While cheap energy prices in industrialised countries can be seen as a short-term reprieve for industries under competitive pressure from low-cost countries, they have negative consequences in the long run, writes Karl Aiginger. He argues that a new industrial policy should support Europe's competitive advantage in clean technology.
Karl Aiginger is director of the Austrian Institute of Economic Research (WIFO).
The upcoming European Summit on 22 May will give very important signals as to whether Europe will stick to its new industrial policy strategy which puts "sustainability at centre stage" (focusing on clean energy, energy efficiency and decarbonisation). Or whether Europe will -under the pressure from low and declining energy prices in the US- return to a strategy for cheap energy itself, giving up its long run climate goals, and its policy to reduce the input of fossil energies by its emission trading system.
We argue that a strategy to boost clean energy, higher energy efficiency, and to stick to the EU 2020 goals (of improving its education and innovation systems) will prove superior for European competitiveness in the long run.
Renwed interest in manufacturing
The importance of the manufacturing sector for industrialised countries has been re-appraised, in particular, in the wake of the financial crisis. Countries with a smaller manufacturing base and with a large trade deficit recovered less quickly (Aiginger, 2013). Interest was further ignited by decreasing shares of manufacturing in industrialised countries and by China´s rise to world no1 in manufacturing. Some academic papers develop ideas how Industrial policy, which had previously been of mixed success, should be different this time (see Aghion et al, 2011, Rodrik, 2004, Aiginger, 2012): the "new industrial policy" should be forward looking, pro competitive, supporting long term societal needs.
Above all, it should not be an isolated policy strand in conflict with regional policy or energy policy, but it should be an integrated or systemic policy. The European Commission developed just such a new industrial policy in "Communications" first calling for an "integrated industrial policy with sustainability at centre stage" (European Commission, 2010), and then for a "stronger European Industry" setting the target to raise the manufacturing share in GDP from 16% to 20% (European Commission, 2012).
The interface with climate policy
The systemic character of industrial policy can be illustrated by the interface between industrial policy and energy policy. Placing sustainability on the centre stage suggests that environmental standards are no longer seen as an obstacle for a competitive manufacturing sector, but as potential drivers of growth.
And the European targets are ambitious: shifting away from fossil energy to renewable energy, increasing energy efficiency and lowering emissions are formulated in the so called "20/20/20" strategy for 2020. Even more demanding is the climate strategy for 2050, namely, of reducing greenhouse gas emissions by 80-90%. The energy system model PRIMES shows that this very ambitious target is in principle feasible without reducing economic growth, but would need radical technological innovations (energy efficiency improvement way above the historical trends) and de-carbonisation initiated by a carbon price of 250 €/t (European Commission, 2011; Kupers, 2012; Schleicher ? Köppl, 2013).
Carbon leakage as counter argument
The ideal solution would be to install an ambitious climate policy in all regions of the globalised world. Industrialised countries should go ahead because they are the largest emitters and they possess or can at least develop technologies emitting less greenhouse gases.
Yet, the strongest and most popular argument against an ambitious lead by industrialised countries and specifically by Europe is the carbon leakage argument. If Europe sets high standards, production of emission intensive industries would relocate to countries with less resource efficiency, thus increasing the overall emissions. This argument is used specifically by the energy intensive industries to oppose any higher energy prices or emissions standards in Europe. The argument has been accepted by policy makers insofar as emission intensive industries receive permits for free until 2020.
The carbon leakage argument has some merits in the decision of a firm, where to locate a new plant at a given point of time, but it is questionable in the long run. The long run dynamics of emissions depends first on the technological progress in the boarder countries and secondly on the speed of global diffusion of clean technologies. High prices and standards in the boarder countries will determine the technological path, and trade and investment policies (and political, legal and moral pressure) will determine the speed of diffusion of optimal technologies to developing countries together with incentives provided by "climate funds".
