OECD Economic Surveys: European Union 2021

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OECD Economic Surveys: European Union

10 September 2021

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1. Key policy insights

Challenges facing the European Union

The COVID19 pandemic has raised multiple challenges for the European Union (EU) and often compounded existing weaknesses. The EU has been worse hit than most other economic areas, suffering in 2020 its largest-ever recession (Figure 1.1). Territorial inequalities risk increasing across countries and regions, potentially worsening divergent economic trends over the past decade. The disproportionate impact of the crisis on sectors with abundant low-skilled jobs, such as hospitality and trade, could increase inequality and poverty.

Figure 1.1. The EU faced its worst-ever recession, but is rebounding strongly

EU27 GDP, Y-o-y, % change

The EU response to the pandemic crisis has been bold and innovative. On the epidemic side, despite initial tensions, border management to avoid contagion was mostly coordinated as well as the procurement of vaccines and other medical supplies, avoiding that countries try to outbid each other. Due to bottlenecks in vaccine production capacity, the vaccination roll-out took time to gather speed, but EU countries have now some of the highest vaccination rates in the world. On the economic side, monetary support was promptly provided and, with the activation of the general escape clause of the Stability and Growth Pact, national fiscal policies became strongly accomodative. As regards support to firms, the full flexibility foreseen under State aid rules was allowed. Furthermore, national governments agreed for the first time on common debt issuance to finance an EU economic recovery plan – Next Generation EU – including grants to member states. Unlike in the aftermath of the global financial crisis, trust in the EU has been preserved and even strengthened (Figure 1.2) and tensions in sovereign debt markets have been, so far, quickly defused.

Nonetheless, the largest challenges from the pandemic crisis might still lie ahead. The two main strands of the recovery plan, the green and digital transitions, already a priority before the pandemic, have gained increased urgency. From energy grids to batteries and the circular economy, the opportunities for investment and innovation in the green economy are immense. The European Green Deal, an encompassing strategy to reduce EU net emissions of greenhouse gases to zero by 2050 (European Commission, 2019a), is welcome, but implementation will be key. Stepping up digitalisation, building on the new European Digital Strategy (European Commission, 2020a), is crucial for investment and innovation diffusion. This will also call for upgrading some regulatory frameworks, such as competition policy.

To make the best of the recovery plan and succeed in the green and digital transitions, the EU needs to secure trust, both from citizens and between member states. For this purpose, it is essential to avoid that the unprecedented deployment of funds from Next Generation EU is marred by irregularities or fraud. The EU also needs to reform migration policy. Migration has long been a highly divisive issue for both member states and the public opinion, but is also a lever to address skill gaps, not least in information and communication technologies, which are essential for the digital transition.

Figure 1.2. Trust in the EU has been preserved, despite the pandemic

Respondents claiming they tend to trust the European Union, as an institution, in per cent of total respondents

Against this background, the Survey has three main messages:

Increasing investment is key to speed up the recovery. Drawing on the EU recovery plan, countries should foster public and private investment, especially to improve European interconnections, and increase cross-country collaboration in innovative industrial projects, including in healthcare.
The transition towards climate neutrality and a circular economy will enhance well-being and open major opportunities for improving European industrial strengths. Better pricing of carbon emissions, new regulatory tools and more R&D funding will all help reinforce green investment and innovation.
To avoid the rise of regional inequalities, poorer regions need to improve their productive specialisation. For that purpose, cohesion and rural development policies need to be revamped to gain in efficiency, notably by supporting more effectively innovation.

The COVID-19 crisis may worsen economic divergence in the EU

The EU faced an unprecedented recession in 2020

The COVID-19 pandemic has deeply hit European countries. In Spring 2020, when the first wave of infections struck, the authorities took unprecedented measures to limit contagion, often imposing country-wide lockdowns with mandatory closure of large swathes of economic activity (Figure 1.3). Stricter containment measures help explain high output losses in international comparison (Figure 1.4). Following the end of lockdown measures, activity rebounded vigorously until mid-Summer. With the resurgence of the pandemic in the Autumn, many countries have progressively, and sometimes recurrently, re-imposed lockdowns, though often less strict than in Spring 2020. These containment measures have tended to remain in place until Spring 2021, which induced a delay of the recovery.

Figure 1.3. Tough containment measures were needed to halt contagion

Lockdowns in Spring 2020 and from Autumn 2020 to Spring 2021 lead to the closure of a significant share of economic activity, which generated a far larger GDP contraction than in the wake of the global financial crisis. Unusually for recessions, the largest contribution to the fall in output came from private consumption (Figure 1.4), reflecting first and foremost prolonged restricted access to certain goods and (especially) services, but also a large rise in precautionary savings. Investment has also contracted sharply, mainly as a result of depressed demand and high uncertainty. Amidst large impacts of the pandemic on international trade, the current account surplus of the EU remained broadly unchanged in 2020. This large surplus reflects an asymmetric adjustment across countries over the past decade (Figure 1.5) and mirrors investment weakness (discussed below).

Sectoral impacts have varied widely, with labour-intensive and low-skilled sectors often hit hardest. Services have been most affected, especially those still relying on direct contact between providers and clients (Figure 1.4). Tourism, also hit by travel restrictions, is a prime example, especially when dependent on international visitors. Activity in manufacturing and in construction was also severely hampered in Spring 2020 but has proved more resilient to the second wave of the pandemic, with a sustained recovery throughout the second half of 2020 bringing these sectors close to pre-pandemic production levels (a rebound which was faster in construction and more gradual in manufacturing of capital goods). In contrast, sectors more amenable to social distancing or teleworking, like agriculture, finance or ICT services, have suffered the least.

The pandemic has also weighed on the labour market. Developments in activity were mirrored in total hours worked, with a strong but incomplete recovery in the third quarter of 2020 (Figure 1.6). Widespread resort to short-time working and, especially in the second quarter of 2020, reduced labour force participation have limited the rise in unemployment. However, broader measures of labour market slack recorded somewhat stronger increases, notably due to more people available to work but not seeking it. The deterioration of the labour market could have a negative persistent impact on young and female workers.

Depressed aggregate demand, together with a host of other factors, reduced inflation in 2020. Core inflation, which had long hovered between 1 and 1.5 percent, declined in the second half of 2020 (Figure 1.6), mainly driven by services (especially those related to recreation, transport, package holidays and accommodation, highly impacted by the pandemic) and also reflecting the temporary VAT cut in Germany. Under the additional impact of falling energy prices, headline inflation in the European Union fell to barely positive levels, and even became negative in the euro area. Euro appreciation has also been disinflationary. In early 2021 core inflation recovered somewhat, though the increase was mostly transient, partly due to a reversal of a VAT cut in Germany, changes in the timing of Winter sales and the annual updating of consumer price index weights. This updating, which reflects the sizeable shifts in spending patterns in 2020, has had an upward impact on inflation (e.g. a larger weight for spending on food, where inflation has been relatively high). The hike in headline inflation in 2021 is proving more persistent, due to higher energy prices.

Figure 1.4. The large recession has been highly asymmetric across sectors

Figure 1.5. The EU current account surplus has remained large

As a percentage of GDP

Figure 1.6. Depressed demand has caused unemployment and disinflation

A vigorous policy response supported demand and reduced financial fragmentation

The European policy response has been forceful, avoiding an even larger recession (Box 1.1). The ECB has strongly increased asset purchases and liquidity provision. To further support bank lending, different forms of temporary bank capital relief have been provided, and European Investment Bank guarantee schemes have been expanded. Low-conditionality lending facilities have been made available to member states, followed by agreement on a EU recovery plan funded by common debt issuance which provides countries with grants, and not only loans. Encouraged by the activation of the general escape clause of the Stability and Growth Pact, national fiscal policies have also provided substantial stimulus to activity, with a large discretionary expansion in 2020 and 2021 and measures to support liquidity and lending, such as loan guarantees and tax deferrals. The OECD Economic Survey of the Euro Area analyses macroeconomic policies in greater detail.

These measures have reduced financial fragmentation and supported credit supply. After flaring up in the early stages of the pandemic, tensions in sovereign debt markets have subsided, with a narrowing of spreads. Early and decisive action by the ECB was essential on this count, and was later supported by the agreement on the EU recovery plan. Non-financial firms across the EU have also benefitted from declining and converging interest rates on new loans, to which they have resorted to address pandemic-induced liquidity gaps (Figure 1.7).

Figure 1.7. Financial fragmentation in the euro area has been reduced further

Box 1.1. The European monetary, financial and fiscal response to the COVID-19 crisis

The ECB has expanded its asset purchase programme by an overall EUR 1970 billion (16.5% of the euro area 2019 GDP). This mainly consists of the EUR 1850 billion Pandemic Emergency Purchase Programme, with net purchases set to continue until it is judged that the COVID-19 crisis is over, but not before March 2022. In March 2020, the Governing Council stated that it would consider revising some self-imposed limits to the extent necessary to make its action proportionate to the risks.
To preserve bank lending and liquidity, the ECB has launched new non-targeted longer-term refinancing operations, made borrowing conditions applied in targeted longer-term refinancing operations (TLTRO III) more favourable and eased collateral standards.
Bank capital and liquidity ratios have been temporarily relaxed. Further temporary capital relief has come from changes to the Capital Requirements Regulation and from supervisory flexibility regarding the treatment of non-performing loans (NPLs).
The Capital Markets Recovery Package has made targeted changes to capital market rules (Prospectus Regulation, MiFID II and securitisation rules), inter alia to make it easier for issuers to quickly raise capital and to facilitate the use of securitisation, including of NPLs, so as to enable banks to expand their lending.
The EU activated the general escape clause of the Stability and Growth Pact (SGP), which allows for temporary deviations from SGP budgetary targets. According to the European Semester Spring Package 2021, the general escape clause will continue to be applied in 2022 and is expected to be deactivated as of 2023.
Two Coronavirus Response Investment Initiatives (CRII and CRII+) have increased the flexibility and accelerated the implementation of cohesion policy, inter alia by reducing national co-financing and enlarging investment eligibility.
Pandemic Crisis Support credit lines have been established within the framework of the European Stability Mechanism, with a benchmark 2% of national GDP (about EUR 240 billion in total) to finance with loans direct and indirect healthcare, cure and prevention related costs due to the COVID 19 crisis. These loans will have a maximum average maturity of 10 years and favourable pricing modalities. So far no country has applied.
A new European instrument for temporary Support to mitigate Unemployment Risks in an Emergency (SURE) has been created. Endowed with EUR 100 billion, SURE comprises lending on favourable terms to Member States to help them finance short-time work schemes and other measures to support workers and the self-employed.
European Investment Bank guarantee schemes have been expanded. In particular, a EUR 25 billion European Guarantee Fund has been created to support up to EUR 200 billion of financing (debt and equity) for companies throughout the EU. At least 65% of the financing will go to SMEs.
The Next Generation EU recovery plan will provide EUR 750 billion (about 5.5% of EU27 2019 GDP) of grants and loans to member states, funded by EU debt issuance. This plan is discussed in greater detail in Box 1.5.
The EU also temporarily adjusted the State aid regime to enable Member States to provide necessary support to businesses.

The recovery hinges on the health outlook and faces considerable risks

While awaiting widespread vaccination, the epidemiological situation has remained difficult in much of the first half of 2021. The European Commission has negotiated advance purchase agreements with vaccine manufacturers on behalf of the 27 member states, giving countries the right to buy a certain number of doses (in proportion to population) when a vaccine becomes available. This approach preserved cooperation and equal treatment across member states, highlighting the value of joint action even in areas where the EU has only limited competences (Box 1.2), but weighed on the initial speed of response (Box 1.3). In a context of worldwide bottlenecks in vaccine production capacity and very limited vaccine exports (to which the EU has been an exception), vaccination roll-out in the EU took time to gather speed but has in recent months largely caught up with leading countries (Figure 1.8).

Box 1.2. The division of competences between the EU and its Member States

For the EU to be able to act in a given policy area, the corresponding competences must be conferred upon it by Member States in the Treaties. Without this conferral, countries alone may act. There are three main categories of EU competences: exclusive, shared and supporting.

