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Irene Lauro | Minister’s renewables tax break for business and the green subsidy race

 

Irene Lauro | Minister’s renewables tax break for business and the green subsidy race
23-02-23 / Irene Lauro

Irene Lauro | Minister’s renewables tax break for business and the green subsidy race

In his National Budget Speech on Wednesday, South African Finance Minister Enoch Godongwana announced that from 1 March 2023, businesses will be able to reduce their taxable income by 125 per cent of the cost of an investment in renewables. He added that there will be no thresholds on the size of the projects that qualify, and the incentive will be available for two years to stimulate investment in the short term.

"South Africa's budget comes at a time when the economy faces a difficult period. Loadshedding continues to cause disruption to power supplies, while the fading tailwinds of commodity prices and the increasing drag from higher interest rates leave the economy facing a slowdown this year. The government announced a concrete, three-year plan for the funding of Eskom while also announcing these large tax breaks for investments in renewable energy in a bid to tackle the current energy crisis. 

"While the announcement from the Minister is not as decisive as measures taken in Western economies such as the US and EU – it is a step in the right direction and a sign that governments the world over are utilising fiscal industrial policy to drive the energy transition," says Senior Emerging Markets Economist at Schroders, David Rees.

The move comes as part of a worldwide shift – especially in the Western world – where government intervention in economic activity via industrial policy is again gaining a lot of traction. In a bid to strengthen their supply chains and improve energy security, some key economies are increasing efforts to expand clean energy technology manufacturing.

Looking at how this is happening in the US, EU and China may reveal insights for economies in the early stages of policy implementation aimed at driving the energy transition.

The Inflation Reduction Act: a game-changer for the US and global climate action

In August 2022 the US signed into law what will probably transpire to be the most important piece of climate legislation in the country's history. Indeed, according to the International Energy Agency (IEA) the Inflation Reduction Act (IRA) is the most significant climate action yet to have followed from the Paris Agreement of 2015.

This new law is set to materially boost the US green technology industry. It entails tax breaks and subsidies worth $369 billion for firms producing electric vehicles, batteries and renewable energy and amounts to a new industrial strategy. By limiting the cost of clean energy production and creating certainty it is likely to make the energy transition cost-effective for the long term.

The strategy is also very much in line with a trend we're seeing for increased "fiscal activism". The US is not the only government using tax and spend policies to ease the effects of higher inflation amid wider shifts in policy and market behaviour.

The strategy will also promote the relocation of global green energy companies to the US, therefore boosting employment opportunities in the country while attracting more capital. In this regard it should also be seen in the context of wider changes to global value chains (GVCs) related to geopolitical factors, as we explore later in this article.

Some of the changes to GVCs have been exacerbated by Covid and the Ukraine war, which are necessitating a more urgent response to climate change, partly in pursuit of greater energy security. The accelerated response to climate change is another key aspect of regime shift identified by us.

How will other countries respond to US attempts to boost industrial competitiveness?

Other countries, however, will not sit idly by and watch the US boost its industrial competitiveness. The IRA represents a key risk to the European Union's (EU) green technology industry in particular. It has the potential to divert clean energy capital away from Europe, a region where green subsidies are lower and energy bills are relatively higher compared to the US.

So far, the EU has been leading on climate action and regulation. It has one of the highest carbon prices at a global level and is set to implement the world's first carbon border tax. The EU introduced carbon pricing through the implementation of its Emissions Trading Scheme (ETS) in 2005. As a result of this initiative the bloc has benefited from an accelerated roll-out of renewable energy compared to other advanced economies.

The 'stick' approach of the EU has been a key pillar of its net zero strategy, but it appears that the focus is now shifting to providing the 'carrot' too. The EU needs to respond to protect its leadership in clean energy, addressing the potential loss of competitiveness to the US and the risk of energy-intensive industries relocating.

