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January 31, 2022

Is the EU on its way to a green recovery from Covid?

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Riwan Driouich (Analyst, 1in1000)

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Following the severe contraction of EU economies in 2020-21, a recovery may be on its way as the Omicron wave appears to be reaching its peak.

Yet governments racing to build back their economies are already facing another imminent crisis: climate change. Extreme weather events caused by global warming wrought disaster for millions around the globe in 2021, with 10 events that each caused more than $1.5 billion in damages alone. Some of the biggest financial impact was from the unprecedented flooding that devastated Europe in July.

These concurrent crises – what may soon be the “new normal” – highlight the urgent need to rebuild European economies in a way that’s green, just, and equitable. They also raise the question: is the EU on its way to a green recovery?

To ensure we recover sustainably, it will be critical for firm and investor sentiment to converge – reallocating capital towards greener projects and enabling a mutually supportive path towards a low-carbon economy. After all, if firms want to develop green projects, they need investment. If both the economy and financial spheres expect a green recovery, this fosters a virtuous cycle – making it more likely that capital will be available for green projects and that more green projects will search for capital.

This is why 1in1000, the long-term risks research program of 2° Investing Initiative, has built a new framework of indices called the Green Market Sentiment Indices (GMSI) to enable forward-looking monitoring of the green recovery. First applied to the EU and soon expanding to Latin America, it covers three climate-relevant sectors (automotive, power, oil & gas) that are together responsible for roughly 80% of CO2 emissions. Its goal is to provide information on the status of the green recovery to European governments and policymakers, enabling them to adjust public policy where relevant and help us “build back greener.” Semi-annual updates will also allow us to track the recovery over time.

Access the indices here.

More on the GMSI

Previously, literature on the green recovery focused on assessing the extent to which government recovery plans will tackle the climate crisis, not whether the economy is actually recovering sustainably from COVID. As a result, the GMSI fills a critical gap, enabling us to monitor the anticipated, actual greening of the economy. Moreover, separately assessing real economy and financial market actors’ anticipations of a green recovery allow us to understand how they relate to each other.

According to our initial application of the framework, EU market agents are anticipating a “pale green” recovery in the EU, with a slightly stronger alignment of production and investment decisions with the low-carbon transition vs. pre-COVID. However, blind spots remain in the auto, oil & gas, and power sectors, and EU policymakers must address these in order to strengthen the observed trend.

A sector-by-sector analysis

Taking a closer look at three climate-critical sectors helps us better understand the extent to which the EU is recovering green and where action is needed.

Auto manufacturing: firms anticipate rapid greening of the sector, while investors are more pessimistic

Planned production of low-carbon vehicles strongly increased in 2020 and 2021 while it strongly decreased for ICEs, in line with robust policy incentives at the EU level. However, financial markets are poorly aligned with this shift. Lagging companies still possess significant capital attractiveness and are deemed less risky than companies leading the transition, at odds with the requirement to quickly phase out ICE vehicles.

Power sector: power firms and investors anticipate more low-carbon opportunities, but the phasing out of high-carbon power is overlooked

Planned low-carbon capacity (renewables, nuclear) strongly increased in 2020-21, but high-carbon capacity (coal, oil, gas) is also set to grow compared to pre-Covid. These changes are also mirrored by financial market expectations: investors anticipate more profits from low-carbon power than before the Covid crisis, but also from high-carbon power.

Oil & gas: firms anticipate a slow recovery and financial markets are pessimistic about the future of the sector

Planned extraction of oil & gas in the near future is significantly lower than what was planned pre-Covid, but companies are still expecting a progressive recovery in oil demand. Meanwhile, financial markets expect the sector to be much riskier than before the Covid crisis.

Key risks jeopardizing a green recovery in the EU

These findings highlight key obstacles to building back better from COVID and ensuring a sustainable economic recovery. First, there is a clear risk that we will continue adding low-carbon to high-carbon power capacity rather than replacing the latter by the former. Second, oil (and gas) demand may increase when the crisis fades away, triggering an increase in supply and consumption. Third, there is a risk that financial markets slow down the green recovery by providing high-carbon companies with easy access to financing.

Already, studies show that while the EU is set to spend billions on accelerating the green transition, €54.2bn in recovery spending could in fact negatively impact the green transition. If adequate capital is not reallocated to more sustainable projects, this will in turn further slow down the transformation of our economies that is desperately needed. We hope the GMSI will fill a much-needed gap in policymakers’ toolbox, helping them better understand potential pitfalls on the way to a green recovery.

Author

Riwan Driouich (Analyst, 1in1000)

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