Exclusive competences refer to areas in which the EU alone is able to legislate, and Member States can only adopt binding acts if so empowered by the EU. It is the case of customs union, competition rules necessary for the functioning of the internal market, monetary policy (for euro area countries), the conservation of marine biological resources under the common fisheries policy, common commercial policy and, under certain conditions, the conclusion of international agreements.

Shared competences refer to areas where both the EU and Member States are able to legislate and adopt legally binding acts. EU countries can act where the EU does not exercise, or has decided not to exercise, its own competence. The policy areas concerned are the internal market, social policy (in specific aspects), regional policy, agriculture and fisheries (except conservation of marine biological resources), environment, consumer protection, transport, trans-European networks, the area of freedom, security and justice, shared safety concerns in public health matters (in specific aspects), research, technological development, space, development cooperation and humanitarian aid.

Supporting competences refer to areas in which EU action is limited to supporting, coordinating or complementing the action of Member States. EU legislation must not require the harmonisation of EU countries’ laws or regulations. It is the case of the protection and improvement of human health, industry, culture, tourism, education, vocational training, youth, sport, civil protection and administrative cooperation.

In addition, the EU can act to ensure that EU countries coordinate their economic, social and employment policies, and the common foreign and security policy is characterised by specific institutional features. In all areas, the exercise of EU competences is subject to the fundamental principles of proportionality (EU action may not exceed what is necessary to achieve the objectives of the Treaties) and subsidiarity (in areas of non-exclusive competence, the EU may only act if the objective of a proposed action cannot be sufficiently achieved by EU countries, but could be better achieved at EU level).

After a strong acceleration starting in the second quarter of 2021, GDP growth is expected to moderate in 2022 but nonetheless remain robust (Table 1.1 and Figure 1.9). In 2021, private consumption is set to benefit from the lifting of containment measures and sizeable pent-up demand, and activity will be further supported by considerable fiscal stimulus and vigorous export dynamism. In 2022, growth will continue to be spurred by exports and capital formation, the latter relying on a significant contribution from public investment. Nonetheless, household saving, albeit declining, is projected to remain higher than before the pandemic, and the recovery of private investment will be only moderate. At the end of 2022, unemployment is projected to return to close to pre‑pandemic levels, and inflation will still remain subdued. Swift implementation of growth-enhancing investment and reforms is essential to spur activity and minimise scarring effects, as discussed below.

Figure 1.8. COVID-19 vaccination in the EU took time to gather speed, but is catching up fast

Cumulative vaccination doses administered per 100 people, 2020/2021, large OECD members

Though of much smaller magnitude than pandemic impacts, Brexit-induced trade losses will also weigh on the recovery, since the UK is a major trading partner of the EU (Figure 1.10). The UK left the EU and its Customs Union and Single Market at the end of January and December 2020, respectively. Though the EU-UK Trade and Cooperation Agreement reached in late 2020 preserves zero-tariff, zero-quota trade in goods, bilateral flows are expected to be lower than if the UK remained in the Single Market, mainly due to higher non-tariff barriers (Box 1.4). Trade in services (financial and other) no longer benefits from passporting and is expected to be affected by rising costs due to regulatory divergence. Besides these negative medium-term effects, short-term costs stemming from the adaptation to new trade rules and procedures have also been felt, with a sharp fall in bilateral EU-UK trade in early 2021.

As bank credit plays an essential role in resource reallocation, the likely surge in non-performing loans (NPLs) over the next few years, stemming inter alia from the expiry of relief measures such as loan moratoria and public guarantees, is of particular concern. Some of the countries still facing legacy problems with NPLs (Figure 1.12) are among those with strongest take-up of the abovementioned relief measures (EBA, 2020; Figure 1.13). High NPLs may hamper credit supply and its reallocation towards more productive firms (ECB, 2020a; Azevedo et al., 2018). A surge in NPLs could also rekindle negative feedback loops between banks and their domestic sovereigns (Table 1.2). Reforms to swiftly tackle NPLs are discussed in the OECD Economic Survey of the Euro Area.

Scarring effects could also become more severe in case of protracted short-time work support to firms with poor prospects and failure to step up active labour market policies and public investment. In addition, the expected lifting of confinement measures and the associated rebound in activity could come under threat if vaccination proved ineffective against new virus variants or its coverage of the population turned out to be insufficient. Besides worsened short-run output losses, higher unemployment and insolvencies would compound medium-term reallocation challenges. On the upside, prompt and efficient deployment of national recovery and resilience plans, with an emphasis on structural reforms to crowd in private investment and promote skilling and activation, would bolster confidence, durably enhance growth and help Europe succeed in the green and digital transitions.

Box 1.3. The EU health response has been cooperative, but exposed gaps in capabilities

When COVID-19 struck, assistance with key medical supplies among EU countries was limited by shortages, and the danger of uncoordinated national purchases trying to outbid one another loomed. The initial EU response to the pandemic emphasized joint procurement of medical equipment and the reinforcement of civil protection capabilities. Joint procurement has also been pursued for vaccines. The European Commission has negotiated advance purchase agreements with several vaccine manufacturers on behalf of the 27 EU countries, thus preserving equal treatment among member states and securing a diversified portfolio of more than 4.6 billion doses. These agreements are also meant to provide advance funding to enable manufacturers to invest in production capacities in parallel with clinical trials. Also in keeping with a cooperative, rules-based approach, millions of vaccine supplies produced in the EU have been exported to a very large number of third countries, including under COVAX, the international effort to ensure fair access to vaccines among rich and poor nations.

This cooperative approach has weighed on the agility of the response. Multiple national and European funding streams have raised coordination issues and overall financing for vaccine development, while substantial, was below that of the US (Aghion et al., 2020). The EU signed its first vaccine advance purchase agreement on 27 August 2020, several months after the US Biomedical Advanced Research and Development Authority (BARDA).

Within the current division of competences between the EU and member states, which mostly leaves health policy to the latter, proposals to reinforce the EU capabilities to deal with cross-border health threats have been recently put forward (European Commission, 2020b). They include the creation of an EU Health Emergency Preparedness and Response Authority (HERA), with responsibilities for threat anticipation, ensuring sufficient reserves and distribution of medical supplies, and coordination of public and private capabilities for R&D. Besides improving emergency preparedness (a central motivation for creating BARDA in 2006), setting up HERA could also help stem the EU declining competitiveness in biotech innovation (Aghion et al., 2020). To pave the way for HERA, a pilot programme was launched in February 2021 to tackle coronavirus variants (“HERA Incubator”), which is welcome. Enlarging EU competences in the domain of public health could also be considered.

Figure 1.9. A robust recovery is expected, supported by fiscal policy

	2018	2019	Projections
	2018	2019	2020	2021	2022
Gross domestic product (GDP)	2.2	1.6	-6.3	4.2	4.4
Private consumption	1.8	1.6	-7.4	2.7	6.1
Government consumption	1.3	2.0	1.4	2.9	0.9
Gross fixed capital formation	4.0	5.2	-8.0	5.1	5.7
Final domestic demand	2.2	2.5	-5.7	3.3	4.8
Total domestic demand	2.3	2.0	-6.0	3.3	4.8
Exports of goods and services	3.8	2.9	-8.9	9.1	5.8
Imports of goods and services	4.1	3.6	-8.5	7.6	6.7
Other indicators (growth rates, unless specified)
Potential GDP	1.3	1.3	1.1	1.0	1.0
Output gap²	0.0	0.3	-7.0	-4.1	-0.8
Employment	1.2	1.0	-0.9	0.2	0.9
Unemployment rate	7.5	6.9	7.3	7.6	7.2
GDP deflator	1.5	1.9	1.8	1.1	1.5
Consumer price index	1.8	1.3	0.6	1.9	1.5
Core consumer prices	1.1	1.2	1.0	1.5	1.3
Household saving ratio, net³	5.9	6.4	13.0	11.2	7.0
Current account balance⁴	3.3	3.2	3.1	3.6	3.4
General government fiscal balance⁴	-0.4	-0.6	-7.1	-7.1	-3.7
Underlying general government fiscal balance²	-0.4	-0.6	-2.5	-5.0	-3.9
Underlying general government primary fiscal balance²	1.2	0.8	-1.3	-3.9	-2.9
General government gross debt (Maastricht)⁴	82.3	80.6	94.3	97.0	95.8
General government net debt⁴	57.8	57.8	69.8	73.1	72.4
Three-month money market rate, average	-0.2	-0.1	-0.3	-0.4	-0.4
Gross government debt⁴	97.0	97.9	115.4	118.2	116.9

Note: 1. European Union member countries that are also members of the OECD (22 countries). 2. As a percentage of potential GDP. 3. As a percentage of household disposable income. 4. As a percentage of GDP

Source: OECD (2021), "OECD Economic Outlook No. 109", OECD Economic Outlook: Statistics and Projections (database).

Figure 1.10. The US and other European countries are the EU27 largest export markets

Per cent, 2019/2020¹

Box 1.4. Simulating the economic impacts of the EU-UK trade agreement

Since 1 January 2021, Single Market rules no longer govern trade between the EU and the UK, and the new EU-UK Trade and Cooperation Agreement applies. Trade in goods remains free from any tariffs or quotas, but has become subject to rules of origin, border formalities and the need to comply with separate regulatory requirements in the two partners. Even though the agreement contains provisions for bilateral cooperation and trade facilitation, some regulatory divergence will likely develop over time, creating non-tariff barriers to trade. Free movement of people and provision of services has ceased to apply, and market access for service providers depends on compliance with host country rules. Again, this creates barriers to trade, though the agreement goes beyond baseline World Trade Organisation (WTO) provisions for trade in services.

The OECD METRO model has been used to simulate the impacts of the agreement. METRO is a computable general equilibrium (CGE) model calibrated for this analysis to 30 regions (with most of the remaining EU members disaggregated), 19 sectors, and 8 production factors. The simulations present medium-term effects (5 to 10 years) where production factors are mobile across sectors, but the overall endowments of labour and capital remain fixed. The different barriers to trade are modelled as an increase in trade costs. For instance, for non-tariff measures affecting goods, the rise in trade costs is calibrated as half of the ad valorem equivalent of those measures on goods imported into the EU from third countries.

Regulatory divergence and increased border measures on goods and services between the EU and the UK would result in a GDP decline of 0.44% in the European Union relative to a Single Market baseline (Figure 1.11). Ending the free movement of people is expected to deepen output losses by 0.1 percentage point. Though relatively small, these estimates are likely to be conservative, as the METRO model does not capture impacts on FDI, labour supply or productivity.

Figure 1.11. Brexit will induce moderate output losses in the EU

Difference in EU real GDP under the EU-UK Trade and Cooperation Agreement (TCA) relative to the EU Single Market in the medium term

Figure 1.12. Non-performing loans are expected to rise again

Gross non-performing debt instruments as a percentage of total gross debt instruments

Figure 1.13. Take-up of loan relief measures varies widely across the EU

Vulnerability	Possible outcomes
New COVID-19 outbreaks linked to new vaccine-resistant virus variants.	Stricter confinement measures would become recurrent and uncertainty would worsen, with major negative impacts on private consumption and investment. Unemployment and bankruptcies would increase.
A surge in NPLs, in a context of increased risk-aversion.	Credit provision and credit reallocation could be hampered, and zombie firms could proliferate. Banks’ increased need for public support could put additional pressure on public finances and make it more difficult for the ECB to phase out public debt purchases. Banks’ holdings of domestic sovereign debt would likely rise.
Slow implementation of the EU recovery plan and premature withdrawal of fiscal support.	Persistently weak public investment would slow down the recovery. Sovereign debt tensions could re-emerge. Perceptions of recovery plan failure would cast a shadow on the cohesion and further integration prospects of the EU.