Industrial policy is now making a comeback in Europe too and will be an important tool to continue promoting European renewable energy. In particular, the EU is looking at its own form of a green subsidy strategy through the Net-Zero Industry Act (NZIA) that was announced in Davos in January 2023. The objective is "... to simplify and fast-track permitting for new clean tech production sites...", with an "aim to focus investment on strategic projects along the entire supply chain".

The EU is also likely to establish the Critical Raw Materials Act that is set to ensure access to critical minerals and metals by diversifying sourcing and reducing dependence on highly concentrated supplies from third countries.

How China dominates in production of clean energy equipment

While the EU and the US have only recently started looking at forms of state intervention to support clean energy manufacturing, China already dominates the scene.

According to research by the Center for Strategic and International Studies (CSIS), China has spent a large amount of resources to boost its domestic industry. It is estimated industrial policy spending amounted to more than $240 billion in 2019. This was three times that of the US and nine times more than that of Japan (see Chart 1).

The CSIS research also shows that relative to other economies China spent more on direct subsidies than any other country, while also providing significant support through credit to its State Owned Enterprises.

The strong efforts of the Chinese government have helped the country become the world's leader in the clean energy sector, with dramatic implications for GVCs.

Data from the IEA highlights that China dominates the processing of many minerals that are critical for green technology manufacturing. It has around a 70% share of global processing for cobalt and 60% for lithium and nickel. Chinese companies started to invest in mineral-rich countries like the Democratic Republic of Congo as early as 2006. Sustained policy support has also helped China take control of the world's production of mass-manufactured technologies.

The Asian economy accounts for more than 70% of global manufacturing capacity of solar panels and batteries. It is also the largest producer of wind capacity and heat pumps respectively commanding 58% and 38% of these markets.

As the energy transition gathers pace China's role in GVCs for the production of equipment used to generate clean, renewable energy is set to expand over the next decade. In its latest Energy Technology Perspectives 2023 report the IEA shows that "China alone would be able to supply the entire global market for solar PV modules in 2030, one-third of the global market for electrolysers, and 90% of the world's EV batteries".

This concentration of production in China is clearly a risk to the decarbonisation plans of advanced economies. The Covid pandemic has already highlighted the need for countries to build more resilient supply chains, as their disruption and the resulting bottlenecks can create significant inflationary pressures.

Renewable energy is an infinite and unconstrained source of power that can lead to higher energy security in many countries, and eventually, much lower costs. However, the current structure of GVCs means that the development of infrastructure that countries need to enjoy electricity from wind and sun is exposed to geopolitical risk.

Climate targets and employment get a boost from energy security

The US and Europe have recognised the importance and the urgency to foster more localised supply chains, and enhancing energy security is one the main objective of the IRA and the subsequent European response. In the meantime, in an attempt to regain some control on supply chains, policies to mitigate climate change are also receiving a boost.

According to modelling from the Princeton University ZERO Lab, the IRA is estimated to cut annual emissions in 2030 by an additional one billion cubic metres below a "No IRA" case, thanks to a faster deployment of clean electricity and electric vehicles. This will reduce greenhouse gas emissions by 42% compared to 2005 levels by 2030, up from 27% previously, narrowing the emissions gap between current policy and the nation's 2030 climate target (50% below 2005).

While improving the US emissions trajectory, the new legislation is also set to support employment and investment in the clean energy sector. Princeton's analysis shows that by 2030, the IRA could add around two million energy supply related jobs, with the manufacturing industry benefitting the most, especially the solar energy sector.

Finally, the legislation will also benefit US households through energy cost savings by lowering the cost of electric and zero emissions vehicles, heat pumps, and promoting efficiency upgrades. The IRA is estimated to reduce annual US energy expenditures by at least 4% in 2030, a savings of nearly $50 billion per year for households.

The EU has not finalised its response to the US spending boost yet. The NZIA aims at creating a more simplified regulatory framework for production capacity, while easing subsidy rules. It is likely to target key product sectors including batteries, wind-turbines, heat pumps as well as technologies such as solar, electrolyser and carbon capture and storage.

