A series of shocks have battered the European economy. Europe was rebounding strongly from the COVID-19 crisis, but now faces a severe worsening of its terms of trade, driven by a surge in energy prices. The cost of this must be shared among European businesses, governments and households. These added pressures risk delaying important investment to address long-term, structural challenges, including the climate transition and digitalisation. Europe’s future depends on being able to compete internationally and on leading in innovation, particularly in strategic technologies linked to the climate transition.
As growth slows and budgetary pressures mount, public investment must be preserved, to limit the economic fallout of the crises and to stimulate much-needed private investment. Higher energy prices are affecting individual EU members very differently, and their capacity to respond to the shock varies widely. For innovation and the climate transition to move forward, countries need well-coordinated policies on the EU and national levels. Clear policies will also help tackle uncertainty, which is weighing on the transition, and foster cohesion.
In the private sector, high energy prices will enhance incentives for climate-related investment, but this effect may be outweighed by heightened uncertainty, regulatory obstacles and a dearth of technical skills needed to implement green and digital projects.
Europe’s long-term challenges
Investment in the European Union recovered rapidly in 2021 and 2022, rebounding to levels before the pandemic, but this strength belies a persistent weakness in productive investment. When investment in housing is excluded, data show that a gap in productive investment of 1.5 to 2 percentage points of GDP opened between Europe and the United States after the global financial crisis, and still persists.
- This gap is driven by greater US investment in machinery and equipment and innovation, particularly in information and communication technology equipment and intellectual property.
- Corporate spending on research and development is also low in the European Union relative to international competitors – 1.5% of gross domestic product (GDP) in the European Union in 2020 vs. 2.6% in the United States and Japan.
- Data from the EIB Investment Survey (EIBIS) also show that EU firms are less likely to innovate or to adopt new technologies than US firms. The gap widened by around 10 percentage points in the 2022 survey, to 19 percentage points.
Investments to limit climate change are increasing but are still well below what is needed to meet Europe’s target of net-zero emissions by 2050. EU climate investment has rebounded after dipping during the pandemic, but investment needs to step up considerably if Europe is to meet its goals.
- Investment of €1 trillion a year is required for the European Union to reduce greenhouse gas emissions 55% by 2030. That is €356 billion more a year than in 2010-2020.
While Europe is trailing the United States in digital innovation, green technologies have so far stood out as an area where the European Union excels. Europe is a leader in patents for green technologies used for sustainable mobility, smart grids and wind power, while it is neck and neck with the United States and China on energy storage and, to a lesser extent, solar energy. To stay competitive, Europe will need to consolidate its position and expand its involvement in more cutting-edge innovation, such as hydrogen technologies.
Sustained public investment is an essential complement to private investment, but it is under threat. Historical data show that public investment is typically more vulnerable than other types of public spending in times of belt tightening. Tighter monetary policy, combined with debt built up during the pandemic, could pressure governments to consolidate their finances by cutting public investment. However, this would be counterproductive.
Analysis of the past five decades shows that maintaining or accelerating public investment during crises is associated with less economic scarring in the medium term, as measured by economic output.
Local government investment (in digital infrastructure, education and research and development, for example) encourages growth and private investment. This effect is particularly strong during downturns.
- For example, firms in regions with relatively fast internet services (reflecting better local digital infrastructure) were 7.1% more productive than other firms, an effect that rises to nearly 16% for firms that also invested in becoming more digital in response to the pandemic
Countries need to protect public investment by making it a priority in national budgets. The effective implementation of the €723.8 billion Recovery and Resilience Facility will help many countries to do that. The facility represents around 1% of EU GDP to be disbursed over four years, or almost one-third of total public investment.
The energy crisis and inflation are disproportionately affecting poorer households and people already disadvantaged by the pandemic. Despite public support, the financial situation of poorer, younger and less qualified people worsened as a result of the pandemic. These groups are also suffering more from rising prices, given that they spend a bigger share of their income on food and energy, have less savings to fall back on and are generally more vulnerable to the effects of inflation.
Regional cohesion is also at risk, with less developed regions in Eastern Europe more exposed to economic and political stress. One factor is the uncertainty created by the Ukraine war, which is slightly higher in Eastern Europe, and which acts as a major deterrent to private investment. Cohesion regions also seem to particularly lack the technical capabilities needed to access pubic or EU funds and increase investment. Across Europe, 69% of municipalities say that a lack of environmental and climate assessment skills is a barrier. Digital skills, engineering and other technical skills, and regulatory understanding are not far behind.
Firms face headwinds
Firms’ sales largely bounced back after the initial COVID-19 lock-downs. But firms are increasingly concerned about energy costs, and a growing share say those costs are impeding investment. A lack of skills and uncertainty are also challenging investment. In addition, small businesses’ ability to obtain finance started deteriorating in 2022, reflecting monetary tightening and investors’ reluctance to take on risk.
For firms, the top three factors hampering investment are:
- availability of staff with the right skills (85%)
- energy costs (82%)
- uncertainty (78%)
Investment by firms is crucial for the green transition. Overall, firms invested more in climate change measures in 2022, following a dip during the pandemic. However, the outlook for corporate investment to tackle climate change is mixed, with uncertainty and administrative barriers weakening investment incentives created by high energy costs.
- 88% of firms reported some form of investment in climate change mitigation, with most taking action on energy efficiency and on minimising waste.
- 33% of businesses report taking steps to adapt to the effects of climate change.
Europe needs to invest massively for the future. The right mix of policies, support and incentives could spur private investment and protect public investment from budget cuts. EU and national policymakers need to act decisively to create an investment friendly environment.
More specifically, they need to:
- Provide clarity and preserve incentives to advance Europe’s transformation. The response to the energy shock should lay the foundation for a more efficient and reliable EU energy market, tackling uncertainty and setting out a clear, ambitious path for the green transition.
- Take advantage of the catalytic effect of public investment to crowd-in investment by the private sector, drawing on resources such as the Recovery and Resilience Facility to protect public investment from spending cuts and to minimise economic scarring over the longer term.
- Use risk-absorbing financial instruments to help shield strategic investment by the private sector. EIB studies show that credit and guarantee instruments for small and medium companies and venture debt for firms with high growth potential can positively affect investment and innovation, countering market failures affecting smaller firms and higher-risk, innovative investment.
- Reduce unnecessary administrative barriers to investment and address technical skills, particularly for firms and municipalities in cohesion regions, and specifically for more complex green and digital objectives.
- Enhance support for innovation, which remains crucial at various stages of the climate transition, while preserving the benefits of the European single market. Uncoordinated responses risk undermining cohesion just as EU members confront the wider ramifications of the pandemic, climate change and the energy shock.