Economic divergence across countries and regions could increase

As witnessed in 2020, the impact of the pandemic is projected to remain asymmetric across the EU, potentially widening the gap in prosperity between countries, though the prospects of worsened divergence are now less severe than in earlier stages of the crisis (Figure 1.14). Differences in sectoral specialization are a key driver of this asymmetry, with Southern countries at a disadvantage due to their higher reliance on tourism. Southern countries also tend to have a higher incidence of very small firms, which are often more vulnerable (OECD, 2020a; Doerr and Gambacorta, 2020). In contrast, Northern countries, with less vulnerable economic structures, have also benefitted from better resourced testing and tracing strategies, at least during the pandemic’s first wave. Central and eastern European countries as a whole fare comparatively well, but with some variation, partly driven by different degrees of reliance on car manufacturing, a sector highly exposed to disruption in international supply chains, and by differences in the intensity of pandemic waves from the Autumn 2020 onwards.

The pandemic’s asymmetric impact could compound regional inequalities across the European Union. Since the turn of the century, progress in regional convergence has been mixed. Overall regional disparities in GDP per capita declined significantly until the global financial crisis, but at a much slower pace afterwards (Figure 1.15). Declining overall disparities were driven by a reduction in inequalities between countries, thanks to dynamic growth in Central and Eastern Europe, where convergence has continued even after the global financial crisis. In contrast, over the past decade Southern Europe has lost further ground and inequalities within countries have even somewhat increased, reflecting a better growth performance of metropolitan regions. Territorial inequalities can be a potent source of social and political discontent (Rodríguez-Pose, 2018).

Figure 1.14. The pandemic is expected to have asymmetric impacts

Change in GDP between 2019 Q4 and 2022 Q4, volume

Figure 1.15. Convergence between countries has slowed down, and divergence within countries has increased

Theil indices¹ based on the distribution of regional GDP per capita (in 2015 constant USD PPPs)

Supporting the recovery and greater convergence

Fostering investment and innovation

National fiscal policies should remain supportive and increase public investment

National fiscal policies are central to the recovery from the pandemic. While European initiatives provide much needed financing, as well as a welcome focus on investment and reforms (Box 1.5), it is national authorities that will take the spending decisions to support aggregate demand and foster structural change. This calls for swift and effective implementation of the national recovery and resilience plans prepared in the context of Next Generation EU, as well as of other planning instruments for investments co-financed by EU grants, such as those from cohesion policy.

At the same time, efforts at EU level are needed to focus on investment-friendly reforms and support their implementation. The assessment and monitoring of national recovery and resilience plans should focus on their internal consistency and efficiency to attain objectives with strong national ownership, rather than becoming a bureaucratic and potentially conflict-prone exercise (Pisani-Ferry, 2021). Priority should go to reforms that lift obstacles to investment (for instance, regulatory or licensing barriers), make investments more cost-efficient (e.g. more competitive public procurement) and increase their ensuing payoffs (e.g. cross-country coordination to improve European interconnections), aspects which are discussed in this Survey. The Commission should then provide technical support to the design and implementation of selected reforms (Box 1.5).

As discussed in the 2021 OECD Euro Area Economic Survey, national budgets should keep a supportive fiscal stance until the recovery is firmly under way. Meanwhile, a thorough review of the EU fiscal framework should be undertaken, acknowledging flaws in current rules and reinforcing national ownership. Best practices from individual countries inside and outside the EU should guide these reforms.

At the same time, the composition of budget expenditure must shift towards public investment, which has been weak over the past decade (Figure 1.16). The need for more investment has been made more pressing by accelerating trends towards digitalisation and climate change mitigation. Furthermore, the usually high short-term multipliers of public investment make it an effective policy tool in recessions. Private investment has also been subdued over much of the last decade (with cumulative impacts on the capital stock) and plunged again in 2020.

Figure 1.16. Low investment is a threat to the recovery

Box 1.5. The Next Generation EU recovery plan

Next Generation EU (NGEU) is a EUR 750 billion temporary stimulus package to boost the recovery from the pandemic and help achieve the Union’s environmental and digital transformation objectives. Its largest component is the Recovery and Resilience Facility, which will fund loans and grants to support investments and reforms. Next Generation EU also provides additional resources to cohesion policy and to a number of other EU programmes and funds, inter alia for rural development, R&D and industrial transition out of carbon-intensive activities (Table 1.3).

Budget item	NGEU		2021-27 EU budget grants for selected items
grants	loans
Recovery and Resilience Facility	312.5	360.0	-
Cohesion Policy (1)	47.5	-	330.2
Just Transition Fund	10.0	-	7.5
Rural Development	7.5	-	77.9
Others (2)	12.5	-	84.8
Totals	390.0	360.0

Note: 1. NGEU resources (EUR 47.5 billion) also include a top-up for the European Fund for Aid to the Most Deprived (FEAD), which is not part of cohesion policy

1. Includes InvestEU, Horizon Europe and RescEU. Resources for InvestEU take the form of guarantees rather than grants.

Source: European Commission (2021).

The cross-country allocation of Recovery and Resilience Facility (RRF) grants is based on population, GDP per capita, unemployment and the impact of the pandemic on GDP in 2020-21. Southern European countries (Greece, Italy, Portugal and Spain) are expected to receive about half of the total. RRF loans do not follow an allocation key, but should not exceed 6.8% of each country’s gross national income.

After political agreement on NGEU was reached in July 2020, operational arrangements have become intertwined with those of the 2021-27 EU budget. The RRF Regulation, a centrepiece document, entered into force in February 2021. After submission by Member States of national recovery and resilience plans (henceforth, plans) setting out their reform and investment strategy, the Commission has two months to assess them. Only after the following step, Council approval of plans by qualified majority, can a pre-financing payment of up to 13% of national allocations be disbursed to countries, which may take another two months. These procedural steps are being swiftly accomplished, with most national plans already approved by the Council and initial disbursements having started in August 2021.

A necessary condition for NGEU implementation, fulfilled in May 2021, was ratification by all member states of the Own Resources Decision. This Decision is part of the 2021-27 EU budget legislative package and enables the Commission to borrow on financial markets to finance the recovery plan. Looking ahead, setting up a permanent framework for common fiscal stabilisation, for example through an unemployment reinsurance scheme, as discussed in the OECD Economic Survey of the Euro Area, would enable more agile and effective policy action in the face of future shocks.

National plans need to include at least 37% of expenditure related to climate and 20% of expenditure in support of digitalisation. Besides the green and digital transitions, other areas eligible for RRF financing are smart, sustainable and inclusive growth and jobs; social and territorial cohesion; health and resilience; and policies for the next generation, children and youth, including education and skills. In all these areas, the plans have to respect the principle of “do(ing) no significant (climate) harm”. As regards reforms, plans are expected to take into account the respective country-specific recommendations.

The emphasis on structural reforms is commendable, but needs to be selective and accompanied, when needed, by the provision of technical support. The Commission’s Directorate-General for Structural

Reform Support (DG REFORM, formerly the Structural Reform Support Service) has carried out numerous reform design and implementation projects in a wide range of policy areas and may thus help member states through the Technical Support Instrument to implement their recovery plans. Among other actions, DG REFORM can contribute to strengthen national administrative capacity to manage and absorb NGEU funds.

Besides providing a welcome temporary stimulus to demand, NGEU has the potential to pemanently increase GDP across the EU. This requires that grants and loans are used to finance additional productive public spending, such as on infrastructures or R&D which crowd in private investment. By 2030, EU GDP could then be about 1 to 1.5% higher than in the absence of the recovery plan (Bankowski et al., 2021; European Commission, 2020c).

Accompanying structural reforms could lead to a long-lasting positive impact not only on the level of GDP but also on its growth rate. For instance, action to promote cross-country collaboration in innovative industrial projects, discussed in Chapter 2, could induce a permanent increase in business sector R&D. A rise in such expenditure by 0.4 percentage points of GDP (enough to close about half of the present gap to the US) might, as an order of magnitude, lead to an increase in EU GDP per capita of 0.6% by 2030, and a multiple of that in the long run (Egert and Gal, 2017).

Investment needs are very substantial. To meet environmental and climate targets alone, the additional annual investment over the next decade has been estimated at around EUR 470 billion per year (3½% of EU GDP; European Commission, 2020c) even before more ambitious emission abatement targets have been set for 2030 (discussed below). Investment for digitalisation would add EUR 125 billion per year (European Commission, 2020c). These amounts far exceed EU grants, making it essential that the latter add to, rather than replace, national funding for public investment, and that barriers and disincentives to private investment are removed.

Investment priorities for a more interconnected Europe

Investments should be prioritised so as to exploit public-private complementarities and thus crowd-in further private investment (EIB, 2019). Crowding-in may follow from the provision of essential infrastructure, but also through the lifting of regulatory barriers. At the same time, investments should also take into account cross-border externalities. This gives a European dimension to several investment priorities, calling for coordination across countries and regulatory action at the EU level to ensure interoperability of infrastructure and avoid market fragmentation.

Investment in electricity grids, often public, must more than double over the next decade for Europe to meet carbon neutrality targets (European Commission 2020d). Grid development is a prerequisite to integrate a higher share of renewables in electricity generation, and thus a prime example of complementarity between public and private investment. Cross-border interconnections are an essential strand of grid investment, and also yield the benefits of strengthened market integration and security of supply. However, most of the largest EU economies are still to meet the 10% interconnection target set for 2020 (Figure 1.17). For instance, interconnections between France and Spain are still vastly insufficient. Offshore grids to integrate offshore renewables (wind, wave and tidal) are another strand of infrastructure development, where efficient deployment calls for coordination among countries sharing the same sea basin. For both grids and renewables generation, licensing procedures need to be simplified: for instance, cross-border electricity lines are often well behind their planned commissioning dates (European Commission, 2020e).

Figure 1.17. The largest EU economies lack cross-border electricity interconnections

Interconnection electric energy ratio, %

Moving towards low-carbon transport also calls for investment, while at the same time highlighting the benefits from grid digitalisation and the need for coordination at the EU level. A dense network of recharging points is essential for the dissemination of electric cars, accompanied by refuelling stations for heavy-duty vehicles powered by low-carbon fuels, like hydrogen (European Commission, 2020f). Digitalisation of the recharging infrastructure will make the energy system more integrated and efficient by allowing demand-side flexibility in electricity consumption and bidirectional energy flows (IEA, 2020). For instance, vehicle-to-grid flows will help accommodate a peak in consumption or a temporary drop in supply from renewables. At the same time, recharging points need to be interoperable across the EU: the current lack of interoperability causes market fragmentation and is a major barrier to stronger dissemination of alternatively fuelled vehicles. Common standards at EU level would also likely reduce uncertainty for private investors.

Widespread availability of high-quality and affordable broadband is a key foundation for innovation and innovation diffusion, and a major strand of the European Digital Strategy (European Commission, 2020a). It is also a precondition for teleworking, which minimises the economic impact of public health emergencies and helps to spread the productivity spillovers from thriving cities over larger surrounding territories. Substantial investment, largely private, will be needed to reach the EU 2025 connectivity targets, which envisage access to much higher connection speeds than today (at least 100 Mbps for all households, and 1000 Mbps – or gigabit – for all main firms and public institutions). In turn, network investment will enable subsequent firms’ investments in digitalisation.

To reduce the cost of network deployment, public authorities can streamline licensing procedures, grant easier access to public assets (e.g. rooftops) for deployment and promote passive infrastructure sharing (e.g. ducts) among operators, as envisaged by the 2018 European Electronic Communications Code and by a recent EU recommendation (European Commission, 2020g). Rural and remote areas still face important connectivity gaps (Figure 1.18) and may be insufficiently attractive for private infrastructure investment. Governments may then directly invest themselves or provide support to private investors (OECD, 2020b). Another strand of public action to foster connectivity is the promotion of competition in telecommunications, which brings about lower prices without evidence of an accompanying negative impact on investment.

