How to Avoid a Transatlantic Trade War over Climate

Introduction

Not for the first time, transatlantic relations are facing a crisis over climate change. But this latest row is not because of U.S. climate denialism or rejection of the Paris Climate Accords, but due to U.S. climate action. The landmark Inflation Reduction Act (IRA), passed in August 2022 to accelerate the energy transition in the United States and fight climate change, has caused an uproar in Europe that threatens to undermine the transatlantic unity forged in response to Russia’s invasion of Ukraine.

The December 5 round of the much-hyped U.S.-EU Trade and Technology Council (TTC) did not result in much. One senior EU official even reportedly boycotted the event in protest. Europe’s complaints about the legislation, while not unfounded, might have lost sight of what should be the overarching priority: addressing the threat posed by climate change. Instead of threatening a transatlantic trade war, the United States and European Union should both adjust their positions and use the IRA legislation as a catalyst to elevate the ambition of the transatlantic relationship.

Transatlantic Disputes around the IRA

Despite U.S. perceptions of Europe as being “socialist,” the European Union is at its core premised on creating a free and fair single market, with strong rules against member states subsidizing industries that secure a level playing field. It is also deeply committed to free trade and adhering to global trade rules central to the European Union’s principles. When the IRA was passed, Europeans were puzzled. On the one hand, they praised U.S. climate action, but on the other hand, they balked at what they viewed as “Buy America” measures that violate World Trade Organization (WTO) principles, discriminate against companies in the European Union, and risk deindustrializing parts of Europe.

At the core of the dispute are subsidies. As part of the IRA, an estimated $369 billion will be dedicated to investments to promote the transformation of different parts of the energy sector. Among other things, there will be substantial subsidies and tax credits to facilitate electrification, produce solar panels, develop green hydrogen, and promote the use of electric vehicles (only 5 percent of new sales of cars in the United States are electric vehicles, or EVs, while in the European Union and Japan, the figure is above 15 percent). However, the IRA has complex “Buy American” provisions that put European companies that export EVs or batteries to the United States at a disadvantage, since they are excluded from the IRA’s tax credits. To qualify for the subsidies and tax credits, battery components must be produced in the United States and cars must be produced mainly in U.S. factories. Moreover, a free trade agreement, which the United States has with Canada and Mexico, or with South Korea, but not with the European Union, the United Kingdom, or Japan, is also a prerequisite to be eligible for some elements of the IRA’s support.

The goal of the IRA is not to damage European producers—it is to accelerate a transition to a low-carbon economy, reduce greenhouse gas emissions, and diversify away from China, which is a world leader in battery production and produces over seventy percent of the critical raw materials required to produce batteries for EVs. These goals are also supported by the European Union. However, major European companies feel discriminated against and argue that the IRA is protectionism in disguise. Valdis Dombrovskis, the EU trade commissioner, said thatmany of the green subsidies provided for in the Act may discriminate against EU automotive, renewables, battery and energy-intensive industries.” And President Macron went further and claimed that “the US risked ‘fragmenting the west’ with [the IRA] by subsidizing American companies to the detriment of European industries.”

Moreover, there is a growing fear that U.S. subsidies, combined with high energy costs in Europe triggered by the Russian invasion of Ukraine, might lead to the deindustrialization of Europe. Companies may well decide to relocate to the United States. Finally, European leaders resent that the more sensitive parts of the IRA were not even discussed at the TTC and that they are incompatible with the rules of the WTO because they are discriminatory. In fact, the European Union has not ruled out taking the case to the dispute settlement mechanism of the trade governing institution.

For Europe, the fact the United States has passed a major legislation which is WTO-incompatible proves that Americans, once the crafters of multilateralism and the so-called liberal world order, are moving away from global economic governance despite their cooperative rhetoric. But the WTO rules were developed without climate change in mind. This is problematic because, as Financial Times columnist Martin Wolf noted, despite the fall in cost in renewables, “the market is not going to deliver the needed transition fast enough.” Thus, to accelerate the climate transition significant investment is necessary. Market mechanisms will not be enough.

But while the European Union has a monetary union and significant regulatory capacity, it does not have a fiscal union and therefore lacks the firepower to match U.S. efforts. Thus, the IRA has led to panic in Europe that U.S. investments in clean energy, combined with low energy costs in the United States, will prompt European industry to move to the United States. But as CSIS’s Emily Benson has argued, “it is highly unlikely that the U.S. is explicitly attempting to ‘hoover up’ EU industry during an economically precarious time on the continent.” Just like with monetary policy, U.S. actions are guided by domestic needs. However, given the size of the U.S. economy, they have profound externalities on other countries that were not taken into consideration by U.S. legislators (in the case of monetary policy, the negative externality is a strong dollar, which is generating problems for many emerging markets). Moreover, higher energy costs in Europe are deeply problematic for European industry but have little to do with the IRA. In short, the enormous size of IRA´s subsidies has exposed some of the European Union’s own structural weaknesses.

