Written by Martin Höflmayr and Magdalena Sapała.
|This paper is one of 10 policy responses set out in a new EPRS study which looks first at 15 risks facing the European Union, in the changed context of a world coming out of the coronavirus crisis, but one in which a war is raging just beyond the Union’s borders. The study then looks in greater detail at 10 policy responses available to the EU to address the risks outlined and to strengthen the Union’s resilience to them. It continues a series launched in spring 2020, which sought to identify means to strengthen the European Union’s long-term resilience in the context of recovery from the coronavirus crisis. Read the full study here.|
The issue(s) in short: The challenge and the existing gaps
The pandemic, the war in Ukraine and related supply shocks have tested Europe’s economic resilience and simultaneously increased the pressure to respond to critical challenges. They range from the need to accelerate the green and digital transition, diversifying energy supplies, to the necessity to provide support to Ukraine. To address them, the EU uses existing and newly created initiatives. Prominent among these are the Next Generation EU (NGEU) post-pandemic recovery instrument, with a rich package of reform and investment under the Recovery and Resilience Facility (RRF), and the REPowerEU plan to reduce energy dependence on Russian fossil fuels. Further ambitious projects, such as the Green Deal Industrial Plan supporting investments for a clean energy economy and the European Sovereignty Fund (see box below), are also in the pipeline. For Ukraine, the EU has mobilised significant political, humanitarian, economic and military assistance and, by granting it EU candidate status, has opened a path towards the future recovery and reconstruction of the country.
All these initiatives require substantial, and increased, financial expenditure. As a result, there is a multi-dimensional pressure on the EU’s financial capacity to act. Although the budgetary package agreed under the 2021-2027 multiannual financial framework (MFF) and NGEU is unprecedented in terms of size (€1 210.9 billion and €806.9 billion respectively), and partly based on common borrowing, it is under severe strain and might be insufficient. To avoid the financing gap and thereby safeguard its capacity to effectively respond to internal and global challenges, the EU needs solid solutions and progress in terms of new own resources (OR), innovative financing mechanisms, an adequate fiscal framework and perhaps a complementary central fiscal capacity.
Even before the NGEU-related borrowing, there had been an ongoing debate on the reform of the EU system of OR, a key goal being to limit the share of OR based on Gross National Income (GNI) and to align the OR system better with EU policies; while new OR were already proposed back in December 2021, to date there has not been substantial progress. Making borrowing-based financing, modelled after NGEU, a permanent feature of EU funding for common strategic goods, such as energy security or defence, had been mentioned as a possible option even before the outbreak of the war in Ukraine. Now, the debate on the EU financial architecture is intensifying with the European Commission’s proposal for the revision of the 2021-2027 MFF and an adjusted package of new OR that the Commission announced in June 2023.
The debate on the EU’s financial resources and expenditure is taking place against the backdrop of a challenging economic environment. After an unexpectedly strong economic recovery from the COVID‑19 pandemic, the economic momentum came to a premature halt. Due to the war in Ukraine, energy prices increased significantly and contributed to inflation rates rising to double digits towards the end of 2022, significantly above the European Central Bank’s 2 % inflation target. This has left the EU facing a difficult balancing act – to bring down inflation while sustaining economic growth.
However, the Commission’s spring 2023 economic forecast has seen upward revisions for 2023, with growth projected to reach 1 %, and 1.7 % in 2024. At the same time, the latest inflation numbers point to a broad-based decline of price components, although from an elevated level, as all four main categories of goods and services contributed to the fall in inflation in the euro area, to 6.1 % in May 2023. Playing into both variables, growth and inflation, are unprecedented fiscal efforts to cushion the impact of past crises; as economic tailwinds fade, governments’ fiscal plans point to future consolidation efforts. In this context, on 26 April 2023 the Commission published a package of three proposals to revise the EU’s economic governance framework, shaped by the trade-off between reducing higher and more dispersed public debt levels and the need for sustained public investment.