Figure 1.18. Disparities in the availability of high-speed internet are large

Households with minimum 30 Mbps of fixed broadband coverage, as percentage of all households in total and rural areas, 2018

Fostering innovation across the whole EU

Both to develop new technologies for climate neutrality, digitalisation and other societal challenges, and to take advantage of the ensuing opportunities for industrial competitiveness, the EU needs to increase investment in research and innovation. In ICT and climate-related R&D, as well as in total R&D performed by firms, the EU has long invested less than the US and no longer invests more than China (EIB, 2019). In addition, synergies between innovation efforts by EU member states have remained limited. As further analysed in Chapter 2, there is a strong case to combine public and private funding to promote cross-country collaboration in R&D and in highly innovative industrial projects. Promising areas include batteries, clean hydrogen (where in both cases joint initiatives are already ongoing), cybersecurity and digital technologies for healthcare (Strategic Forum for IPCEI, 2019).

Promoting wide participation across the EU in innovative industrial projects will help spread their benefits. Regional convergence requires that poorer regions upgrade their productive specialisation, innovating to develop new activities which build on regional assets and strengths. Stronger R&D investment in these regions, which cohesion policy should help finance, is needed to foster innovation and knowledge diffusion, and will ease partnerships with more prosperous counterparts.

Fostering innovation also requires upholding competitive markets despite new challenges to competition policy. For instance, merger control cannot always avoid that large firms buy smaller rivals to pre-empt future competition, sometimes by halting the development of rivals’ innovative projects. Furthermore, competition policy should be updated to better respond to the digitalisation of the economy. For instance, new competition tools and regulation may be needed to tackle positions of entrenched dominance in digitalised markets, due inter alia to strong network effects, consumer lock-in or lack of access to data. Chapter 2 further analyses these issues.

Making public investment more efficient

The medium and long-term benefits from public investment will be enhanced if it generates demand to innovative and highly productive firms, competitively selected, rather than to inefficient suppliers. For example, this will make cohesion policy more effective in fostering regional convergence. Procurement procedures play a major role on this count. In EU countries, public procurement is often not competitive enough, with a high prevalence of single bidding and often a lack of transparency in procedures. Contracts tend to be awarded to suppliers of the same country, and even region, of the buyer (Herz and Varela-Irimia, 2017). This may lead to higher prices without compensating gains in other dimensions (e.g. quality, innovation or environmental impacts), or even fuel fraud and corruption (European Court of Auditors, 2015). Increasing the centralization of procurement and the professionalization of the officials involved, and giving greater weight to quality as a selection criterion will help make public procurement more competitive and supportive of innovation. More openness to bidders from other EU countries will also contribute to these goals.

Support to private investment should be focussed on projects well aligned with policy objectives and which would not be carried out in the absence of public co-funding. For instance, cohesion policy should make greater use of competitive project selection procedures (rather than selection on a first-come first-served basis), with an emphasis on projects’ contribution to regional development objectives. This requires stronger administrative capacity by managing agencies, which should also strive to enlarge the pool of applicants by adjusting project calls to the ability to respond of potential beneficiaries and helping them address capacity gaps.

Given the multiplicity of funding instruments at EU level (Box 1.5), efficient investment also calls for integrated strategies bringing together complementary EU policies. A case in point is investment in rural regions eligible for support from both rural development policy and cohesion policy, whose interventions have often been poorly coordinated.

Making migration policies more supportive to growth

International migration often has a positive impact on the growth of the host economy, not least by alleviating skill shortages. While theoretical arguments can lend support to opposite conclusions regarding the impact on growth of immigration, most empirical studies find positive effects (Alesina, Harnoss and Rapoport, 2016; Jaumotte, Koloskova and Saxena, 2016), which tend to become more important the higher the immigrants' skills relative to natives (Dolado, Gloria and Ichino, 1994, OECD, 2010). For example, highly educated immigrants and foreign graduate students have made a positive contribution to US patenting activities and innovation (Hunt and Gauthier-Loiselle, 2010; Kerr and Lincoln, 2010). High-skilled immigrants also make a sizeable contribution to the healthcare sector and help to overcome skill shortages (OECD, 2015a; OECD, 2020c). Foreign-trained doctors and nurses accounted for about 18% and 7% respectively of the healthcare workforce across the OECD countries in the past five years, and several OECD countries have resorted to additional foreign health workers to respond to the COVID-19 crisis (OECD, 2020c).

Other economic impacts of immigration, such as on natives’ wages and employment and on public finances, are prominent in the public debate. Empirical evidence indicates that the wage effect of immigration is limited (OECD/ILO, 2018) and depends on the skill structure of the immigrant workforce (Borjas, 2014; Edo and Toubal, 2015). Likewise, the fiscal impact of immigration is around zero on average across the OECD (OECD, 2013).

However, despite mostly benign economic impacts and the decline in the number of asylum seekers (Figure 1.19), immigration remains a highly divisive issue and its political importance has risen (MPC-OPAM, 2018). Europeans have polarised views regarding the impact of immigration and their willingness to accept migrants from poor non-EU countries (Figure 1.20). This is related to public concerns about a perceived lack of control over immigration and external borders (Jeannet et al., 2019; MPC-OPAM, 2018), which would leave final destination countries unable to determine the size and composition of arrivals. This has potentially major implications for EU policies, such as the protection of external borders (Frontex), the determination of the Member State responsible for examining an application for asylum (Dublin regulation), the Blue Card scheme to attract highly-skilled labour or even the acceptance of the passport-free Schengen area. As the pandemic recedes and international travel resumes, immigrant arrivals will likely increase, which could rekindle tensions in the EU, especially under still high unemployment.

Figure 1.19. Arrivals of asylum-seekers have decreased

Monthly first-time asylum applications in the EU27, thousands

The distribution of asylum seekers among EU Member States remains a thorny issue. In 2016, a package of proposals to reform the Common European Asylum System (CEAS) was put forward, but the process has stalled due to political disagreement over inter alia reform of the Dublin Regulation. This regulation sets out the criteria for determining the Member State responsible for examining an application for international protection, which often assign responsibility to the first EU country that asylum seekers enter. This puts, initially, a disproportionate burden on frontline countries. A reform proposal of mandatory quotas for relocating asylum seekers was met with strong opposition by some Member States in 2016 (MEDAM, 2018). In order to overcome political deadlock, the European Commission (2020h) has recently proposed a New Pact on Migration and Asylum, the main element of which is to replace the Dublin Regulation by a more flexible framework for a fairer sharing of responsibility built on mandatory but flexible participation by Member States. This is a welcome initiative, which could also make it possible to conclude the negotiations on the harmonisation and greater convergence in asylum decisions, a component of the 2016 package of proposals where provisional agreement has been reached but was stalled over the Dublin Regulation. Harmonisation aims to address the present large disparities across member states in asylum procedures and in the propensities to grant asylum. For instance, in 2020 recognition rates for Syrians ranged from 35% in some countries to 100% in others. Disparities were even wider for Afghans (from 1 to 99%). The transformation of the European Asylum Support Office into an EU Asylum Agency, for which an agreement has recently been reached, will enable the organisation to better contribute to the management of migration flows and provide greater support to Member States.

Figure 1.20. Public opinion about immigration is polarised

Countering irregular migration into the EU while safeguarding refugees’ access to protection requires close cooperation with countries of origin and transit. It also requires stronger protection of the EU external borders, to which plans to reinforce the European Border and Coast Guard Agency (Frontex) will contribute. Frontex has recently started recruitment of its standing corps, which the Commission proposes to become 10,000-strong by 2024. Cooperation on return, readmission and reintegration with countries of origin has often not been effective enough, since those countries often find it politically difficult to support the forced return of their citizens. To this end, the New Pact on Asylum and Migration (European Commission, 2020h) proposes to strengthen coordination and cooperation with third countries by creating a common EU system for returns which includes a stronger role of the European Border and Coast Guard, a newly appointed EU Return Coordinator, and a voluntary return and reintegration strategy. Furthermore, cooperation on return, readmission and reintegration will be part of partnerships with key third countries of origin and transit.

To enhance cooperation with countries of origin, skill partnerships for vocational training, leading to employment either at home or in the EU, are an important tool (Triandafyllidou, Bartolini and Guidi, 2019). As an additional benefit, they may also help to address skill shortages. An example is the skill partnership agreement between Germany and Tunisia in the health sector (Clemens, 2015). Within these partnerships, facilitating the return (mandatory or voluntary) of migrants after working for a period in Europe is important. For this purpose, migrants who return to their countries of origin could be aided in their job search (MEDAM, 2018). The New Pact on Asylum and Migration plans to start Talent Partnerships with key non-EU countries that will match labour and skills needs in the EU.

Europe has managed to attract a growing inflow of high-skilled workers through the Blue Card scheme (Figure 1.21) – an EU-wide work permit scheme for non-EU citizens – but numbers remain very small. For instance, Blue Cards issued in 2018 represent less than 0.01% of the EU population (without taking into account national schemes; see below), against annual arrivals of 0.4-0.5% of population in Canada or Australia (European Commission, 2018a). Moreover, skill shortages, not least in the digital area, have been persistently reported as a highly pressing issue in business surveys, hampering investment and the future competitiveness of the EU (EIB, 2019; EIB, 2021). The effectiveness of the EU Blue Card has been undermined by its restrictive conditions and by competition from national schemes offering far more favourable conditions for companies (MEDAM, 2018). Indeed, most member countries admit more high-skilled workers through national schemes than through the EU Blue Card (OECD/EU 2016). In 2016, the Commission proposed to make Blue Card admission conditions less restrictive and to abolish parallel national schemes (MEDAM, 2018). However, some countries have opposed this abolition (European Commission, 2018a; Table 1.4). The EU should indeed make accession to the Blue Card less restrictive. In addition, rather than scrapping national schemes, the EU should allow high-skilled workers benefitting from a national scheme to access the EU Blue Card with only limited formalities. This would ease further access to the Blue Card and facilitate mobility of high-skilled immigrants across the EU.

Make effective the proposed simplification of eligibility and procedures for the EU Blue Card for high-skilled labour migrants.

After being stalled since 2018, negotiations on the 2016 Commission proposal to revise the EU Blue Card Directive have been resumed at the end of 2020 following the adoption of the Commission Communication on a New Pact on Migration and Asylum.

Figure 1.21. Blue Card attractiveness is growing, but remains limited

Number of Blue Cards, EU27, thousands

Stepping up the fight against corruption

Corruption has large economic and social costs. It makes public procurement more expensive and can thus induce significant inefficiency in public spending. Furthermore, the distortions created by corruption can lower private investment and discourage innovation, which in turn reduces economic growth (Mauro, 1995; Schleifer and Vishny, 1993). Some estimates suggest that corruption can cost the EU more than 1% of GDP per year (European Parliamentary Research Service, 2016). More broadly, corruption weighs on many other dimensions of well-being. It damages the credibility of public institutions, tends to increase social inequality and may even threaten public health and safety when it allows to circumvent regulations in those areas (OECD, 2015b; Svensson, 2005). All these considerations gain increased relevance in a pandemic context, where the need for swift policy implementation, sometimes under emergency conditions, often heightens risks of corruption (OECD, 2020d), and increased demands on public budgets put efficient spending at a premium.

Perceptions of corruption vary widely among EU member states, making it even more important that the deployment of commonly funded resources, such as those from the EU budget and the recovery plan, are accompanied by enhanced anti-corruption measures. On average, perceived corruption in the EU and in the whole OECD membership are fairly close (Figure 1.22). However, perceptions are vastly different across EU countries, some of which rank among the top OECD performers, while others feature among the worst. These indices are subjective measures and should be regarded with prudence. In this respect, greater efforts should be made to develop quantitative approaches to assess corruption. Indeed, on top of other costs of corruption, those wide differences across the EU may affect mutual trust between countries and deter further economic integration.

Figure 1.22. Perceptions of corruption vary widely across EU countries

Fighting corruption is a competence shared between the EU and member states, and poses considerable coordination challenges, as countries are responsible for law enforcement, prosecution and judicial measures. EU anti-corruption initiatives have often focussed on the protection of the Union’s financial interests, concerning the EU budget on both expenditure and revenue sides. While this focus is narrower than corruption in general, EU initiatives also have the potential to lead to improvements in national anti-corruption legal and operational settings. For instance, some EU initiatives involving the areas of prevention and detection, respect for the rule of law and whistleblower protection (discussed below) can increase effectiveness in the fight against cases of domestic corruption, even when these cases do not have direct implications for the EU budget.

