Saturday, July 27, 2024

Balancing Act: Managing European Dependencies on China for Climate Technologies

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China did not become a climate technology giant overnight. The current supply chain distribution is the result of long-standing global market trends, explicit government policies aimed at promoting manufacturing and strategic industries, international cooperation and integrated supply chains, and entrepreneurship. Moreover, government policies aimed at attracting domestic and foreign investment in targeted industries created highly competitive environments. In other words, China’s manufacturing advantage is not just the result of subsidies, though those have been significant. Therefore, reproducing alternative supply chains can be challenging, and matching subsidies or tariffs have generally been insufficient on their own in creating the same conditions elsewhere.

The importance of globalized value chains in the development of these technologies should also be a reminder of the challenges that lie ahead in pursuing policies explicitly aimed at creating redundancies in supply chains. This process, however, in many cases raises costs. For example, some studies suggest that in 2022 solar PV manufacturers in Europe faced a 20–25 percent disadvantage relative to the lowest global cost levels due to high energy, capital, material, utility, and labor costs, even if they were to achieve economies of scale. Given current goals under the REPowerEU plan, some estimates indicate it would cost an extra $36 billion if all solar panels were made in the European Union.

Multinational companies rely on China for inputs and components, which is particularly evident in the refining of critical materials. But perhaps less understood is how China has now become central to many international corporations’ innovation systems. Interviews with companies and business associations indicate that many rely on the Chinese market for commercialization of products but also, increasingly, R&D. Scientific collaboration is also central to innovation, and Chinese universities are increasingly involved in fruitful exchanges with research institutions and scholars internationally, including Europe. In some cases, European companies (for example Volkswagen) have been investing in or creating joint ventures with promising Chinese companies, adding a layer of complexity to identifying a firm’s nationality.

These trends put in stark relief the challenge for European governments and the European Commission as they chart a path forward. Given China’s centrality in climate technology supply chains and the growing global footprint of Chinese companies abroad, the debate should comprehensively address the role of Chinese companies as they internationalize and invest in Europe and other parts of the world. Part of the solution lies in identifying more clearly what risks need to be addressed in a derisking policy for climate technologies.

Defining Threats

There are several concerns regarding China’s heft in the climate technology industry, many of which are laid out in the European Economic Security Strategy released in June 2023. First, there are security concerns of overreliance on a single source for critical products or inputs or vulnerability in critical infrastructure, as outlined by Davidson et al. Second come economic concerns that center on the loss of manufacturing competitiveness and the threat to established domestic industries like the automotive one.

National security and economic security concerns over dependencies in technology and energy have been heightened since Russia’s invasion of Ukraine and the subsequent economic fallout, including restrictions on gas exports to Europe from Russia. Relying on a single source for minerals or manufactured goods—especially when the producing country is an economic competitor or systemic rival—could make European importers more exposed to price surges, shortages, and potential export bans.

Indeed, in the course of 2023, China expanded export license requirements for gallium and germanium—and more recently, graphite—raising the specter of weaponization of critical materials needed for clean energy technologies such as batteries. The move was likely aimed to signal China’s ability to leverage its position in an industry where it holds a relative advantage in response to the tightening of U.S. export controls on advanced semiconductors.

A restriction on the trade of climate technologies or their components would likely be less crippling than an oil or gas embargo. Moreover, a conflict in Taiwan could lead to wide-reaching shortages of a variety of technological inputs, including semiconductors, leading to a crisis reaching well beyond climate technology supply chains. As a consequence, the actual likeliness of climate technologies being weaponized in a meaningful way is relatively low.

However, high dependencies on key goods may limit countries’ willingness to enact punitive policies that could raise costs or lead to disruptions—something that may have slowed the response to Russia’s invasion of Ukraine, for example.

Economic risks including threats to domestic employment can at times outstrip security ones. Central to the whole discussion is an overarching concern over deindustrialization in Europe and lack of competitiveness, in part accelerated by high energy costs triggered by Russia’s invasion of Ukraine. Europe’s economic situation has become an increasingly urgent topic given the current challenges in the face of increasing competition with China and the United States.

Retaining some of the economic benefits of the large investments needed to achieve decarbonization domestically is politically necessary to ensure continued taxpayer support for the energy transition. Policymakers should also be prepared to address shocks to legacy industries and potential job losses from adjustments to the economy.

The distinction between security and economic concerns is important because these imply related but distinct policy actions. They may also help determine how strict derisking policies should be when it comes to managing exposure to Chinese supply chains.

Policymakers should also track changes in the Chinese industrial landscape when adopting policies to support manufacturing of specific technologies. At least three trends are already observable to varying degrees. As noted, Chinese firms continue to scale up existing capacity to meet growing demand. This has already been observed in the case of solar panels, where record deployment in Europe since 2021 has been met by a surge in exports from China.

Second, Chinese firms can reinvest profits in R&D, which government programs also support. This means Chinese firms may be in an advantageous position when developing and commercializing the next generation of some technologies—for example, solid-state batteries. This advantage could further solidify China’s leadership position in some of these supply chains and make it even harder for non-Chinese companies to compete without collaboration with China.