EU policy responses (Commission and Council responses so far)
The European economy is undergoing unprecedented transformation towards a more sustainable, green and digital economy, while at the same time facing the challenges related to the war in Ukraine. Both require ambitious investments and reforms. The recovery from the COVID-19 pandemic has been supported by new EU instruments, including the European instrument for temporary Support to mitigate Unemployment Risks in an Emergency (SURE), the Coronavirus Recovery Investment Initiative (CRII), and NGEU (see more details below).
The Green Deal Industrial Plan presented in February 2023, partly a reaction to the US’s massive funding programme to provide incentives to accelerate the transition to a clean energy economy (Inflation Reduction Act, IRA), is designed to enhance the competitiveness of Europe’s net-zero industry and support the fast transition to climate neutrality. As part of this plan, the Commission proposed the Net-Zero Industry Act and the Critical Raw Materials Act to scale up the EU’s manufacturing capacity for net-zero technologies; it also announced the European Sovereignty Fund. Following Russia’s invasion of Ukraine, there has been a more generous application of State aid rules, with the temporary crisis framework created in March 2022, and its latest modification transforming it into the temporary crisis and transition framework (TCTF).
Created in 2020, NGEU is a key initiative helping to repair the damage caused by the pandemic, and at the same making Europe more resilient and sustainable. Together with the 2021-2027 MFF, it represents 1.8 % of EU GNI and is the largest investment package ever implemented through the EU budget. The main advantage and innovation of NGEU is the way it is financed, its performance-based nature, its national ownership and its focus on the climate and digital transformation. To finance the instrument, the Member States agreed for the Commission to carry out borrowing operations on behalf of the EU.
Although resorting to the financial markets to provide Member States with financial support has happened in the past, this time it is taking place on an unprecedented scale. As a result, since the first auction in June 2021 the Commission has moved from being a small issuer, raising funds to finance relatively small lending programmes like the European Financial Stabilisation Mechanism (EFSM) and macro-financial assistance (MFA and MFA+), to being a significant and effective issuer of funds. The optimistic views of NGEU are amplified by estimates of its substantial macroeconomic impact. By 2024, it is expected to trigger at least a 1.5 % increase in the EU’s real GDP compared to a baseline scenario without NGEU investments, and to increase employment by up to 1 % during its period of operation. It provides a much-needed catalyst for public and private investment, particularly in the green transition, and modernisation of EU economies.
The centrepiece of NGEU is the RRF (10 % of NGEU’s resources are channelled through six other budgetary programmes: React-EU, the Just Transition Fund, InvestEU, Rural Development, Horizon Europe, and RescEU). Worth €723.8 billion, the RRF is a mix of grants and loans, to be invested in line with six pillars representing policy areas of European relevance, in a package of reforms and investments based on national recovery and resilience plans (NRRPs). These plans take into account many of the 2019 and 2020 country-specific recommendations of the European Semester. Thanks to the introduction of compulsory targets for spending on green transition and digital transformation under each national plan (at least 37 % and 20 % respectively) much of the RRF financing supports projects in the areas of decarbonisation, renewables, energy efficiency, resilience of key infrastructure, and sustainable transport.
Furthermore, with the new crisis caused by the war in Ukraine, and adoption of the new European initiative to reduce dependence on Russian fossil fuels, known as REPowerEU, the role and scope of action of the RRF has been extended, without changing its initial borrowing limits. The RRF and the NRRPs turned out to be agile crisis-response tools, useful for the financing and implementation of additional reforms and investments in the energy sector. Based on the agreement of 27 February 2023, Member States can amend their RRF recovery plans and include new, reinforced measures to save energy, produce clean energy, and diversify supplies. To finance these measures, Member States will be able to use up to €225 billion in loans still available under the RRF, and up to €72 billion in grants (financed by the EU emissions trading system (ETS), the Innovation Fund, and voluntary and limited transfers from the Brexit Adjustment Reserve and cohesion funds).