In 2017 the Directive on the fight against fraud to the Union's financial interests by means of criminal law (“PIF Directive”) was adopted, replacing a 1995 PIF Convention. To enhance the protection of the EU’s financial interests, the PIF Directive harmonises the definitions, sanctions and limitation periods (after which prosecution is no longer possible) of certain criminal offences affecting those interests (i.e. fraud, corruption, misappropriation and money laundering). The deadline for transposition of the PIF Directive into national law expired on 6 July 2019. By the end of 2020, 24 Member States had notified complete transpositions.

Also in 2017, the European Public Prosecutor’s Office (EPPO) was created to investigate, prosecute and bring to court the offenses addressed in the PIF Directive, hitherto an exclusive prerogative of national authorities. Currently, 22 EU countries take part in EPPO, which became operational on 1 June 2021. The amended Regulation governing the European Anti-Fraud Office (OLAF), which entered into force in January 2021, not only improves the effectiveness of OLAF's administrative investigations but also streamlines its articulation with EPPO. Both EPPO and OLAF will also be assisted by Europol’s European Financial and Economic Crime Centre, launched in June 2020 to pool expertise in the area and provide operational support to EU member states and EU bodies (Europol, 2020).

Curbing fraud and corruption against the EU budget has faced limitations, which the above reforms help to address. OLAF’s administrative investigations have been hampered by operational constraints. With the revised OLAF Regulation, OLAF has gained access to financial flows and bank accounts, which it did not have before. In addition, some Member States, invoking national law, had questioned OLAF’s competence to conduct on-the-spot checks (which are foreseen by EU regulations). The revised Regulation clarifies to what extent EU or national law apply in the conduct of those checks. Furthermore, when investigations are concluded and passed on to countries for judicial action, follow-up is modest: between 2015 and 2019, only 39% of the cases submitted to national judicial authorities resulted in indictments (OLAF, 2020).

Despite welcome progress, investigative effectiveness will still depend on Member States’ compliance with their duty to assist OLAF. Further amendments would also be desirable, notably to reinforce admissibility in national courts of evidence collected by OLAF on behalf of EPPO (European Court of Auditors, 2019a). While the operation of EPPO will help strengthen judicial enforcement, especially in cases involving several member states, it will not be free from challenges, as it is necessary to take into account not only the articulation between national courts and Union bodies, but also between national law and EU law (Erkelens et al., 2015; Weyembergh and Brière, 2016; Bachmaier Winter, 2018).

To further protect the EU budget, the Commission proposed for the 2021-27 period a regulation on a general regime of conditionality for the protection of the Union budget (the so-called “rule of law conditionality”), which would allow the suspension of payments from the EU budget or the imposition of other financial measures to countries with generalised deficiencies as regards the rule of law. The suspension or the imposition of other measures could take place if those deficiencies were to affect, for instance, the prosecution of fraud and corruption related to the implementation of the Union budget or the effective and timely cooperation with OLAF and EPPO. This proposal gave rise to some concerns about the discretionary power it would assign to the Commission (European Court of Auditors, 2018; Vita, 2018) and caused considerable controversy among countries. The approved regulation provides more clarity on the sources of information available for the Commission’s assessment (including reports from OLAF and EPPO), narrows the scope of the potential deficiencies to be assessed and sets more demanding voting requirements in the Council for a suspension of payments or other measures to be imposed on a Member State. Still, some controversy remained.

As a compromise, countries have agreed on a set of principles for applying the newly adopted regulation, which made it possible to adopt it together with other legislative instruments of the EU 2021-27 Budget. The text of the new regulation has not changed, but according to European Council conclusions (European Council, 2020) it would only apply to budgetary commitments under the 2021-27 Budget or Next Generation EU, thus excluding outstanding payments from the 2014-2020 Budget. Furthermore, under the newly adopted regulation, the relevant rule of law breaches require a direct link to the negative consequences on the Union’s financial interests. Given that two Member States have challenged the validity of the Regulation, the European Court of Justice will deliver a judgement that will be taken into account by the Commission. In due time, the effectiveness of the measures adopted under the new regulation should be assessed, and consideration should be given to tightening this “rule of law conditionality” if needed.

Prevention and detection of fraud and corruption also have scope for improvement. The Early Detection and Exclusion System (EDES), the EU’s debarment tool, aims at detection of individuals or entities representing risks to the Union’s financial interests and may exclude them from receiving EU funds managed under direct or indirect management mode, while EU Member States should also take this information into account when awarding contracts under shared management arrangements. However, the number of publicly available cases is very limited since EU legislation, in line with the requirements of the Charter of Fundamental Rights, limits publication to the most severe cases (only 9 in September 2020, which compares, for instance, with hundreds of entities publicly debarred by the World Bank). Other levers for strengthened prevention and detection include greater use of data-mining tools (discussed in the thematic chapter) and more systematic development by member states of formal anti-fraud strategies and fraud prevention policies, accompanied by assessments of their effectiveness (European Court of Auditors, 2019b).

Money laundering has also been the object of successive EU directives since 1990. However, partly due to the minimal harmonisation sought, the effectiveness of anti-money laundering (AML) measures is still assessed as widely different across member states (Figure 1.23). In 2018, the 5^th AML directive amended the rules of access to registers of beneficial owners (BO), set up by the 4^th AML directive in 2015, to make available to the public a set of BO data on legal persons, whilst also expanding the scope of legal arrangements covered by the obligation to have their BO recorded in a register. The 5^th AML directive also made cooperation between national authorities more efficient. However, recent high-profile money laundering cases involving banks have highlighted the need to step up anti-money laundering supervision, hitherto relying on the European Banking Authority as hub for coordination and convergence of national supervisors. In reply to this, an Action Plan to step up the fight against money laundering and terrorist financing presented by the Commission in May 2020 (European Commission, 2020i) foresees more harmonised rules and setting up a direct EU-level anti-money laundering supervisor. This is welcome, as it will lead to a stronger anti-money laundering framework from both regulatory and institutional viewpoints. A key priority for the EU-level supervisor is to improve supervision in cross-border cases, for which current arrangements are unsatisfactory (European Commission, 2020i). In any case, the new supervisor should be endowed with resources commensurate to its duties. Draft legislation presented in July 2021 aims to implement the Action Plan, proposing inter alia that a new EU anti-money laundering authority starts direct supervision activities in 2026, with directly supervised financial institutions proposed to be generally determined on the basis of risk categorisation and cross-border activity.

The fight against money laundering, its predicate offences and terrorist financing would also benefit from more effective freezing and confiscation of illegally acquired assets. In the EU, only 1% of the estimated criminal proceeds are confiscated (Europol, 2016), and cross-country cooperation has been hampered by differences in national law. A 2018 regulation on the mutual recognition of freezing and confiscation orders attempts to tackle these barriers and the creation of the European Financial and Economic Crime Centre within Europol aims to foster cooperation among law enforcement authorities in this field.

Robust protection to whistleblowers is essential to increase the likelihood of wrongdoing detection. A 2019 directive increases protection to people reporting breaches of EU law (thus covering money laundering and crimes against the EU budget, among many other areas) and harmonises protection across countries. For instance, some Member States would only provide protection to whistleblowers working in the public sector, while others would only provide protection in corruption cases. Full and timely transposition into national legislation (due by December 2021) is now called for. Furthermore, countries should take advantage of transposition to increase whistleblower protection also in cases of breaches of national law.

Figure 1.23. Stronger action against money laundering is needed

Anti-money laundering measures, scale: 1 (low) to 4 (high effectiveness), 2019 or latest year

Special focus: climate change and a circular economy

Achieving zero net greenhouse gases emissions by 2050

The European Green Deal has set an objective of zero net emissions of greenhouse gases in the EU by 2050. This will require a significant acceleration in emission abatement (Figure 1.24), as current policies are only projected to yield a 60% reduction relative to 1990 levels by that date (European Commission, 2019a). More ambitious intermediate targets have also been agreed upon, such as stepping up the previous 40% reduction by 2030 to at least 55% of net EU emissions.

Making progress towards net zero emissions requires a strategy to tackle a broad range of sectors, including electricity generation, construction, transport, industry and agriculture (OECD, 2019). Reaching net zero emissions requires electrifying most energy end use while generating at the same time most electricity from zero-emission sources. Low-carbon fuels should be developed for sectors hard to electrify, carbon capture, storage and utilisation (CCSU) further pursued and energy efficiency increased more generally. The recent “Fit for 55’ policy package to achieve the 55% emissions reduction target by 2030 contains legislative proposals in many of these areas (Box 1.6; European Commission, 2021a).

This section looks at reducing greenhouse gases emissions in transport and agriculture, where emissions abatement has proved harder, and in buildings, where energy efficiency is of paramount importance. It also analyses the role of a clear identification of environment-friendly activities and of financial regulation and supervision to steer investment towards greener assets. These are challenges felt throughout most, if not all, of the European Union.

In contrast, other challenges for reaching low carbon emissions have a stronger regional dimension, as they are territorially concentrated and have major implications for productive specialisation. It is the case, for instance, of the transition out of coal mining and energy-intensive industries, which is discussed in the thematic chapter. Long-term transition plans with wide stakeholder involvement should be prepared for the regions concerned . These plans should pay particular attention to re-skilling and upskilling, as well as to job search assistance and adequate social safety nets for displaced workers, who in carbon-intensive sectors are often elderly.

Figure 1.24. Greenhouse gas emissions have been reduced, and this should continue at a fast pace

Emissions of greenhouse gases

Box 1.6. Delivering the European Green Deal: the Fit for 55 policy package

In July 2021, the European Commission presented Fit for 55, a package of proposals for the EU to reduce its GHG emissions by at least 55% by 2030 compared to 1990 levels and reach climate neutrality by 2050. The Commission’s proposals include stronger and more efficient carbon pricing and more stringent regulations to curb emissions, with a major focus on the transport sector.

The EU Emissions Trading System (ETS) will be strengthened through the broadening of its scope to emissions from the maritime sector, a faster decrease in the annual cap of emissions and the phasing-out of free allowances, including in the aviation sector. Member States are bound to earmark all their revenues from ETS to climate and energy-related projects.
Emissions from road transport and buildings will be priced from 2026 through the creation of a separate emissions trading system based on fuel distribution in these sectors. Emission caps will lead to a 43% reduction of targeted emissions in 2030 relative to 2005.
More stringent standards for emissions will be applied in the transport sector. By 2030, average emissions for new cars (vans) should be 55% (50%) smaller than in 2021, up from a previous 37.5% (31%) reduction target. In addition, the reduction should reach 100% by 2035. This will be accompanied by new requirements for member states to provide adequate electric charging and hydrogen fuelling points. More stringent requirements and easier access to sustainable fuels will also apply to the aviation and maritime sectors.
A Carbon Border Adjustment Mechanism will apply to a selection of carbon-intensive products (iron and steel, cement, fertilisers, aluminium and electricity generation) to align carbon prices for domestic production and imports and avoid carbon leakage. This mechanism will be consistent with WTO rules and will be phased in from 2026, after a three-year transition period in which importers of the selected goods will have to report the respective embedded emissions. Free allocation of ETS allowances to the covered sectors will be phased out.
The Energy Taxation Directive will be updated to set minimum energy tax rates that encourage energy efficiency and the use of sustainable fuels. Several fossil fuel tax exemptions and reduced rates will be phased out.
New ambitious targets are set for carbon removal (including an EU Forest Strategy aiming to plant 3 billion trees across the EU by 2030), the share of renewable energy (40% of production by 2030) and energy efficiency (energy saving targets being nearly doubled, with annual targets for public sector buildings renovation).
A Social Climate Fund will support vulnerable households and micro-enterprises in the transition to higher energy efficiency and cleaner heating, cooling and mobility systems. Financed by the EU budget with an amount equivalent to 25% of the expected revenues of the new ETS for road transport and buildings, the Fund will be able to provide temporary income support and help finance investments in energy efficiency.

