High level comments and policy implications

The Inflation Reduction Act: a subsidy programme for North-American production

In 2022, the USA enacted the Inflation Reduction Act (IRA). While the Act contains a number of measures, some of its more eye-catching measures are those that aim to promote decarbonisation. To do this, the IRA aims to provide subsidies and tax credits directed notably at electricity generation from renewable energy sources and input assets, batteries, electric vehicle (EV) sector and the production of low emissions fuels like hydrogen.

The need for subsidies

The recourse to subsidies as a means of making progress on decarbonisation is partly a reflection of the political difficulties in enacting carbon pricing at a federal level. Indeed, such is the toxic politics around carbon pricing,  it is  unclear whether any carbon price could send a credible signal to investors. If investors believe that a carbon price might be revoked by a future hostile congress, they are not likely to undertake large-scale investments with significant sunk costs.

In any event, the use of subsidies, which would have been needed to respond to market failures associated with new technologies even in the presence of a carbon price, is a welcome development in the fight against climate change. They should help the USA make some progress in meeting its international commitments on climate change.

In principle, subsidies can have positive international spillovers: increased demand for low emissions technologies in the USA presents market opportunities for foreign suppliers. Given the size of the US market, together with the production of technologies at scale in the USA, these subsidies could support globally reducing the cost of low emissions technologies and the goods and services that embody them. Indeed, European (and, in particular, German) subsidies for renewable power starting in the late 2000s are likely to have been a major contributing factor to the cost reductions in wind and solar energy seen in the 2010s.

At the same time, the deployment of subsidies in emerging green technologies creates challenges for the USA’s trade partners, particularly in light of some of the measures associated with the implementation of the subsidies, such as local content requirements. Both the EU and the UK have been considering what options are available to them to respond to the IRA.

What the subsidies look like

The main categories of IRA green subsidies include:

• Subsidies for the purchase of EV;
• Production and investment subsidies for manufacturers of clean-tech products, including batteries and components used in renewable electricity generation; and
• Subsidies for producers of carbon-neutral electricity as well as hydrogen and other clean fuels.

Comparing the impact of the IRA subsidies in the EU requires a detailed and careful investigation. The analysis should not only consider subsidy levels but also other aspects of the subsidies design and scheme, for instance:

• The mitigation of risks, including the uncertainty that investors face concerning the volume or level of demand, input prices, and the expected revenue per output unit. Subsidies minimising more difficult risks for investors to manage more effectively incentivise investments.
• Complexity of subsidy schemes. Understanding the processes to apply for subsidies and applying for these can be time-consuming and costly. Subsidy schemes that are more transparent and simple can reach a more significant number of investors.
• Credibility about the duration and terms of subsidies. These features enable investors to assess their projects' financial credibility and long-term prospect, encouraging them to commit their capital and supporting them in securing third-party financing.

The extent to which subsidies translate into higher investments in the clean energy industry also depends on the overarching regulatory, industrial, and policy context. Aspects such as the permitting regime or the availability of inputs and skills are critical in shaping investment figures. Without engaging in a detailed level of analysis, we note that there is an expectation that these subsidies would be a game changer for the clean energy sector, as the growing attention of European-based companies suggests. Beyond the direct effects on businesses that compete with the beneficiaries of subsidies, subsidies to low-carbon energy products could contribute to widening existing energy price differentials between the US and the EU. Energy prices in Europe are already more than double those in the USA.

Local content requirements

One of the distinctive aspects of the IRA is that subsidies are conditional on meeting local content requirements. These are found in relation to the purchase of electric vehicles, investment in clean technology manufacturing and clean energy production.

Local content requirements are among the most egregiously trade distortive forms of industrial policy instruments. They are also a very expensive form of protectionism. In essence, they raise the cost of the good they are protecting. Where the good is an input, this cost effect gets passed through to downstream products. These requirements will tend to undermine, in part at least, the price-reducing effects of the subsidies, increasing the social cost of transition to a low carbon economy.

That local content requirements are at the heart of the IRA is deeply ironic, for the USA was a driving force behind their prohibition at the WTO. Their presence is aimed squarely at gathering political support for large-scale subsidies, which have traditionally been viewed with suspicion in the USA. The EU does not currently apply local content requirements and, indeed, has brought WTO dispute proceedings against jurisdictions that have introduced them in connection with green subsidies. So has the USA. 