The Biden administration has been eager to try to address European concerns. Closer economic and technology cooperation with Europe is seen as vital to the United States’ broader China strategy.

On December 1, French president Macron met with President Biden in Washington to try to reduce the tension and find pragmatic solutions. In a joint press conference, President Biden said, "There's tweaks that we can make that can fundamentally make it easier for European countries to participate." He also said that he "never intended to exclude folks who were cooperating with us. That was not the intention. . . . And we are going to continue to create manufacturing jobs in America, but not at the expense of Europe." He also said that exemptions had been made for companies from countries that had free-trade agreements with the United States but suggested that this should be extended more generally to "allies."

After these declarations, which for French finance minister Bruno Lemaire represent a “major breakthrough” to avoid a trade war, Europeans expect to be granted the treatment that Canada and Mexico enjoy as members of the United States-Mexico-Canada Free Trade Agreement (USMCA). This option is supposed to be worked out by a specific high-level working group discussing the issue that runs parallel to the TTC.

But implementing these tweaks will not be easy. A free trade agreement is clearly delineated in U.S. law, which may prompt legal challenges should the U.S. Treasury seek to treat the European Union as a free trade partner while implementing the IRA. Furthermore, given the shift to a Republican-controlled Congress in January, it is virtually impossible for the administration to modify the IRA through legislation (minor changes, though, are possible during the implementation phase by the U.S. Treasury).

The Way Forward

The United States and the European Union cannot let this escalate into a new trade dispute that ends up contaminating the transatlantic relationship in a moment when U.S.-EU collaboration is most needed. Only China, Russia and the rest of the geopolitical rivals of the West want a trade war between Washington and Brussels. Moreover, the IRA and the European Green Deal are clearly aligned in their goals to fight climate change. There is divergence in the instruments: the European Union emphasizes market-based mechanisms and taxes, while the United States prefers subsidies, does not want to use carbon pricing, and takes advantage of being a political union, having deeper pockets, and issuing the world´s reserve currency.

Now that the United States has acknowledged the anxiety in European capitals and the European Union has recognized the fundamental step forward that the United States has taken to fight climate change, transatlantic partners should transform this potential conflict into a win-win situation.

On the U.S. side, efforts should be made, if possible, to reduce discrimination against European companies. Washington should both defend the ultimate goals of the legislation in Europe and highlight its transformational impact. The United States should also explain to European officials why there was a lack of consultation over the final legislation. In short, the White House was not able to consult with Europe because the resurrection of IRA negotiations was a closely held secret in Washington with the final legislative text the byproduct of negotiations between senators.

Finally, the United States should actively encourage the European Union to develop a fiscal union—one that could both be used to accelerate the green transition, provide support for Ukraine, and invest in defense. Just as Washington pushed European states to spend 2 percent of their GDP on defense, it could push the European Union to subsidize the green transition more heavily.

In fact, the president of the European Commission Ursula von der Leyen has already claimed that the European Union will explore ways to adjust state aid rules to allow European companies to benefit from subsidies to counteract the impact of the IRA and accelerate the deployment of renewables. The problem for the European Union is that if these subsidies come from specific European countries, there is a risk of fragmentation of the single market. There will also be problems of unfair competition because some countries have more fiscal space than others.

The solution, therefore, would be to generate resources at the European level through a specific fund following the premise of the NextGenerationEU program, which was put in place in 2020 for Covid-19 and will channel up to 750 billion euros to European countries. In fact, as Martin Sandbu, European economics columnist at Financial Times has argued, it would be in the interest of the European Union to increase subsidies, especially to accelerate the energy transition in order to reduce energy dependency and structurally reduce its energy costs. That is probably the most urgent part of the so-called EU strategic autonomy.

In the end, the European Union should recognize the need to make its fiscal rules (currently under revision) more flexible and create a permanent fiscal capacity to finance European public goods. In this case, European energy security and strategic autonomy through an accelerated transition away from Russian gas.

Finally, the United States and European Union should use this moment to elevate the ambition of transatlantic relations and forge a stronger economic partnership. The German government has suggested the possibility of negotiating a new U.S.-EU trade agreement. This was rejected by those in Brussels who spent years fruitlessly working on the Transatlantic Trade and Investment Partnership (TTIP) during the Obama administration. But what is needed is a new form of economic agreement that is focused on climate change, secure supply chains, and that consolidates Western common standards and rules for the global economy that could eventually be adopted by emerging markets and contain the rise of China.

Instead of letting U.S. climate action undermine this partnership and weaken the alliance, the IRA should be the catalyst to forge an even stronger partnership.

Max Bergmann is director of the Europe Program at the Center for Strategic and International Studies (CSIS) in Washington, D.C. Federico Steinberg is a visiting fellow with the CSIS Europe, Russia, and Eurasia Program and senior analyst at the Elcano Royal Institute.

Commentary is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s). 

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