Differences in carbon pricing across countries may lead to the shifting of carbon-intensive production to low-price jurisdictions, which reduces the impact of higher domestic carbon prices on global CO2 emissions through carbon leakage (i.e., lower domestic emissions are partly offset by higher foreign emissions). Evidence on ETS-induced leakage is so far scarce, but it could become a more serious problem if carbon prices increase in Europe but not elsewhere (Dechezleprêtre et al., 2018), reflecting divergent degrees of climate ambition. In this case, a carbon border adjustment mechanism (CBAM) could play a useful role in minimising carbon leakage, with the advantage of not weakening domestic abatement incentives. The design of a CBAM should be compliant with WTO rules and take into account both the carbon content of imports and the carbon price they have already been charged in their countries of production. To avoid any perception of protectionism and to ensure a level-playing field, the carbon cost imposed on importers and foreign producers should be as close as possible to the carbon cost paid by domestic producers, and administrative costs imposed on importers and foreign producers should be kept to a minimum. Progress in international cooperation to reduce global greenhouse gases emissions should remain the policy priority in this domain.

As part of the Fit for 55 package, the Commission has recently proposed a carbon border adjustment mechanism (CBAM), to be phased in from 2026 and initially applying to a limited number of energy-intensive and trade-exposed sectors covered by the EU Emissions Trading System (European Commission, 2021b). The proposed mechanism aims at equalising carbon prices for domestic production and imports. For this purpose, importers will buy at the same price of Emissions Trading System (ETS) allowances an amount of carbon certificates corresponding to the emissions generated in the production of the imported quantities, with the possibility to deduct carbon prices already paid by non-EU producers in third countries. Over 2026-35, the CBAM’s phasing-in will be proportional to the phasing-out of the free allocation of ETS permits in the sectors concerned, which avoids a duplication of instruments to prevent carbon leakage and the ensuing advantage to domestic producers (OECD, 2020e). The possibility to report actual emissions generated in production (as an alternative to using default values) and to deduct carbon pricing paid in origin countries reinforces incentives to green production there, but the required verification and certification mechanisms could turn out cumbersome.

Carbon pricing needs to be accompanied by sector-specific interventions

Emissions in transport have risen in recent years (Figure 1.25), calling for decisive price and regulatory action to reach targets. As part of a broader policy package, bringing transport into the EU Emissions Trading System (ETS) could help to ensure that transport contributes to reaching emission targets cost-effectively (Table 1.5). In this vein, the Fit for 55 package proposes the creation of a separate ETS for fuel used in road transport and for heating and cooling buildings. Recent reforms to the existing ETS, especially concerning the Market Stability Reserve, have made it more effective, increasing the price of allowances (Figure 1.26) and reducing volatility. The Fit for 55 package envisages further reforms, including a faster reduction in the overall emissions cap, the inclusion of maritime transport and a gradual phasing out of free emission allowances, which is welcome.

Increase the price of greenhouse gas emissions and consider bringing all fuel use, including transport, into the EU Emissions Trading System (ETS).

Member States have agreed to raise the 2030 greenhouse gas emission reduction target to at least 55% compared to 1990 (as compared to the previous target of 40% reduction). To deliver these additional reductions, the Commission proposed in July 2021 a comprehensive policy package (Fit for 55) to revise where necessary all relevant climate-related policy instruments. This package comprises reforms to the existing Emissions Trading System (ETS), such as lowering the overall emissions cap, including maritime transport and gradually phasing out free emission allowances, including for aviation. The Fit for 55 package also envisages the creation of a separate ETS for fuel used in heating and cooling buildings and in road transport.

Increase minimum tax rates on fossil fuel use that falls outside the ETS, especially where tax rates are currently low or zero.

The Commission presented in July 2021 a proposal to revise the Energy Taxation Directive, including changes in the structure of rates and a rationalisiation of the use of optional tax exemptions and reductions.

To move towards low carbon emissions in transport, regulatory tools and price incentives should work together, in tandem with the promotion of more systemic changes in mobility (e.g. digital-based ride sharing, discussed below). Private cars account for the lion’s share of emissions from fuel combustion in the transport sector (Figure 1.25), and are the transport segment where zero-carbon technologies are most readily available. The proposed inclusion of road transport in an emissions trading scheme and the promotion of competition in the supply of electricity for vehicle recharging would reinforce price incentives for electric cars. As for regulatory tools, the Fit for 55 package envisages more ambitious medium-term emission standards for new passenger cars and vans, which should all become zero-emission from 2035 on (Box 1.6). This requirement is welcome: given an average car useful life of 15 years and the 2050 deadline for zero net emissions, ending the sale of new cars with internal combustion engines by 2035 would avoid premature depreciation of newly purchased cars after that date. Several countries had already committed to such phasing out, often between 2030 and 2040. Recent research suggests that a switchover by 2030 would result in lower costs, even without taking into account the substantial benefits in terms of reduced air pollution (UK Committee on Climate Change, 2019). As electrification proceeds, gradual tax reforms in the road sector, with an evolving mix of taxes and revenues increasingly stemming from taxes on distances driven, can contribute to a more sustainable tax policy (OECD/ITF, 2019).

The experience of Norway illustrates some of the trade-offs involved in reducing carbon emissions in transport. Norway ranks first in the world in electric vehicles relative to population, and aims at ending the sale of non-zero-emission cars as early as 2025. Exemptions from VAT and vehicle registration tax, together with cheaper tolls and parking, have often made electric vehicles cheaper than their petrol or diesel counterparts. However, the implicit cost of carbon abatement has been inefficiently high, as discussed in the 2019 OECD Economic Survey of Norway. Possible social tensions associated with strong hikes in fuel prices have been avoided. Still, the tax advantages of electric cars have mainly accrued to better-off households.

Figure 1.25. Cars are the main source of emissions in the transport sector

Despite a high environmental ambition of the Common Agricultural Policy and a 20% reduction in agricultural GHG emissions since 1990, virtually no progress has been made over the past 15 years in reducing emissions (Figure 1.24). In 2014-20, almost 20% of direct payments to farmers were deemed to contribute to climate action, and at least 30% of rural development spending to environmental objectives (climate and other; European Court of Auditors, 2020). However, the effectiveness of the underlying policy instruments was insufficient (DeBoe, 2020). The requirements for greening payments (part of direct payments) largely corresponded to existing farming practices (e.g. maintaining permanent grassland), which have thus changed little (World Bank, 2017; Henderson et al., 2020). Other environmental requirements for direct payments (cross-compliance) have often lacked ambition and scrutiny (European Commission, 2018b; DeBoe, 2020). Similar reasons, plus an emphasis on agricultural practices rather than on environmental outcomes, help explain why agri-environmental measures under rural development policy have also had a modest impact on emissions mitigation (European Commission, 2018b; Henderson et al., 2020). More significantly, some direct payments, left at the discretion of member states and widely used, are still linked to the production of specific commodities and tend to be climate-harmful, especially in the case of subsidies to ruminant cattle, a major source of methane emissions (Henderson and Lankoski, 2019).

In line with the European Green Deal and the objectives for a sustainable food system contained in the EU Farm to Fork Strategy (European Commission, 2020j), the recent political agreement for the Common Agricultural Policy in 2021-27 envisages a stronger link between direct payments to farmers and improved environmental outcomes (“eco-schemes”, to which countries must in general allocate at least 25% of their direct payments budget). This is welcome, and countries should use this new tool to strengthen incentives for reducing animal methane emissions, inter alia through novel approaches to feeding. Such incentives would also minimise the risks of carbon leakage through imports from the desirable phasing-out of production-based direct payments (Jansson et al., 2020). Furthermore, member states should stop subsidising fuels used in agriculture, a still widespread practice (OECD, 2019a).

Figure 1.26. The price of EU emission allowances has significantly increased

EUR/tCO2, primary market auctions, spot price

Buildings account for 40% of energy consumption, and thus making them more energy-efficient is key to reaching carbon neutrality. Energy efficiency in homes also delivers important health and wellbeing gains by improving the quality of indoor living (OECD, 2019b), especially for those households who currently cannot afford to heat their homes sufficiently. From 2021 on, all new buildings in the EU should be “nearly zero-energy buildings”, though countries have operationalised this requirement in different ways (Climate Action Tracker, 2018). In 2018, the requirement was extended to all buildings by 2050. To meet this target, annual renovation rates, currently varying between 0.4% and 1.2% across EU countries, will need to at least double (European Commission, 2019a). In this vein, the Fit for 55 package proposes to require the public sector to renovate 3% of its buildings every year. Greater uniformity and stronger enforcement of the nearly zero-energy buildings requirement would improve information and avoid market fragmentation across the EU.

Investment and reforms to improve the energy efficiency of buildings should be a priority area for national recovery plans. Over long horizons, investments in energy efficiency often more than pay for themselves (IEA, 2018), by yielding benefits to property owners (higher property values) and occupiers (less energy consumption). Deep renovation of public buildings at all levels of government is an opportunity to spearhead better integration between different energy carriers (e.g. electricity, heat) and consuming sectors (e.g. buildings, industry; IEA, 2020). For instance, heating and cooling planning can exploit synergies with local waste recycling and industrial sectors. Furthermore, energy efficiency actions should be coupled with the adoption of circularity principles throughout the lifecycle of buildings to reduce the consumption of materials, as discussed below. Besides promoting job creation in retrofitting, the renovation of public buildings can help demonstrate the benefits of energy efficiency to private owners. Policy tools to support private investment in retrofitting include grants, loans, guarantees and technical assistance, possibly in combination. It is also necessary to lift regulatory barriers that inhibit renovation in rented housing, namely by allowing landlords in regulated rental markets who carry out energy-efficiency investments to increase rents, as is the case, for instance, in Denmark and Germany.

Reinforcing price incentives is also needed, since heating fuels are often lightly taxed (OECD, 2019a). The revision of the Energy Taxation Directive, also part of the Fit for 55 package, envisages to phase out certain tax exemptions and reductions which subsidise fossil fuel use. Furthermore, the proposed integration of buildings into an emissions trading scheme will also help align price incentives with the EU emission reduction targets. As in the case of the policy measures to foster investments discussed above, targeted support to poorer households will be required. The proposal to set up a Social Climate Fund (Box 1.6) to address adverse social impacts from the new ETS for buildings and road transport is thus welcome.

Steering public and private finance towards sustainable investments

The mobilisation of public and private finance for the transition to a low-carbon economy requires a clear identification of environmentally sustainable activities. For instance, this identification provides a basis for the issuance of green financial instruments, such as bonds or loans, and minimises risks of greenwashing (misleading claims regarding the sustainability of an investment product). Regulatory stability is also essential: changing regulatory goalposts may alter the risk-return profile of the investment during the project life cycle, undermining investors’ confidence (BIAC, 2016). In this context, the adoption in 2020 of the EU taxonomy was a welcome step. In order to qualify as environmentally sustainable under this classification system, an economic activity must make a substantial contribution to at least one of six environmental objectives (e.g. climate change mitigation or the transition to a circular economy) while doing no significant harm to any of them. Delegated acts prepared in 2021-22 define technical screening criteria for each of the objectives, making it possible to establish an actual list of sustainable economic activities.

The taxonomy is an important tool to make EU budget spending more environment-friendly. Thirty percent of the 2021-27 budget (and of the Next Generation EU recovery plan) will be devoted to fighting climate change, up from 20% in 2014-20. However, the Commission’s methodology for tracking climate spending has been criticised for likely overstating the budget’s true contribution, particularly in the case of the Common Agricultural Policy (European Court of Auditors, 2020). For instance, in this policy or elsewhere, there is no accounting for spending with negative climate impacts. It is essential to avoid that the EU budget finances investments that are inconsistent with the transition to a low-carbon economy, at least when there are no strong positive externalities for those investments or alternative lower-carbon options exist. More broadly, environmental considerations should be mainstreamed into national fiscal plans, with the promotion of green budgeting practices and green public procurement.

