The Looming EU Climate Investment Gap Presents Debt Sustainability Trade-off

With the EU facing such a vast climate investment gap, it will be a challenge to achieve Paris Agreement goals and ambitions.

The European Commission estimates that the region will require annual climate investments of EUR 1.07trn (7.4% of EU GDP) per year, including EUR 1.04trn to meet the ‘Fit for 55’ targets and around EUR 30bn under the REPowerEU plan to reduce dependence on Russian fossil fuels (Figure 1). This represents a rapid increase in investments of almost EUR 400bn a year.

Figure 1. EU wide average annual climate investment needs, 2021-30
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Climate Investments Pose Clear Medium-term challenges for Public Finances

This poses clear medium-term challenges for public finances, which have already been hit hard by the Covid-19 and energy crises as countries face an increasingly challenging macroeconomic outlook. These factors, combined with higher government borrowing costs, are constraining governments’ fiscal space and risk hampering climate action in the region. After all, 39% of EU Effort Sharing emissions cuts under Fit for 55 proposals are expected to come from countries with debt-to-GDP ratios of above 100% (Figure 2).

Figure 2. Effort sharing emission cuts by 2021 public debt-to-GDP level
% of total Effort Sharing emission cuts, 2021-30

EU governments therefore face a difficult trade-off. Delivering on their climate ambitions presents a considerable upfront fiscal cost and can weigh on public finances in the short to medium-term. Conversely, the cost of inaction will likely be massive, with a disorderly transition estimated to reduce GDP by around 25% by 2100, according to the ECB. This would undermine countries’ economic and fiscal sustainability longer term, lead to heightened social and political tensions and result in more persistent damage to their creditworthiness.

The EU Financial Architecture Can Provide Crucial Support

The EU financial architecture can provide crucial support. Firstly, increased use of common resources through the EU’s multi-annual budget and NextGenerationEU can help mitigate the cost for Member States with weaker public finances amid higher rates. Potentially over EUR 670bn (30%) of the EU budget will support climate action among its Member States. In addition, EU funding conditionality can galvanise national governments and bolster increased investment with structural reforms.

On the positive side, the development of new, cost-efficient green technologies can be non-linear, as reflected by competitiveness and the price of renewables, which has fallen dramatically in the past decade. Future investments may be lower than expected due to innovation. Also, green investments can have positive macroeconomic effects via a Keynesian demand-side push and enhanced productivity. But these macroeconomic effects are still not fully understood when also accounting for other essential climate policies, such as carbon pricing, which tend to weigh on growth in the near term.

Long-term Benefits of Green Investment Are Clear

Long-term benefits are clear. Increased green investments are critical to setting EU economies on a path of sustainable growth and enhancing their resilience to shocks, as also demonstrated by the recent energy crisis. They can also place the EU in a leading position in developing the strategic sectors, products, and business models of the future, securing an important first-mover advantage.

In this context, green bond issuance, which increased almost fivefold between 2017 and 2021 (Figure 3), will accelerate in coming years as public and private actors look to fund rising climate-related expenditure and attract ESG-oriented investors. Countries with well-established and credible green bond markets – such as France, Germany and the Netherlands – are likely to benefit from a ‘greenium’ and more flexible funding conditions as governments implement stronger regulations and policy incentives to channel financial flows to climate initiatives.

Figure 3. Public sector green bond issuance in Europe
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Thibault Vasse is an Associate Director in Sovereign and Public Sector ratings at Scope Ratings GmbH.