Finally, supply chain diversification, insofar as it is happening, is also the result of internationalization of Chinese firms. Companies in the solar, EV, and battery industry are expanding production in countries outside China to access local markets or qualify for subsidies under the Inflation Reduction Act (IRA). Europe is an important destination for some of this investment, especially for the battery industry, which is now one of the main drivers of Chinese foreign direct investment (FDI) into the European Union. In the EV industry, several Chinese firms have also indicated they are considering setting up production in Europe, thus overcoming the risk of tariffs as a result of the ongoing anti-subsidy investigation the European Commission launched in September 2023.

The internationalization of Chinese manufacturing may bring some global benefits. EU countries have high environmental and labor standards, so as long as enforcement is carried out effectively, this could potentially lower the carbon footprint of production and reduce concerns over transparency. Moreover, in theory, by facing the same costs as local companies and hiring local staff, they would be competing more fairly with local firms and contribute to the local economy. Outside of the European Union, there are opportunities for countries in the developing world to attract more Chinese investment in manufacturing of climate technologies and upgrade their economy.

The European Dilemma: Balancing Green Industrial Policy and Trade Action

The European Union finds itself in a fragile position when it comes to balancing its priorities for climate, economic growth, and national security. Since the outbreak of the Covid-19 pandemic and the 2022 Russian invasion of Ukraine, the region has faced multiple crises affecting its competitiveness and long-term growth prospects, with important implications for climate policy.

Companies report in private interviews and public statements that high energy costs are particularly concerning for future manufacturing plans in the region. Trade and industrial policy instruments deployed in other countries, such as the generous subsidies linked to localization requirements introduced to attract domestic investment in the United States through the IRA, may put Europe at a further disadvantage.

These challenges are reflected in recent regulatory activity in Europe, and official documents put out by the European Commission including the Net Zero Industry Act, the European Critical Raw Minerals Act, the Carbon Border Adjustment Mechanism, and a series of other trade instruments that are increasingly important in the clean energy technology space. Member states’ inbound investment screening tools will also likely become more important as Chinese manufacturers’ investment in the European Union expands. The European Commission’s recent announcement that it would launch an anti-subsidy investigation into EV exports from China is now putting to the test the efficacy of trade defense tools in the climate space.

Trade defense tools may be effective in defending certain industries and redirecting trade, but they are often insufficient in securing long-term competitiveness and can raise costs with harmful consequences for the deployment of certain goods. Strong industrial policy can be helpful in strengthening companies’ ability to compete effectively, but a green industrial policy includes tools to attract FDI. This requires taking a closer look at derisking efforts in solar, battery, EV, and wind industries and the implications for policy moving forward.

Solar: Revisiting a Settled Argument?

Until recently, the rise of the solar PV industry was seen as a remarkable achievement of globalization. Building on years of R&D and small-scale production in the United States, Japan, and Germany, the solar industry achieved maturity thanks to integrated manufacturing in China starting in the late 2000s. Also, the industry rapidly scaled thanks to generous subsidies for deployment in Europe and, later, China, which allowed commodification of solar modules. However, in the process, production became increasingly concentrated in China, which today accounts for 80 percent of solar module manufacturing.

The dynamics that enabled the growth of the Chinese solar industry are coming under closer scrutiny due to concerns about concentrated supply chains and energy security. Identifying how the European Commission might have better prevented this reorganization of supply chains when it investigated Chinese exports a decade ago, however, may be challenging because the rapid decline in solar prices is linked to Chinese large-scale manufacturing. The European Commission’s decision to pursue an anti-subsidy investigation on Chinese EV exports ex officio, rather than wait for an official complaint, was likely shaped by the sense that action was taken too late in the PV industry.

Solar Power Europe estimates there are about 49,000 full-time equivalent positions in solar manufacturing in Europe, an insignificant share of the 195 million people employed in the European Union today. Because the industry is highly concentrated in China, the actual impact on employment or potential economic implications of deepening reliance on China is not as high as in other industries.

There are, however, very high risks of disruption due to the highly concentrated nature of supply chains. The European Union was an early leader in solar but only accounts for about 1 percent of solar PV module production today. Although the International Energy Agency expects manufacturing in the European Union to double, it predicts that 70 percent of deployment will be met through imported modules in 2030.

Solar module manufacturing capacity in China is expected to expand by another 500 gigawatts (GW) by 2030, adding close to 1,000 GW of manufacturing capacity. This presents a real challenge because the industry is already facing overcapacity in China, which has lowered profit margins and make it more challenging for companies to compete effectively. Thus, even partially achieving the Net Zero Industry Act’s target of ramping up PV manufacturing in the European Union to 30 GW across the entire supply chain will require significant state support. Given the type of concerns associated with dependence on China for this technology, maintaining a small but comprehensive supply chain within the Union could help reduce some of the risk of Europe’s dependence on China even though it is unlikely to lead to a competitive domestic industry in the foreseeable future.

Another important strategy that can help enhance security is to promote diversified sourcing from places like India and certain Southeast Asian nations, where alternative supply chains are also being developed. This strategy could have positive effects for global development, though in some cases supply chains are still highly dependent on upstream inputs from China, for example wafers.

EVs and Batteries: Balancing Competition and Competitiveness

If the concentration of solar PV manufacturing in China mainly raises concerns over potential disruptions to supply chains, the risks to overall economic welfare are far higher in the case of the EV and battery industries. In fact, the automotive industry is quickly evolving into a flash point for EU-China relations. The rapid rise in exports from China to Europe (Figure 3) has raised concerns that a key export industry for several countries, including Germany, might be at risk.

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