Investment in low-carbon activities would also benefit from a better assessment and disclosure of sustainability-related risks for investee companies and financial market participants. Physical risks originating from extreme weather events, such as floods, storms, wildfires and rising sea levels (Figure 1.27), generate losses which could reach up to 10% of global GDP in 2100 (OECD, 2015c), eroding collateral and asset values and increasing insurance liabilities. A second source of risk, transition risk, originates from policy actions and technological advancements linked to the process of adjustment towards a low-carbon economy, leading to stranded assets (high-carbon assets which need to be written off before the end of their economically useful life). The long useful lives of many assets (buildings, power plants or even, as discussed above, cars) underline the importance of ensuring that investments are consistent with carbon neutrality objectives.

The disclosure of sustainability-related risks is still at an early stage, but progress is being made. The Non-Financial Reporting Directive (NFRD) has required listed firms with more than 500 employees, including banks and insurance companies, to publish information since 2018 on their policies regarding environmental and social performance and due diligence. In 2019, the Commission issued non-binding guidelines on NFRD reporting of climate-related information, which integrate the best-practice recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) and include indicators based on the EU taxonomy. The 2020 ECB guide on climate-related and environmental risks (ECB, 2020b) expects banks, as a minimum, to follow those guidelines. Though improving, bank disclosures for 2019 were still far below these standards (ECB, 2020c). In 2022 the ECB will carry out a full supervisory review of banks’ practices in this domain. Recent months have seen further steps by the Commission to improve sustainability reporting, including draft legislation to review the NFRD (the proposal for a Corporate Sustainability Reporting Directive) and a delegated act to the EU taxonomy concerning disclosure of the proportion of environmentally sustainable (taxonomy-aligned) economic activities in the turnover, expenditure and financing and investment activities of financial and non-financial companies. These steps will make taxonomy-consistent reporting mandatory for an enlarged set of firms.

Granular and high-quality disclosures are required for stress-testing and the possible ensuing imposition of capital buffers (ESRB, 2016). The next ECB supervisory stress test, due in 2022, will also cover climate-related risks. This is welcome but challenging. It will first require an elaboration of the links between climate risks and financial stability. It will require as well the consideration of a longer time horizon (stress tests usually consider risks likely to materialise within only three to five years) and forward-looking scenario-based methodologies, rather than statistical analysis based on historical data (NGFS, 2018; Banque de France, 2019; BIS, 2019). The new monetary policy strategy of the ECB, discussed in the OECD Economic Survey of the Euro Area, envisages upgraded analytical tools to assess the impacts of climate change as part of a detailed roadmap of climate change-related actions until 2024.

At the same time, there is a need for further efforts to develop global standards for climate and environment-related disclosures. Initiatives like the International Platform on Sustainable Finance, a forum for dialogue now grouping the EU and 16 third countries, are helpful in this perspective. Recent years have witnessed a proliferation of disclosure frameworks, metrics and methodologies, posing risks of global fragmentation in sustainability reporting (OECD, 2020f). There remain important knowledge gaps to be narrowed in areas like sustainable finance taxonomies, with appropriate differentiation among “green” or “grey” activities, and methodologies for assessing financial impacts of environmental risks, especially in the long-run. Even if efforts initially focus on standards for disclosing the impact of climate and environmental risks on financial performance and financial stability, attention also needs to be paid to the impact of corporates on the environment, which may have a financial impact on companies over time.

Figure 1.27. Climate-related events are on the rise worldwide

Number of events

Improving resource efficiency by moving towards a circular economy

Moving to a more circular economy can reduce the consumption of raw materials and thus avoid a variety of major environmental impacts from their extraction and processing. These impacts relate to climate change, biodiversity, water and the health impacts of environmental pollution (OECD, 2012), and are set to worsen on current policy trends: by 2060, growing incomes and populations, especially in poorer countries, will drive a strong increase in the global demand for materials (Figure 1.28). By avoiding wasteful materials use, as well as by encouraging reuse, recycling and shared use, a circular economy will hence contribute to reaching a broad range of sustainable development goals (SDGs), including those on clean water, sustainable cities, responsible consumption and production, climate action, and protection of all life.

Figure 1.28. On current policies, global materials extraction is projected to strongly increase

Extraction of materials in gigatonnes (Gt)

In the EU, per-capita materials consumption embodied in final demand (the “materials footprint”) has tended to grow since 2000 (Figure 1.29, panel A). Materials use is lower than the materials footprint, reflecting materials extraction and processing in the production of imported goods (Figure 1.29, panel B). Non-metallic minerals, mostly used in construction, account for the bulk of raw materials use. Although the extraction and processing of these minerals pollutes less per ton than metals, they have important lifecycle environmental impacts (Wilts et al., 2014). For example, concrete generates high greenhouse gas emissions, which are difficult to reduce. It has significant impact on energy demand, soil acidification and land use (OECD, 2019c).

Figure 1.29. High materials use requires policy action to reduce environmental impact

The EU recycles more and landfills less household waste on average than the OECD area (Figure 1.29, panel C). Economy-wide it recycles 40% of end-of-life products. Extended producer responsibility schemes, which make producers of specific product groups collectively responsible for recycling and waste management, have been successful in increasing recycling (OECD, 2018). Even so, recycled materials only meet 12% of materials demand (European Environment Agency, 2019). Regulatory and business initiatives in EU member countries have focussed on waste management and recycling. Waste prevention by reinforcing action in early product stages, such as design, could yield bigger benefits.

To go beyond, the European Commission adopted two Circular Economy Action Plans, one in 2015 and another in 2020 (Box 1.7). This new plan is part of a broader policy strategy, which also includes the European Green Deal and objectives of industrial innovation and development. It announces new policy avenues, including resource-saving product design and leveraging digitalisation. In addition to plastics, it focusses on other value chains posing major sustainability challenges, such as construction, textiles and electronics.

Box 1.7. The 2020 EU Circular Economy Action Plan

Building on the earlier 2015 plan, the new Circular Economy Action Plan (European Commission, 2020k) envisages the following main strands:

Making products placed on the EU market increasingly sustainable by setting requirements for characteristics such as durability, reusability, reparability, recyclability and recycled content.
Ensuring that consumers have access to reliable information on products’ durability and reparability, notably through digital tools.
Pursuing sector-specific measures in value chains with a high potential for circularity, such as electronics and ICT, batteries and vehicles, packaging, plastics, textiles, construction and buildings, and food.
Reducing waste and transforming it into high-quality secondary raw materials for which there is a well-functioning market.

Taxation could improve incentives for resource efficiency

Taxes on materials can internalise environmental costs and provide incentives for circular economic activity (Bibas et al., 2021). Macroeconomic simulations (Chateau and Mavroeidi, 2020) indicate that taxes on primary raw materials use can increase employment in economies where resource extraction does not play a major role, especially if revenues are used to lower labour taxes. There could nonetheless be geographically concentrated job losses, due to lower demand for some skills. Therefore, policies would be needed to provide upskilling opportunities, including life-long learning, as well as regional policies to support structural change (Chapter 2).

Materials taxes are subject to political economy limitations and to design complexity. If taxes are not imposed by all countries, competitiveness losses may result in lower net employment. Taxes on the materials content of goods used for final consumption, including imports, could reduce competitiveness concerns but may be impracticable when the exact materials content of each product is unknown. Some practicable options would be to set minimum taxes on non-recycled construction materials (Wilts and O’Brien, 2019) or on unsustainable plastic use. The ensuing tax revenues could finance, for instance, a decrease in labour taxation. Construction is not subject to major relocation outside the EU. Denmark, Sweden and the UK have taxes on primary construction raw materials, which have lowered raw material use (Soderholm, 2011; Stahel, 2013). In addition, establishing an inventory of environmentally harmful subsidies in EU member states could reinforce policy action to remove them (OECD, 2019d). It should go beyond explicit fossil-fuel subsidies to include, for example, below-cost pricing or tax advantages in the use of environmentally sensitive goods and materials, such as irrigation water or company car use. Such taxes and phasing out of environmentally harmful subsidies could be part of a stronger implementation of the polluter pays principle, to more efficiently deliver environmental objectives.

The circular economy requires steps to lower information and transaction costs

Given the limitations in the use of corrective taxes, other instruments should be used to improve resource efficiency, like standards. If well designed, standards may also be a potential source of competitive advantage (Bundgaard et al., 2014). For example, they can encourage innovation and generate resource savings to downstream firms. By setting some standards for energy-related products, the EU Ecodesign Directive has generated environmental benefits. The EU Ecolabel yielded similar benefits as producers can voluntarily certify that their products meet environmental criteria such as xºrecycled material content. Such standards could be expanded for example to include requirements on durability or recyclability, which could boost circular economy business models and meet circular economy objectives (Bundgaard et al., 2014). The new Circular Economy Action Plan envisages steps along these lines, which is welcome (Box 1.7).

Steps to provide information on the durability of goods have substantial impact on consumer behaviour (Börkey and Laubinger, 2021) by overcoming market failures which prevent consumers and downstream firms from choosing higher-quality products. In the absence of product information, markets rely on reputation which depends on producer market power (Kreps, 1990). Providing information on the durability of goods requires developing a robust methodology (Börkey and Laubinger, 2021).

Digital technologies can reduce information and transaction costs and thereby encourage circular economy activities (Barteková and Börkey, 2021). For instance, a digital passport could provide information on a product’s origin, composition, repair and dismantling possibilities, and end-of-life handling (European Commission, 2019b, 2020k), along the lines of the recent proposal on a batteries digital passport. Digital codes and tags can trace materials and components across the value chain. Digital technologies also foster innovative circular economy business models. For example, real-time on-demand ride sharing coordinated by a digital platform (combined with other technologies, such as artificial intelligence and machine learning tools) can meet daily mobility needs provided by cars, lowering the number of vehicles in cities by close to 90%, improving connectivity and reducing pollution (ITF, 2018), provided shared rides fully replace individual car use. The European Commission could promote a pilot to introduce digital-based ride sharing.

