EU leaders searching for a response to the IRA are grappling with how to match foreign incentives while not upending the playing field in the EU itself.
The IRA sets out plans for $369 billion in subsidies for green industry and energy over a decade. It has led to complaints of discrimination against EU companies.
Implications of the European Response to the US Inflation Reduction Act
Source: Citi Research
The EU is expected to respond to the IRA. But what options are available to it?
The new Citi Research report explores that question. The team expects a political agreement to emerge that loosens state aid rules for clean technology and repurposes some 300 billion euros of existing funding lines to help governments with less fiscal firepower compete with the US.
Scaled-up subsidies and increasingly protectionist policies add to the risks of higher inflation in the medium term, the authors warn.
The EU’s dilemma
The report describes the EU’s “business model” as promoting free trade, strict competition rules, and soft power. But doubts about that model now abound given the economic fallout from the Russia-Ukraine conflict and the need to accelerate Europe’s energy transition.
The pain of Europe weaning itself off Russian gas has raised concerns about other critical economic dependencies.
EU leaders have discussed how to respond, but the authors suspect that response will prove modest due to the EU’s own complexities.
Trade restrictions imposed since 2008 (Global, number)
Source: Citi Research, Global Trade Alert, IMF
How much the IRA accelerates green investments may depend on the extent to which subsidies lead to additive investment at the global level rather than diverting investment to the US from elsewhere.
The EU has criticized these discriminatory provisions as giving US manufacturers an unfair advantage, as well as for going against global trade rules and diverting industrial plants away from Europe.
For the EU, the risk is twofold: IRA subsidies may drive key industrial sectors away from the EU when its industrial competitiveness is already suffering; and a US turn to protectionism poses a more fundamental challenge to core tenets of the EU business model.
Potential responses
Discussions under way about an EU “Green Deal Industrial Plan” are likely to extend into the spring. The authors think a political agreement is likely in the first half of this year, one that would outline a short-term response.
The authors cite three reasons the response might be muted:
- The EU must balance its own internal cohesion with its strategic interaction with the rest of the world. A response in kind to US subsidies intended to keep EU industries ashore would almost certainly allow large, deep-pocketed EU members to outspend smaller, more fiscally constrained ones, which could spur industrial relocations within the EU.
- Access to joint EU funds comes with strings attached, making them less attractive for EU governments.
- While the IRA is envisioned as fully funded by tax increases, the EU hasn’t achieved clarity on how larger-scale industrial subsidies would be paid for.
Challenges for the UK
The report notes the challenges faced by the UK, where broader political disruptions in recent months have left policymakers “on the back foot.” The UK seems particularly exposed to domestic US economic changes associated with the IRA. It also seems likely to be hurt by the broad consequences for international trade. And unlike the EU, the UK is in a particularly weak position in terms of a response.
The authors summarize their argument saying that being “a small open economy in an increasingly protectionist global economy is bad news,” adding that the UK is at risk both because of changes in the US economy driven by the IRA and because of the medium-term reaction from the EU.
For more information on this subject, please see: EMEA Equity Research - Macro to Micro: Implications of the European response to the US Inflation Reduction Act
Citi Global Insights (CGI) is Citi’s premier non-independent thought leadership curation. It is not investment research; however, it may contain thematic content previously expressed in an Independent Research report. For the full CGI disclosure, click here.