Clean Energy Industrial Policy: The US and EU Clash

The Inflation Reduction Act, signed into law by President Biden in August 2022, is actually a mixture of tax, healthcare, and clean energy policies.

Here, I’ll focus on the last category. It represents a belief that industrial policy can work when it comes to clean energy: that is, large subsidies targeted at a specific industry can both accelerate the development of a new and healthy sector of the US economy, as well as reducing carbon emissions. David Kleimann, Niclas Poitiers, André Sapir, Simone Tagliapietra, Nicolas Véron, Reinhilde Veugelers and
Jeromin Zettelmeyer compare the US policy to pre-existing European policies in “How Europe should answer the US Inflation Reduction Act” (Bruegel, February 2023). Here are some takeaways.

The clean energy subsidies enacted by the Inflation Reduction Act will catch the US up to the level of subsidies that are already available across EU countries in some areas, but not others.

The authors divide up the new US clean energy subsidies into three categories. First, there is a tax credit of up to $7500 for consumer purchases of electric cars. However, this tax break is hedged around with requirements about how much of the car must be made in the US, as well as limits on the income of those receiving the tax credit. Second, there are subsidies for producers of “batteries, wind turbine parts and solar technology components, as well as for critical materials like aluminum, cobalt and graphite.” As one example, a “mid-sized 75kWh battery for an EV would receive $3,375 in subsidies, equivalent to roughly 30 percent of its 2022 price.” Third, there are subsidies for producers of carbon-neutral electricity. This includes solar and wind power, but also hydrogen, “clean fuels (such as renewable natural gas),” and nuclear power.

There are lots of details surrounding these rules, and I won’t try to do justice to them here. The authors cite overall estimates from the Congressional Budget Office that the cost will be $400 billion over 10 years–but they also warn that this cost estimate is based on underlying estimates about the extent to which people and firms will take advantage of these subsidies. Comparisons between the US and the different subsidies across EU countries are also necessarily imprecise. But the authors offer this chart:

In other words, the new US subsidies for electric cars and clean-tech manufacturing are similar to what already prevails in the European Union. The new US subsidies for renewable energy remain MUCH lower than similar subsidies in the EU.

One key difference between the US clean energy subsidies and the European approach is that the US approach includes “local content” requirements, which among other issues violate the fair trade rules that the US has long advocated for the World Trade Organization.

“Local content” requirements are politically popular everywhere: after all, they restrict tax breaks to domestic producers. That’s also why such rules are generally prohibited by World Trade Organization agreements. But first under President Trump, and now under President Biden, the US is showing that in decisions about tariffs and subsidies, it feels comfortable flaunting those rules. The authors describe the specific local content rules in the Inflation Reduction Act like this:

The $7500 consumer tax credit applies only to electric cars with ‘final assembly’ in North America (the US, Canada or Mexico). In addition, half of the tax credit is linked to the origin of batteries and the other half to that of raw materials used in the electric cars. To obtain either half, a minimum share of the value of battery components (presently 50 percent) or critical minerals (presently 40 percent) needs to come from the US or countries with which the US has a free trade agreement (presently 20 countries). These thresholds will increase by about 10 percentage points per year. In addition, from 2024 and 2025, any use of batteries and critical minerals from China, Russia, Iran and North Korea will make a vehicle ineligible for the tax credit.

Renewable energy producers are eligible for a ‘bonus’ subsidy linked to LCRs [local content rules]. If the steel and iron used in an energy production facility is 100% US-produced and manufactured products meet a minimum local-content share, the subsidy increases by 10 percent, with the required local-content share rising over time11. A similar bonus scheme conditional on local-content shares applies to investment subsidies for energy producers.

Local content rules are also a bit paradoxical. Presumably the reason such rules are needed is that, without them, a substantial share of the clean energy subsidies would flow to producers in other countries, because those producers would be providing products with the combination of price and quantity preferred by US consumers and firms. The Inflation Reduction Act is thus based on a claim that clean energy subsidies are badly needed for environmental reasons–but also that clean energy goals aren’t quite important enough to justify importing needed goods.

Will the Clean Energy Industrial Policy Work?

The authors of this paper assert with some confidence that the US and EU industrial policies with regard to clean energy will work: that is, they will both build up local producers of clean energy–presumably to a point where they no longer need to rely on government subsidies–and also will reduce carbon emissions.

The future is of course unpredictable by definition, but I am dubious that the US clean energy industrial policy subsidies are likely to be very effective. First, the US clean energy subsidies are an all-carrot, no-stick policy. They hand out subsidies, but do not impose, say, additional limits or costs on carbon emissions. Second, the US industrial policies are focused on current tech, not future tech. AS the Bruegel authors write: “in the clean-tech area, the IRA [Inflation Reduction Act] focuses mostly on mass deployment of current generation technologies, whereas EU level support tends to be more focused on innovation and early-stage deployment of new technologies.” Third, tying the subsidies to local content rules will be a disadvantage for US producers in the clean energy arena, compared to producers in the European Union and other places who do not need to follow such rules.

Finally, government industrial policy to advance technology tends to work best when it is tied to concrete goals. For example, the incentives to produce COVID vaccines were linked to the vaccines actually being produced. In South Korea’s successful industrialization strategy several decades ago, government subsidies were linked to whether the firm was successfully exporting to the rest of the world–and the subsidies were cut off if the target level of exports wasn’t reached. But when industrial subsidies are just handed out, it’s a fairly common pattern for people and firms to soak up the subsidies, without much changing. Those who follow these issues will remember prominent examples like Solyndra, the solar energy company that burned through about a half-billion dollars in federal loan guarantees about a decade ago, or going back further, the “synfuels” subsidies that failed to deliver fuel alternatives back in the 1980s. I hope that I’m wrong about this, and that this time around, US industrial policy aimed at clean energy will be a big success. But I’m not optimistic.