MAIN FINDINGS	RECOMMENDATIONS (key in bold)
Supporting the recovery and increasing growth potential
Fostering investment to enable the green and digital transitions
Preparations for the EU recovery plan have taken about one year. National recovery plans combining investment and structural reforms should speed up the recovery from the crisis, but also increase growth potential in the EU, which requires careful project selection..	Swiftly implement national recovery and resilience plans to deliver structural reforms and investments based on sound cost-benefit analysis.
Public investment has been weak over the past decade and achieving climate neutrality will require massive investment, with important scope for coordination at EU level and between public and private sectors.	Invest in European interconnections, such as in electricity grids and smart recharging infrastructure for transport electrification.
Investment in digital infrastructure and energy often faces cumbersome licensing.	Remove barriers to private investment for the climate and digital transitions by simplifying licensing procedures.
Increasing resilience to health threats
The COVID-19 pandemic exposed gaps in preparedness to deal with cross-border health threats and in the ability to quickly mobilise substantial funding for medical research. Procedures have generally been slow and bureaucratic.	Set up an autonomous agency to fund and coordinate public and private responses to health threats, including in R&D.
Making migration policies more supportive to growth
The European Blue Card programme attracts fewer high-skilled workers than similar schemes at the member states level. This reduces the attractiveness of Europe and mobility between countries.	Ease access to the Blue Card for workers already benefitting from similar national schemes.
Cooperation with origin and transit countries to curb illegal immigration and facilitate return and readmission has often proved ineffective.	Promote partnerships for vocational training in countries of origin, addressing skill shortages in the EU and including provisions to facilitate the return of migrants after working for a period in Europe.
Stepping up the fight against corruption
Corruption and fraud lower economic growth, weaken institutions and worsen the quality of public spending, including that funded by the EU budget. Most relevant policy levers are controlled at national level.	Step up national efforts to fight corruption and fraud, notably through full and timely transposition of relevant Directives and stronger cooperation with dedicated EU bodies. Enforce the suspension of payments from the EU budget or other measures in case of relevant breaches of the rule of law. Assess in due time the effectiveness of the measures adopted and consider tightening this conditionality if needed.
Despite successive directives, the EU is still vulnerable to money laundering. Draft legislation to tackle this vulnerability was presented in July 2021.	Set up an independent EU direct anti-money laundering supervisor and increase cooperation between national authorities.
Protection to whistleblowers varies widely across EU member states. A 2019 EU Directive increases protection to people reporting breaches of EU law and harmonises protection across countries.	Ensure full and timely transposition of this Directive into national legislation and increase whistleblower protection also in cases of breaches of national law.
Achieving climate neutrality and moving towards a circular economy
The EU Emissions Trading System (ETS) covers around 40% of total EU greenhouse gases emissions. Transport accounts for more than 20% of EU emissions, and abatement has proved particularly difficult. Buildings account for 40% of energy consumption and significant resource use. In July 2021, the European Commission proposed to include shipping emissions in the ETS and to set a new, separate ETS for road transport and buildings.	Consider increasing the EU Emissions Trading System coverage, by for instance including transport and buildings. Strengthen regulatory standards for energy efficiency.
Investment in low-carbon activities would benefit from further progress in the assessment and disclosure of climate-related risks for companies and financial markets. Recent draft legislation envisages more informative disclosures by a wider set of firms.	Require comprehensive disclosure of climate and environment-related risks by financial intermediaries and large non-financial firms. Further engage in international cooperation to set global standards for such disclosures.
Taxes on primary materials and on unsustainable practices provide incentives to reduce natural resource consumption and associated environmental impacts	Take steps towards the pricing of natural resource use and environmental impacts, for example by introducing a harmonised tax on non-recycled construction materials or on unsustainable use of plastic.
Missing information on used materials and product characteristics hold back the capacity of markets to recycle and use goods for longer. Digital technologies can reduce information and transaction costs and encourage innovative business models.	Introduce requirements for the use of digital tools to provide information on products, including on their recycling and repair possibilities. Conduct pilot projects to introduce innovative circular economy business models, such as digital-based ride sharing.
MAIN FINDINGS	RECOMMENDATIONS (key in bold)
Despite their environmental requirements, direct payments to farmers under the Common Agricultural Policy have so far been largely ineffective to reduce emissions. In 2021-27, implementation by countries of a new tool (eco-schemes) has the potential to address this ineffectiveness. Payments coupled to the production of specific commodities have been linked to higher emissions.	Phase out payments to farmers coupled to the production of specific commodities, Set a stronger link between direct payments to farmers and improved environmental outcomes, including reduced animal methane emissions.
Effective carbon tax rates on non-road energy use, such as on fuels for heating or agriculture, are often too low. The proposed revision of the Energy Taxation Directive aims to phase out some tax exemptions and reductions on energy use.	Eliminate tax exemptions and reductions which subsidise fossil fuel use or other environmentally harmful subsidies.
Higher carbon prices in Europe may shift carbon-intensive production to jurisdictions with lower prices, which causes carbon leakage and may harm some regions disproportionately. To tackle carbon leakage, a carbon border adjustment mechanism was proposed in July 2021.	Within World Trade Organisation rules, consider possible measures to prevent carbon leakage.
Information on the durability of goods can have substantial impact on consumer behaviour and thus contribute to less use of materials.	Develop a methodology for providing information on durability for selected products and integrate it in the Ecodesign Directive.

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Annex 1.A. Progress in main structural reforms

MAIN RECOMMENDATIONS	ACTION TAKEN SINCE THE PREVIOUS SURVEY (2018)
Reforming the EU budget to foster more inclusive growth
Consider enhancing the efficiency of spending and increasing revenues, and reassess how the European budget is financed.	For the 2021-27 period, some reforms to EU budget revenues have already been introduced, such as a new national contribution based on non-recycled plastic packaging waste and a simplification of the VAT-based own resource. Moreover, to contribute to the repayment of Next Generation EU borrowing, new own resources will be introduced: The Commission has committed to put forward proposals on a carbon border adjustment mechanism and on a digital levy. The Commission will also propose an own resource based on the Emissions Trading System. In addition, the Commission will propose further new own resources, which could include a Financial Transaction Tax and a financial contribution linked to the corporate sector or a new common corporate tax base.
Phase out production-based payments in the Common Agricultural Policy.	After strong increases over 2014-18, expenditure on production-based payments broadly stabilised in 2019.
Increase research and development (R&D) spending.	In 2021-27, Horizon Europe’s budget (EUR 84.9 billion at 2018 prices, including a top-up from Next Generation EU) is 9% larger than the initial budget of Horizon 2020 (its predecessor in 2014-20) and 30% larger than Horizon 2020’s budget adjusted for subsequent reductions in resources and for the expenditure allocated to the UK. The 2020 European Research Area Communication: a) proposed to re-affirm the 3% of GDP EU R&D investment target; b) proposed a new EU 1.25% of GDP public effort target to be achieved by Member States by 2030; c) prompted further cooperation among Member states by setting a target of 5% of national public funding to joint research and development programmes and European partnerships, by 2030; and d) proposed that Member States lagging behind the EU average R&D investment over GDP direct their investment efforts to increase their total investment in R&D by 50% in the next 5 years.
Reducing regional divides by making cohesion policy more effective
Prioritise cohesion funding to less developed regions.	In 2021-27, less developed regions will continue to receive 75% of total cohesion funding, as in 2014-2020. Their share under the Jobs and Growth goal of the European Regional Development Fund and the European Social Fund Plus will increase, but the Cohesion Fund, for which only the poorest Member States are eligible, will become smaller.
Better target cohesion funding on spending with long-term growth benefits(human capital, innovation and network infrastructure), and to projects with clear spillovers across borders.	The eleven thematic objectives used in 2014-2020 have been simplified to five policy objectives in 2021-27 : 1. a more competitive and smarter Europe by promoting innovative and smart economic transformation and regional ICT connectivity. 2. a greener, low-carbon transitioning towards a net zero carbon economy and resilient Europe by promoting clean and fair energy transition, green and blue investment, the circular economy, climate change mitigation and adaptation, risk prevention and management, and sustainable urban mobility. 3. a more connected Europe by enhancing mobility. 4. a more social and inclusive Europe implementing the European Pillar of Social Rights. 5. a Europe closer to citizens by fostering the sustainable and integrated development of all types of territories and local initiatives. To ensure further targeting of cohesion policy on Union priorities, most European Regional Development Fund resources (from 55 to 85%, depending on countries and regions) is proposed to be concentrated on the first two policy objectives above.

MAIN RECOMMENDATIONS	ACTION TAKEN SINCE THE PREVIOUS SURVEY (2018)
Consider increasing national co-financing rates to encourage better project selection taking into account the relative impact of the project and the EU added value.	Only limited adjustments to national co-financing rates have been made for the 2021-27 period relative to 2014-20, notably taking account of the post-pandemic context.
Create a “single rule book” for EU funding programmes.Use e-government and e-procurement more often.	There has been progress towards a single rule book, as a common Regulation for 8 shared management funds has been agreed upon. Moreover, the proposed legal framework is significantly simpler in comparison with the 2014-20 period, rationalising overlaps and repetitions and significantly decreasing the number of secondary legislation acts. In the implementation of 2021-27 cohesion policy electronic data exchange will be further developed, which will inter alia ease auditing. In the context of the Public Procurement Action Plan prepared by the Commission, some Member States have prepared national strategies aimed at improving their e-procurement practices, and a Pilot Project developed by the Commission in cooperation with the OECD helped Slovakia and Bulgaria to improve administrative capacity in public procurement.
Leveraging the single market to improve long-term growth and living standards
Simplify administrative formalities for the establishment and provision of cross-border services, and provide guidance on implementing EU legislation.	Over 2019-20, the Commission has stepped up enforcement efforts to ensure that the Member States correctly transpose and apply the Professional Qualifications Directive. Furthermore, the Commission has systematically pursued infringement actions with regard to the implementation of the Services Directive and the Treaty provisions on freedom of establishment and freedom to provide services. Areas of concern include disproportionate and excessive document requirements and the lack of electronic channels for recognition procedures. The Single Digital Gateway, operational from end-2020, will help in both these areas.
Pursue the planned cross-border co-operation on power system operation and trade, including interconnection capacity calculations and reserve margins.	The Electricity Market Regulation (2019/943/EU) stipulates that, as from 1 January 2020, at least 70% of cross-border interconnection capacity should be made available to the market for trade. While a number of options allow for gradual implementation, this target should be fully achieved by end-2025 at the latest. The Regulation also contains provisions for strengthening cooperation among distribution system operators and mandates the creation of Regional Coordination Centres for transmission system operation.
Develop tools to help member states monitor digital skill needs. Set EU standards for the monitoring of digital skills and task content of occupations.	Cedefop, an EU agency for vocational education and training, has been piloting the use of big data analysis to examine the skills demanded by employers in real-time, including at sectoral and regional level. Although this work covers all skills demand, digital skills needs clearly emerge among them. At a sectoral level, the Blueprint for Sectoral Cooperation on Skills,an initiative launched under the 2016 Skills Agenda for Europe, brings together partnerships within a specific industrial sector to build and deliver a sectoral skills strategy for growth. Digital skills needs are a transversal element in all the Blueprint sectoral projects. The first five projects were launched in 2018, and there have been 3 further rounds since then, covering 21 sectors in total. The Digital Economy and Society Index (DESI) monitors Europe’s overall digital performance and tracks the progress of EU countries in their digital competitiveness. In particular, the human capital dimension of DESI monitors digital inclusion and skills, drawing on the European Commission's Digital Skills Indicator, which is computed based on the number and complexity of activities involving the use of digital devices and/or the internet. The Digital Skills Indicator has been recently reviewed. On-going reviews of social statistics (such as the EU Adult Education Survey or the EU Labour Force Survey) include proposals to collect additional information related to digital skills.

MAIN RECOMMENDATIONS		ACTION TAKEN SINCE THE PREVIOUS SURVEY (2018)
Eliminating barriers to people working and supporting intra-EU mobility
Increase spending on mobility programmes such as Erasmus+, and facilitate access irrespective of socio-economic background.	Funding for the Erasmus+ programme will increase by about 50% in 2021-27 (at constant prices, relative to 2014-20), with expanded learning and training mobility opportunities, including for low-skilled adults.
Foster the harmonisation of professions’ curricula at the EU level	The revised Directive on recognition of professional qualifications (2005/36/EC as revised by 2013/55/EU) has introduced the possibility to set up "common training frameworks" and "common training tests", which are voluntary frameworks for the automatic recognition of qualifications of specific professions or activities. The Commission has adopted a Common Training Test for ski instructors in 2019 (Delegated Regulation (EU) 2019/907 of 14 March 2019). Directive 2013/55/EU also provided delegated powers to the Commission to update certain minimum training requirements for professions that fall under the automatic recognition regime. In 2018, the Commission launched a study on training requirements for the profession of general care nurse. The Commission also started work to assess the necessity to update training requirements for the professions of pharmacist and dentist.
Make the electronic European professional card available to all sectors.	No action taken.
Step up efforts at the EU level to coordinate the design and organisation of joint cross-border labour and tax control activities.	The European Labour Authority (ELA) was established in 2019 and is expected to reach full operational capacity in 2024. It aims at facilitating access to information and its cross-border exchange, support cooperation between EU countries and capacity building in the enforcement of relevant Union law, and mediate disputes between national authorities. ELA is currently preparing the ground for the kick-off of joint and concerted inspections within the EU (including in the cross-border regions).
Better protecting EU citizens in the face of change
Revise application requirements and procedures to speed the use of the European Globalisation Adjustment Fund (EGF) and expand eligibility to workers affected by other shocks, such as automation.	Draft legislation proposes to broaden the scope of the EGF, which would make it more inclusive and more responsive to economic developments such as automation, digitization and the transition to a low-carbon economy. The proposal also envisages a streamlined mobilization procedure, which would allow for quicker deployment of the fund.

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