Draghi Report: tackling EU's energy problem

Watching the Tides - Marchel Alexandrovich

“If Europe’s ambitious climate targets are matched by a coherent plan to achieve them, decarbonisation will be an opportunity for Europe. But if we fail to coordinate our policies, there is a risk that it could run contrary to competitiveness – and ultimately be delayed or even rejected.” Mario Draghi, The future of European competitiveness, 2024 

As highlighted by Mario Draghi in his seminal report on the future of Europe, a successful green transition could become one of the key pillars to help improve the region’s competitiveness and its growth prospects. Compared to the US, over the past two decades, Europe has seen weaker productivity growth coupled with slower population growth, such that it is now a substantially smaller economy than the US. In constant terms, the US economy is around 30% larger in size than the EU, compared to being only 17% larger in 2002. In PPP terms, two decades ago, the EU was around 4% larger than the US, now it is 12% smaller. As Draghi writes, during this time, weak productivity growth has been seen “as an inconvenience rather than a calamity”. But this thinking needs to change because the foundations on which EU’s prosperity is built “are being shaken.” 

The EU economy benefited from three tailwinds over the past two decades: expanding world trade, cheap energy and low defence spending. Russia’s invasion of Ukraine dramatically altered the geopolitical landscape, however, and created a fundamental challenge to the EU’s economic model. Going forward, the region needs to foster alternative sources of growth, those that focus on improving domestic productivity rather than being so heavily reliant on a benign external environment and strong foreign demand.

GDP evolution: euro trillion, 2015 prices

Source: The future of European competitiveness, Mario Draghi

How does Europe make this pivot? Draghi identities three key areas of development: 1) closing the innovation gap that exists between the EU, and the United States and China; 2) a plan for decarbonisation and competitiveness; and 3) a strategy to increasing security and reduce dependencies. 

As Draghi highlights, “EU companies spent around EUR 270 billion less on R&D than their US counterparts in 2021, largely because we have a static industrial structure dominated by the same companies and technologies as decades ago.” Draghi also points to the crucial role played by the public sector in fundings research and innovation. As a share of GDP, the EU and the US spend a similar amount on public R&I. However, only a tenth of this spending takes place at the EU level. The rest it done at the national level, which can be “excessively complex and bureaucratic” and “most member states cannot achieve the necessary scale to deliver world-leading research and technological infrastructures.”

Another major obstacle to growth is Europe’s high energy costs. Energy prices are not only high on average compared to the US and China, but they also vary significantly by EU member state, as well as being extremely volatile. This volatility leads to higher economic uncertainty, impacts government revenues and expenditure, and contributes to less stable consumer price inflation.   

Gas and retail price gap for industry

Source: The future of European competitiveness, Mario Draghi

Electricity prices for households (2023, euro per kWh)

Source: Eurostat

When it comes to potential reforms, the EU energy market will not be transformed quickly, and while the drive to increase the share of renewables is a must, as Draghi states, “it will take time before we see a major downward effect on energy prices played by decarbonisation.” There is also no one-size-fits-all model of what future energy generation will look like. And for the avoidance of doubt, Draghi’s report clearly advocates continued use of nuclear, and specifically ‘new nuclear’ which means small modular reactors, with standardised and identical components.

In the meantime, amongst a series of other proposals, the countries of the EU must move toward joined-up procurement and long-term contracts for gas supply, and find a way to decouple the price of electricity (which increasingly comes from domestically generated renewables) from the price of imported fossil fuels.

Price-setting technology per EU Member State and their generation mix

Source: The future of European competitiveness, Mario Draghi

The one area which Draghi’s 328-page tome did not tackle is the role of the ECB. Unquestionably, however, it can play a major role in helping to finance some of the EU’s future investment needs, which are estimated to be in the region of €750-€800bn annually (4.5% of GDP). For instance, there have long been murmurs of a Green TLTRO, where the ECB provides cheap, long-term funding to banks to be channelled into green investment. And, once the common debt to fund the much needed EU-wide infrastructure projects is issued, if required, the ECB could use its balance sheet to help lower the cost of funding of these projects.

Of course, these particular decisions are no longer in Draghi’s hands. But given how much of his report focused on joined-up pan-European action, the generational challenge he laid out will require a coordinated fiscal and monetary policy response.  

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