The bloc still needs to finalise the details on how to finance its green spending boost and this will be probably agreed on at the EU leaders' next summit at the end of March. This is when the president of the European Commission Ursula von der Leyen will have to present a reform package to member states. If implemented, the return of industrial policy in the region is likely to boost EU competitiveness and productivity, while strengthening its path towards net zero.

There are multiple approaches available to the EU to support its green spending. Some governments, like Germany, are proposing to completely relax restrictions on subsidy rules. However, this will be in conflict with state aid rules that aim at preventing EU member states from granting financial assistance in a way that distorts competition and inter-state trade within the bloc.

Other governments are proposing to only partially ease these rules along with a subsidy cap to protect poorer countries from unfair competition. Finally, President von der Leyen is in favour of a European Sovereignty Fund, but she has not provided much detail on where the funding should come from.

The fund could be financed by common debt, similar to the NextGeneration EU, a proposal supported by Spain. However, Germany and the Netherlands are not in favour of issuing more EU debt, and have highlighted there are some unused funds, such as the money left in in the Recovery and Resilience Facility that was designed to help the EU recover from the pandemic.

A number of challenges ahead for industrial policy

The EU's move to relax its state aid regime is not a done deal. Unlike the US, the EU does not have a fiscal union and fiscal capacity is mostly in the hands of single member states. Some EU countries have more fiscal space than others and looser subsidy rules could lead to unfair competition within the single market, a key pillar of the bloc.

This is because not all European countries can offer the same magnitude of support that can be provided by Germany and France, the two largest economies. Relaxing the bloc's state aid regime could "lead to significant negative effects including the fragmentation of the internal market, harmful subsidy races and weakening of regional development", the governments of Denmark, Finland, Ireland, the Netherlands have highlighted.

However, prospects for industrial policy remain good as the EU has already eased those rules in the past, including during the Covid pandemic and in response to Russia's invasion of Ukraine.

The EU was largely surprised by the scale of the US move. However, we argue that from a macro perspective the bloc does not need to mobilise such a large amount of money to boost its clean energy capacity. Putting a price on carbon through the EU ETS has already incentivised the decarbonisation of the European energy sector.

As a result, the bloc is now further along in its journey to net zero. In contrast, the US has to do much more compared to the EU in order to make renewables more attractive relative to carbon sources of energy. The US has historically avoided the 'stick' approach in the form of carbon taxes due to political reasons. As a result, it is now only left with subsidies and tax credits to cut its carbon emissions and meet climate targets.

US policymakers also face an important challenge in setting out their green industrial policy. The EU has welcomed the US move, as the IRA is an important step in the fight against global warming. At the same time however, it has raised concerns over green protectionism due to the discriminatory nature of the US incentives that have some domestic-production or domestic-procurement requirements.

The US incentives are only applied if battery components and cars are produced in the US or in a country that the US has free trade agreement with, such as Mexico and Canada. European governments have therefore claimed that the IRA's provisions on locally produced content discriminates against companies in the EU and thereby violate World Trade Organization (WTO) rules. Biden replied that the US is "going to continue to create manufacturing jobs in America, but not at the expense of Europe".

Meanwhile, a US-EU task force has been created to address EU's concerns over protectionism. It is highly unlikely the US will modify the IRA through legislation in Congress, given that the House of Representatives is now controlled by Republicans. Some changes, however, can be made by the US Treasury during the implementation phase. The EU wants European companies to be included into the benefits of the IRA and this remains a possibility that would also alleviate concerns over violation of the WTO rules.

Should the EU's requests not be accommodated, geopolitical risks could arise on the back of a transatlantic trade war. We think this scenario is not on the cards, as both countries recognise the importance of international cooperation on climate action.

Finally, we think it is also worth highlighting the implications for other advanced economies. Countries that will not take part to this green subsidy race, like the UK, will be more exposed to foreign competition. As a result, they will not be able to fully exploit the employment and investment opportunities that the energy transition creates.

*Irene Lauro is an Environmental Economist at Schroders.

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