No later than 2028, the EU will begin to repay the liabilities incurred by the borrowing allocated to NGEU. The EU budget will repay the grants and their borrowing costs, while Member States that have resorted to loans will be in charge of their repayment. The maximum timeframe for the repayment is spread over 30 years and should finish by 2058 at the latest. Since the EU budget is financed mainly by OR based on the Member States’ GNI, value added tax (VAT) and custom duties, if there are no new OR, other options – such as an increase in national contributions to the EU budget or cuts to existing MFF programmes after 2027 – will be necessary to secure funds to repay the NGEU grants when they became due.
Bearing this in mind, the decision to create NGEU was linked to the agreement on interinstitutional cooperation on a roadmap towards the introduction of new OR. Apart from the guiding principles of the reform, the roadmap includes a timetable for the introduction of different types of resources, between January 2021 and January 2026, and is divided into three steps. However, apart from the new OR from plastic packaging, introduced in 2021 and already contributing some €6 billion per year to the EU budget, the implementation of the roadmap has not gone as planned. In 2021, after a delay, the Commission proposed the first basket of the next generation of OR, namely the revenues from emissions trading (ETS), resources generated by the carbon border adjustment mechanism (CBAM), and the recent OECD/G20 agreement on a reallocation of taxing rights over multinational corporations (‘Pillar One’). The proposal – which, if adopted, could generate up to €17.3 billion (in 2018 prices) on average annually from 2026 to 2030, and thereby help to repay the NGEU funds – has been stuck in the Council. In the meantime, the Commission has announced that it intends to propose further new OR in the third quarter of 2023.
One aspect of a broader discussion on the EU budget concerns the resources and tools needed to ensure the EU contribution to the recovery and rebuilding of Ukraine. Among various options and strategies that have been presented, the financial involvement of the EU is considered vital, not least since Ukraine (along with Moldova) has been granted EU candidate status. With a view to catering for the short- and medium-term recovery needs, in June 2023, as part of the mid-term review and revision of the 2021-2027 MFF, the Commission proposed to create the Ukraine Facility for 2024-2027. Questions about financing both the recovery and the possible accession process will certainly also be an important part of preparations for the post-2027 MFF.
Obstacles to implementation of response
The pandemic and energy crises put a heavy strain on public finances, with public debt-to-GDP levels peaking above 90 % in early 2021. While declining since then in the majority of Member States due to strong nominal GDP growth, debt levels are still markedly above pre-pandemic levels, at 84 % of GDP in the fourth quarter of 2022 for the EU overall. In the context of heightened economic and geopolitical uncertainty, on 26 April 2023 the Commission published a package of three proposals to revise the EU’s economic governance framework. The reform proposals are shaped by the trade-off between reducing higher and more dispersed public debt levels after several years of unprecedented fiscal challenges on the one hand, and the need for sustained public investments for common EU priorities on the other.
To reorganise the current fiscal governance framework, the Commission proposes to establish a new type of document: medium-term fiscal-structural plans. These plans are the cornerstone of this proposal and would encompass, besides country-specific fiscal trajectories, an incentive for investment and reform commitments through a possible extension of the fiscal adjustment path. In addition, public investment under EU programmes would not count towards the underlying deficit indicator. Whether this framework is compatible with the required increase in investment in defence, secure energy supply and a competitive green economy is currently a subject of debate.
As far as the implementation of NGEU is concerned, potential obstacles concern both financing and spending. On the financing side, the provision of support under NGEU would not be possible without successful borrowing operations conducted by the Commission on behalf of the EU. The first assessments of the implementation of the Commission’s borrowing strategy were positive and encouraged discussion on the possibilities of making it a permanent solution. However, with the escalation of the war in Ukraine, deteriorating market conditions, and the growing cost of the debt, the debate has become more focused on the risks related to the costs and repayment of NGEU funds.
While the cost of the NGEU funds programmed under the 2021-2027 MFF (€14.9 billion) was based on the assumption of an increase in interest rates from 0.55 % to 1.15 % over the period, the actual level was close to 2 % at the end of 2022 and reached 3 % in 2023. In this situation – and in the context of the process to draw up the EU budget for 2024 and of the mid-term review of the 2021-2027 MFF – the European Parliament cautions that the amounts envisaged to cover the borrowing costs could be insufficient. Given that the limited flexibility and narrow margins available under the MFF have already been used extensively for unexpected needs, the Parliament warns there is a risk that, in order to pay the interest, reductions will have to be made in EU programmes and funds.