Remember that total subsidies for fossil energy are estimated to be 300bn €, and at least a part of these subsidies could be used to boost technology transfer. A strategy to decelerate technological progress via lower energy and emission prices in the countries with leading technology will very probably increase worldwide emissions in the long run.
The enticement of cheap energy prices
Currently emissions permits are extremely cheap, and energy prices are decreasing. The former is due to the breakdown of European emission trading, the latter to the new resources of gas found in the US and as a result of new exploitation techniques (shale gas; extraction by fracking or horizontal drilling). Gas prices in the US have fallen to one third of their peak. The tendency of falling energy prices spills over into Europe. Coal prices decline as a consequence and the US starts to export coal to Europe.
While cheap energy prices in industrialised countries can be seen as a short-term reprieve for industries under competitive pressure from new low cost countries, they have negative consequences in the long run. Innovation efforts for increasing resource efficiency will be dampened, and investment into clean energy will prove to be less profitable.
Gas is a welcomed "transitional" energy up to the point of time when renewable energy is available at a large scale. It can reduce greenhouse gases if it is substituted for coal (the climate impact is half that of coal), but nevertheless it is a fossil energy contributing to global warming. If it decelerates the transition to alternative energy or current investments into renewable break down, cheap gas will have a long run negative effect on the climate.
Europe has a competitive advantage in clean technology. Energy efficiency is high, and Europe has a trade surplus in technology driven industries. The new industrial policy strategy of the European Commission intentionally builds on these strengths.
The alternative response
The optimal answer of Europe to the lower energy costs in the US should be in general to increase investment into innovation and education and specifically to increase energy efficiency and innovations in ultra low carbon technology. The European Commission has initiated research programmes e.g. for ultra low carbon technology in steel, the research looks promising, but the partners could not agree on a pilot plant.
In general, Europe still lags behind the US in R&D expenditure, has never reached its Lisbon goal of 3% of GDP; and it trails in the efficiency of universities. Closing this gap will lower the unit labour costs by increasing productivity. Any cost difference in energy prices can be more than compensated by reducing the costs of skilled labour or innovation.
Industrial countries in the long run can compete only in skill intensive products. Competitive advantage is created by innovation; specialisation occurs in skilled technology intensive products. A forward looking industrial policy boost Europe`s competitive advantage and resists the temptation to be set off course by a short run decline in energy prices.
Integrated or isolated again?
A new industrial policy should support long run societal goals; it will make synergies out of conflicting policy strands and prevent energy policy to turn back from green goals (renewables, energy efficiency) to grey goals (cheap and reliable supply). Industrial policy should promote a competitive advantage of Europe by fostering new, clean energy technologies, ultra low carbon technologies and higher energy efficiency. This is the superior strategy in the long run.
A new industrial policy has to be integrated, i.e. solve problems jointly. If, on the one hand there was an industrial policy calling for innovation and skills, and on the other hand an energy policy calling for cheap and reliable energy, there would in short be no cross-over between the policy strands, and we would be witnessing old-style industrial policy. In a systemic industrial policy, the synergies between policies are developed in order to make the individual policy strands more efficient and furthermore, societal goals can be attained.
In short, it makes sense for Europe to base higher growth on a strong manufacturing sector, and Europe should try to become the technology leader in sustainability. It makes sense for the US to close its current account deficit by "re inventing manufacturing".
But it may even be problematic for a resource-rich country like the US to base the rejuvenating of its industry on low energy costs. For resource scarce Europe this holds even more: if industrial policy and climate policy have different goals, neither will reach its objective and we will be back to square one of the old, isolated industrial policy decelerating structural change and reducing economic growth.
 This is six times as much as the subsidies for renewable energy sources, a large share of it the subsidies are spent in developing countries (IEA 2012)
 Carbon leakage element is restricted to a few industries. Only four industries have energy costs of 10% of total costs, for the majority of industries the energy costs are between 1% and 2% of total costs (Aiginger, 2013).