Implications for the EU and UK and possible responses

The local content requirements in the IRA are problematic for the EU and UK. They risk excluding EU and UK businesses from value chains supplying the USA market, thereby incentivising those firms to invest directly in America in order to qualify for the subsidies.

Local content requirements limit the ability of the EU and UK to compete against subsidised USA rivals, even if they can increase their efficiency or reduce prices below those in the USA market.

In theory, America’s trade partners could launch proceedings against the USA at the WTO. In practice, however, this may not be a realistic option. For a start, the WTO’s dispute settlement mechanism is currently not operational since the Trump administration blocked appointments to the Appellate Body. Moreover, acting against a significant piece of US climate legislation could be perceived as a provocation in Washington, with damaging repercussions, or as a signal of pushing back on a rare and awaited attempt by the US to act on decarbonisation efforts.

In the absence of a functioning WTO dispute settlement mechanism, the main coercive way of trying to get the USA to change its ways may be some form of retaliatory tariff. The EU’s new Enforcement Regulation would give the Commission the legal scope to do this. For the UK, the situation is more complex as its smaller size means that whatever punishment generated by a tariff would be limited. But both the EU and the UK would pay an economic cost: tariffs increase prices domestically, act as a tax on exports and distort resources.

More importantly, any such action could potentially provoke a trade war, souring transatlantic relations at a time when the US, the EU and the UK are trying to work together not only on climate change.

Theoretically, the EU and the UK could try and skirt the local content requirements by redoubling efforts to negotiate free trade agreements (FTA). Previous EU-USA FTA negotiations failed, and the USA-UK talks are stuck: the US has essentially conveyed that it is not willing to enter into any talks that have the words “free” and “trade” in them for fear that voters associate trade liberalisation with job losses. 

Looking for a work-around

In the absence of an FTA, the alternative would be to persuade the US to relax the rules for the EU and UK, on the grounds that the USA really wants to target China and Russia. The guidance on the implementation of the IRA published by the Treasury on 31 March 2023 set out such a pathway.

The guidelines would allow critical minerals from countries with which the US has an agreement on such minerals to count towards the minimum content requirements specified for batteries. This would make it easier for cars using batteries sourced in such countries to qualify for the IRA tax breaks.

The USA already has an agreement with Japan on critical minerals sourcing. Deals with the EU and the UK, respectively, are under consideration, the latter following the recent Atlantic Declaration agreed by Rishi Sunak and Joe Biden.

It may be in the USA’s interest to continue to demonstrate such flexibility, given its limited access to critical minerals and to certain key battery parts like cathodes and anodes. These limitations would have the effect of restricting the range of vehicles eligible for subsidies, and in turn undermine the effects of the Act on reducing inflation.

Uncertain consequences

Looking beyond the impact of local content requirements, the overall effects of the IRA on the EU and the UK are ambiguous for a number of reasons:

• If the subsidies accelerate the extensive deployment of green technologies and inputs (e.g. new fuels), their global costs will fall, benefiting EU and UK industries that use them. It would thus be unwise for the EU and the UK to introduce countervailing duties on subsidised USA imports without considering the wider cost-benefit calculus.
• If value chains are reconfigured away from China and Russia, this may benefit the EU and the UK, especially if they can negotiate some preferential relaxation in rules (such as an agreement on minerals sourcing with the USA).
• The impact of the IRA on the global fight against climate change could be significant. By promoting the transition to a low-carbon economy the Act could also increase the global market for green technologies.
• Companies in the EU that are affiliated to or supplied by firms benefiting from IRA handouts may fall under the scope of the EU’s Foreign Subsidies Regulation (FSR). The purpose of the new rules, which came into force on 12 January 2023, is to ensure a level playing field in the Single Market by addressing distortions caused by foreign subsidies. However, the effects of the FSR are still ambiguous.
• EU consumers stand to benefit from imports of subsidised US clean fuels. But the revenues of non-USA suppliers might be squeezed as a consequence, making them reluctant to sign long-term supply deals with the EU. As these will presumably be needed when the IRA subsidy scheme expires, the development of the EU market for clean fuels could be hindered.

Conclusion

The IRA has the potential to reshape entire swathes of USA industry and to make a significant contribution to the shift to a low-carbon economy. The ramifications for the EU and the UK are likely to be far-reaching. It would be unwise for them to react “in kind” to the IRA with local content requirements of their own and aggressive tariffs. A more sensible response would be to ensure that existing subsidy schemes work efficiently and to enact policies that enable industries to take greater advantage of global opportunities.