The Parliament sees the risk as yet another argument for urgent reform of the OR system. Over the years, such reforms have proven to be difficult. The need for a unanimous decision by all Member States when negotiations happen in the spirit of juste retour, rather than that of common interest and European added value, makes the process challenging, and even more so when discussing such reform in the current context of the war and volatile economic situation. However, if the new resources are not in place in time to repay the NGEU funds, or if they do not deliver the expected and needed revenues, some policy options are either to increase Member States’ contributions based on GNI, or to limit the spending on EU funds under the next MFF. As mentioned above, despite some progress made in implementing the roadmap for the new OR agreed together with the 2021-2027 MFF and NGEU, the delays and bottlenecks are already apparent.
On the spending side, the risk is mainly related to the delays in implementing the NRRPs and the possibility of misusing or wasting resources under the RRF. Two years since the first NRRPs were submitted for assessment, the Commission reported that RRF implementation was firmly underway.
In May 2023, slightly more than 30 % of the approved grants and loans had been paid out and, on average, the RRF seemed to be operating according to the agreed timeline. However, progress has varied between Member States. In some, increasing prices and the changing political landscape and priorities have not been conducive to the smooth implementation of the agreed investments and reforms. Whereas payments have been highest in Spain (53.3 % of the approved resources), Lithuania (37.4 %), Greece (36.4 %), Croatia (35.2 %) and Italy (34.9 %), countries such as Hungary, Ireland, Poland, Sweden and the Netherlands have not received a single euro. In particular, unblocking the resources in Hungary and Poland depends on politically tough reforms related to the rule of law. In some countries, the difficulties in fulfilling certain milestones and targets have resulted in the decision to postpone requests for payments or to amend the NRRP. This is the case, for instance, for the plans of Belgium, Germany, Lithuania, Slovakia and Slovenia. Moreover, there are signals that Italy, the biggest beneficiary of the RRF, after a good start, is beginning to struggle to meet the conditions for the next payments.
Doubts are also arising over how the RRF funds are used and governed. Concerns relate to the limited budgetary scrutiny over the borrowed funds, and to the transparency of the performance-based implementation and disbursement method of the RRF, which differs from the approach used for EU budgetary instruments so far. Right at the beginning of the implementation, analysts raised the issue that speedy implementation of such large amounts should not take place at the cost of quality of reforms and investments, and of proper control of spending, also in the context of rule of law conditionality, with experts highlighting the risk of fraud and corruption. These concerns are all the greater due to the off-budget character of NGEU resources and, consequently, limited transparency and democratic scrutiny of spending. Treated as external assigned revenue, NGEU resources are not part of the usual budgetary procedures – for example, only the grant component of the funds is subject to the ex-post discharge. Moreover, the involvement of the European Parliament as the budgetary authority is restricted compared to the rest of the EU budget, and the European Court of Auditors has highlighted the existence of ‘assurance and accountability gaps’ in the systems for protecting the financial interests of the Union under the RRF.
Position of the European Parliament
Whereas a substantial share of the investment will be borne by the private sector, public investment will have to increase as well. To mobilise private investment more efficiently, a functioning Banking Union and progress on the Capital Markets Union are crucial, including action on sustainable finance. On the fiscal side, in its resolution on the ‘review of the macroeconomic legislative framework’ from June 2021, the European Parliament stressed the need to strengthen the democratic legitimacy, accountability and scrutiny of the economic governance framework; thus, responsibilities should be assigned at the level where decisions are taken or implemented, with the Parliament scrutinising the European executives. Furthermore, the Parliament adopted an own-initiative report on the European Semester, calling for an urgent review of the EU fiscal framework, preferably to be completed prior to deactivating the general escape clause.
