Draghi's dilemma: Balancing action and reaction to the energy transition

The Draghi report can be seen as a wake-up call to the EU. At over 70 pages long, plus 328 pages of data, it contains several in-depth analyses and recommendations about Europe’s competitiveness. It gives Europe a diagnosis that’s difficult to argue with: The EU is lagging behind the US’ and China’s pace of development. And it calls for decisive action to reverse that trend.

However, sometimes facts brush up against political reality. Despite the clarity of the report and the ample data backing up Draghi’s argument, the topic remains sensitive, particularly in the context of growing populism and polarization within Europe. In this report, we try to understand what Draghi’s analysis needs to gain member state acceptance and navigate the current political reality in the EU.

As president of the European Central Bank, in 2012, Mario Draghi issued the memorable instruction “Do whatever it takes” to solve the European sovereign debt crisis.

Back then, the determination and acting power of an institution, as he put it, sufficed to reverse the underlying dynamics of a critical financial situation. The quest to restore EU competitiveness, however, is fundamentally different, as it involves aspects that cannot be fully adjusted by any European power (see figure 1).

In short, the report’s underlying reasoning can be summarized as: The EU will not achieve strategic autonomy unless it recovers its lost competitiveness, which is a prerequisite to consolidate and sustain growth.

To regain competitiveness with the US and China, the EU needs to undergo three transformations: An acceleration of innovation to find new growth engines, an energy transition that achieves a cheaper energy supply, and a reaction to geopolitics to prevent dependencies from becoming vulnerabilities. Such transformations will demand an historic wave of investments, mobilizing both public and private capitals in unprecedent volumes, namely, up to EUR 800 billion on a yearly basis, equal to 4.7% of the EU’s GDP in 2023. As the report notes, such spending goes beyond even the Marshall Plan, which required 1% to 2% of EU GDP between 1948 and 1951.

The report sets out a new EU industrial strategy to trigger the three transformations required. The strategy covers: how to ensure the full implementation of the single market; alignment of industrial, competition, and trade policies; the related financing required; and an updated EU governance.

It is just after this well-structured diagnosis and subsequent treatment proposal that we see a dilemma surfacing for the implementation of Draghi’s proposal.

How ready is the EU to deal with its competitiveness issues now, in the way proposed in the study? All the solutions that Draghi is offering require a more centralized, systemic-thinking, and ambitious EU. But can the EU really pursue a more integrated market, a set of more consistent trade and industry policies, and faster and more decisive governance at this time? Can that be achieved when a big share of citizens are looking for closer, more local, and simpler recipes?

The last European elections (find more here) made clear that there is an urgent debate to be held. But with France’s Emmanuel Macron stranded and the extreme right support registered in Germany, there is little room for either country to lead a fundamental debate.

The dilemma is rooted in the current complex political context. Rising populism may turn any calls for a more ambitious and holistically focused EU into an even more fragmented and less functional, diluted union. The ingredients required to synthetize the remedy, may result in weakening the patient beyond recovery. Non-systemic decision making results in inefficiencies as those illustrated last week by Norway’s reaction to the increased power prices effect driven by Germany’s “Dunkelflaute”.

Let’s further investigate what this internal contradiction implies for the energy transition.

In Draghi’s report, the energy transition is “just” one of the three transformations required to recover competitiveness. As a sign of the times, there isn’t a single mention of 1.5 to 2 degree Celsius limits across the whole report. So, has the Green Deal had its day?

The energy analysis begins by pointing to the elements in the current EU energy system that are behind the competitiveness gap. In 2023, high energy prices were an impediment for investment for 60% of EU companies.

Regarding natural gas supply, the price levels and the volatility registered in natural gas markets reveal energy-intensive industries as being unable to compete with their counterparts in the US or China. When it comes to electricity, dependence on gas imports and the combined impact of marginal gas and coal in power prices, topped with EU Emissions Trading System (EU ETS) costs, are cited among the causes.

Severe network bottlenecks are exacerbating the urgency to act. The European Commission assesses that investments of over EUR 500 billion will be required this decade to address them. Further down the line, the manufacturing capacity of the EU will also be tested in key sectors. Cumbersome, lengthy permitting processes (that reach up to six years for onshore wind) complete a difficult picture. And everything is wrapped up in higher and non-homogeneous taxation schemes that external competitors don’t have to deal with.

The report gathers specific proposals for both the natural gas and the electricity sectors. It also includes some cross-sectorial proposals as well. For natural gas, recommendations include moving away from spot-linked sourcing, reinforcing joint procurement, or progressively shifting to hydrogen. Regarding electricity, the suggestions range from simplifying permitting to decoupling the remuneration for renewable and nuclear from that for fossil plants, with reinforced system integration or accelerated deployment of “new nuclear” in between.

Draghi’s proposals fall short of addressing how to trigger such a quantum leap amid rising populist sentiment which is unconvinced or downright hostile toward the EU’s Green Deal and other environmental policies. Fact-based analysis and proposals alone are not enough. The report’s proposals require a holistic deployment, led by a central planner with unprecedented capacity and power, exactly the best fuel for the current wave of social skepticism.

We believe that the energy transition could evolve through three different paths:

In the current state of things, it is almost impossible to bet on any of the paths described. A mix of logic and hope points to a path between RE-REPowerEU and the Full-EU. But the scope of this article allows us to draw attention only to the implications of failing to act systemically at this historical point, and try to clearly express what’s at stake.

As globalization declines, Europe needs to realize that a reduction in global trade is not a zero-sum game but a negative one. The EU can no longer afford to delay the shift from “everyone gets something they are used to” to answering, “Who gets what?” through optimized and balanced criteria. Draghi’s report hints at some guidelines for considering which industries to prioritize or nurture:

As these guidelines indicate, EU industry faces difficult times. We are in the middle of a critical period, waiting for the energy transition to result in significant price reductions in the energy supply. This is especially sensitive for energy-intensive industries that cannot decide to make significant decarbonizing investments without a very solid supportive context. The report devotes a whole chapter to this challenge.

Draghi advocates for decisive supportive financing mechanisms: from reallocating EU ETS funds to even postponing the phaseout of free carbon allowances if the Carbon Border Adjustment Mechanism does not provide the expected protection against carbon leakage. The hardest-to-abate industries are the most extreme cases. Without final clarity on a carbon-free business model, these industries will not be able to remain active. It is vital for EU companies to understand the underlying dynamics of decarbonization investment decisions.

As clearly illustrated in the report, despite the size of the challenge, the EU’s innovation capacity remains a global asset. While this has solidly translated to leadership in clean energy technologies, the EU still needs to catch up in terms of artificial intelligence or advanced computing. It also needs to increase the technology diffusion achieved after basic research.

In our view, the EU’s real quest is to find a place between where the US and China are currently. The US is heading to a mix of protectionism combined with an ultra-liberal domestic regulatory approach. And China is driving an ultra-centralized, state-guided economy. A place between the two can only be found by reaping the best of both worlds, where, when, and if needed. The EU needs to search for that place by being aware of its complex internal equilibriums.

Draghi’s report is a bold call for action, given the times the EU is living through. While it puts the main focus on competitiveness, the energy transition, and innovation, the topics are addressed with an implicit and strong link to the key existential questions that the EU needs to answer.

It is vital to hold this debate with a full understanding of its scope and the costs of not being able to reach agreement or hold discussions in constructive and mutually beneficial terms for all member states.