common taxes on wealth, financial transactions, capital gains and carbon emissions, along with an EU corporate tax. Together, these could raise resources equivalent to between four and eight percent of the Union’s GDP per annum.

Sharing Risks and Profits

Markets are not apolitical institutions but are co-created by private and public sector actors. By acting as investors of first resort, and by co-creating and shaping markets, states have remained core contributors to radical innovation. However, amid scarce fiscal resources, European policymakers have tried to finance the green transition through financial “de-risking” — the absorption of various business risks by the public sector to increase private investment.

Instead of subsidising profits and socialising risks, a progressive de-risking strategy should include conditions for firms that receive subsidies. Conditionalities could require companies (i) to reinvest profits into R&D, worker training or other productive activities; (ii) to ensure the right to collective bargaining and decent wages; (iii) to agree to private-public profit sharing schemes through royalties or partial government equity ownership; (iv) to grant the public sector access to, for example, intellectual property rights in exchange for subsidies; and (v) to levy taxes on excess profits and introduce bans on excessive shareholder remuneration, including on dividends and share buybacks.

Conditionalities used under the Biden administration’s industrial policies offer some examples. The CHIPS Act partly forbade dividend payments or stock buybacks, while the Inflation Reduction Act put a one percent excise tax on stock buybacks. Meanwhile, a “prevailing wage clause” stipulated that receiving firms must pay decent wages and benefits. Such measures, as the former Italian prime minister, Enrico Letta, pointed out in a recent report, have largely been absent in the EU. Moreover, whereas credit guarantees restrict the European Commission’s ability to attach performance criteria or conditionalities to financial support, grants offer EU institutions greater control over profit-sharing mechanisms and performance-based conditions, according to a policy brief by the Jacques Delors Centre.

Leveraging Europe’s Development Banks

Multilateral development banks account for over one-third of climate finance to developing countries and 10 percent of global investments annually. European development banks, including Germany’s KfW and France’s CDC, have likewise been among Europe’s major green financiers; the European Investment Bank, for instance, funded 40 percent of Europe’s offshore wind capacity as of 2020. The Commission has also proposed an “Industrial Decarbonisation Bank”, aiming for €100 billion in funding in 2026, though its final structure remains to be seen.

Further public resources could be allocated to these banks for credit creation, including assets of sovereign wealth funds, public pension funds, central bank assets and IMF Special Drawing Rights. The European Investment Bank could also be leveraged by accepting new member states while receiving increased paid-in capital from existing members.

As Europe lacks equity financing, development banks are also well-suited to take equity stakes in technology start-ups. Why? First, public equity investments help prevent the unsustainable leveraging of firms. Second, public equity stakes enhance the ability of policymakers to steer green technological innovation more effectively. Third, expanding the use of equity instruments enables development banks not only to absorb risks but also to share in the rewards of successfully co-financed innovative firms—returns that can be reinvested to support future projects and lending activities.

Reforming the EU Fiscal Framework

It is widely believed that the Stability and Growth Pact has failed to limit European public debt-to-GDP ratios. Its contribution to fiscal restraint also depressed demand and was detrimental to the EU’s growth performance in the years after the 2008 financial crisis. Public underinvestment was chronic even before the crisis, and public net investment has turned negative or remained stagnant throughout Europe ever since. The need to reform the EU’s budgetary framework has also been emphasised by studies published by the IMF.

The 60 percent benchmark for public debt was chosen arbitrarily, according to the former ECB Vice President, Vítor Constâncio, at a time when climate and digitalisation investments were considered less pressing. Progressive activists, scholars and policymakers should therefore continue to mobilise for long-term alternatives to the existing contractionary fiscal framework.

A Strong European State, Not Just Subsidies

European policymakers have perceived public investment guarantees as a cheap alternative to guide private investment towards socially important but otherwise unprofitable destinations. This has been exemplified by the EFSI and InvestEU programmes. The Letta report similarly proposed the launch of a “European Green Guarantee”.

As these measures have fallen short of closing Europe’s green investment gap, it is clear that corporate subsidies cannot substitute for supranational public investment and lending. An expanded fiscal capacity is imperative to accelerate Europe’s decarbonisation, whether through permanent EU bonds, taxation, a permanent EU investment fund, the further leveraging of public development banks, or a combination of these approaches.