The Parliament’s role in the overall management and scrutiny of NGEU is bigger than with other intergovernmental tools created in response to various crises over the last decade, such as the European Stability Mechanism. Still, it is rather limited due to the legal basis chosen for the creation of the recovery instrument (Article 122 of the Treaty of the Functioning of the EU), the treatment of the resources borrowed as external assigned revenue (see above) and in comparison, for example, with the role it has as the EU’s budgetary and discharge authority over the EU spending on cohesion or agriculture. The Parliament sees it as a risk to central budgetary principles and calls for more transparency in the implementation process, and for relevant changes to the financial rules applicable to the general budget, in particular making external assigned revenue an integral part of the budget.
The Parliament closely monitors the implementation of the RRF, including through the regular dialogues with the representatives of the European Commission, the Standing Working Group on the RRF, and in the budgetary discharge procedure (albeit the latter is limited to the grant part of the NGEU). Among the key aspects discussed and monitored by Members of the European Parliament are the quality of the reforms and investments included in the NRRPs, risks and delays in the implementation process, assessment of the payment requests and verification of the milestones and targets that are the condition for payments. Also under discussion are equal treatment of the Member States, application of rule of law conditionality, and involvement of national parliaments and regional and local authorities in implementing the RRF.
The Parliament pays much attention to the borrowing process, its costs, and the preparations for the repayment of NGEU funds. In this context, the Parliament sees the solution to be in creating new, fair sources of revenue, which will unload the pressure on the GNI-based resource and guarantee the EU’s capability to repay NGEU-related debt without risking limitation of existing EU policies. The Parliament’s long-term commitment to the reform of the OR system was recently reiterated in the resolution of 10 May 2023, where it stresses that EU finances are going through a critical period and that a lack of reform can have highly detrimental effects on the future of the EU, its policies and objectives, and the trust of Europeans and investors in the Union.
|In focus: Strategic Technologies European Platform (STEP)|
In September 2022, in her State of the Union address, European Commission President Ursula von der Leyen announced the Commission’s intention of proposing an EU Sovereignty Fund. With the aim of creating a more sustainable, efficient and self-sufficient industrial policy, the fund would support projects of common interest in critical and emerging technologies across different sectors of EU industry, including microelectronics, quantum computing, artificial intelligence, biotechnology, biomanufacturing and net-zero technologies. It will be one of the key EU financial tools for the implementation of the Green Deal Industrial Plan for the Net-Zero Age.
The details of the proposal were announced in the framework of the mid-term review and revision of the 2021-2027 MFF. Instead of creating a new fund, the Commission proposes to bring together and adapt existing instruments under a common framework called the Strategic Technologies European Platform (STEP). It would include such programmes as: InvestEU, the Innovation Fund, Horizon Europe, EU4Health, Digital Europe and the European Defence Fund. In addition, the proposal envisages involvement of the RRF and cohesion funds.
Policy gaps and pathway proposals
The successful launch of NGEU and the RRF is seen as a turning point for the EU. It has demonstrated that the European Commission’s borrowing on behalf of the EU as a way of financing the EU’s common needs is politically and legally possible, and has added a new dimension to the debate on a fiscal capacity for the euro area, reforming the European Semester, and financing the EU’s common needs, for instance those related to the green and digital transformations. Besides the supply of high-priority EU public goods, recent large-scale temporary shocks have prompted discussions about a fiscal capacity to ensure public investments. Some analysts consider transforming NGEU into a permanent facility to be a key priority for reinforcing the EU’s economic policy framework, seeing it as a way to solve financial constraints that the EU is facing and a tool to finance the provision of EU public goods.
The idea of extending NGEU to cover new objectives or even to resort to new joint borrowing gained even more momentum after Russia’s invasion of Ukraine put the EU on the path to a new crisis. Although, so far, resorting to new joint debt has been too controversial, it remains one of the options under consideration, particularly in the context of the rebuilding of Ukraine.
Some experts emphasise that a positive evaluation of the implementation of NGEU and the RRF will be crucial for a decision on using them as templates for any future instruments. Among the aspects that need improving, analysts mention anti-fraud measures, transparency, control mechanisms and broadening the accountability of RRF management. In addition, there are many voices calling for better involvement of national parliaments, the European Parliament, civil society and regional partners.