Bonds issued by the European Union (EU); while it would have seemed inconceivable before the corona pandemic, the European Commission now plans to give the European economy the kick-start it needs. If the package gains approval, it will of course be unprecedented. And perhaps it is just as interesting to look at what the funds will eventually be spent on and how they are to be repaid.
The "Next Generation EU" package, running to €750 billion, will be used for investing in a green, digital and resilient EU. As a comparison, the European "Green Deal", which was presented in November 2019 and was to extend over a decade, was a €1,000 billion package. Next Generation EU will pull in €750 billion between 2021 and 2024 and use it to invest in a green and digital Europe. Another way to look at this is as an acceleration of the European Green Deal's implementation, aimed at investing in innovation in the fields of sustainability and digitalisation.
The proposal still has to be approved and this seems to present a real challenge. For instance, the "frugal four" (Netherlands, Sweden, Germany and Austria) have some objections to the issue of a European bond. The less credit-worthy countries (in the south) will benefit from this and the "frugal four" are among those who will not. But even the clique of southern countries, such as Greece, Spain and Italy, will not be too happy with the plan as it stands. This is because of the significant conditions attached to the support package and the investments, which have always proved to be a thorny problem in the past. It is hard to imagine an agreement being reached without a struggle.
If the support package is approved, it will be interesting to see where its impact will be felt. To take advantage of this, investors will really want to know what the support package will look like and which sectors, countries and businesses will benefit from it or, in fact, suffer at its hands.
The support package
Source: European Commission
The bulk of the €750 billion that is to be pulled in (€560 billion) will be used for recovery and resilience. This amount will be spent on financial support for investments and reformation, partly related to the green and digital transitions of national economies. The proposed key for dividing up this package comprises three elements:
- Gross Domestic Product (GDP);
- GDP per capita; and
- average unemployment between 2015 and 2019.
The impact of the corona pandemic was not, apparently, taken into account when this distribution was being worked out. It is assumed that where an economy is already weak, it will be seriously impacted by corona and unable to scramble back to its feet without support.
Some of the package will be used for stimulating private investment, with the EU playing its part. The EU will take on board a small proportion of the risk so that private players can contribute the remainder of the demand for funds. The aim includes, for instance, guaranteeing the solvency of fundamentally profitable businesses during the corona crisis. The EU's investment vehicle "InvestEU" will also be topped up by €15 billion so that it can do a similar job for green investments.
The final element of the support package will be used to implement any lessons learned from the crisis and may include a budget to prepare for any future crisis, although it will also include funds for research and healthcare as well as the green and digital transition.
The method of attracting the funds needed for this emergency package via the capital markets is not the only new and unprecedented aspect. The repayment method for the loans is also novel. The European Commission is proposing to repay the funds through four different avenues:
- an extension of the current emissions trading system to the maritime and aviation sectors;
- a CO2 threshold mechanism;
- a Digi Tax (targeted at the likes of Facebook and Google);
- a plan, not quite so full worked out yet, in terms of which the EU itself might collect taxes over and above the tax regime in the country where the products are sold.
Prolongation of the emissions trading scheme and extension to the aviation and maritime sectors (annual income: €10 billion).
Taxation on businesses profiting from a single European market, with the possibility for taxes over and above the tax regimes of individual countries (annual income: €10 billion).
CO2 threshold scheme: tax on CO2 prices in production countries on the import of goods (annual income: between €5 and €14 billion).
Digi Tax for businesses with global revenue in excess of €750 billion (annual income: €1.3 billion).
While the EU had already announced some support measures for the corona crisis, this is the plan that is most striking in terms of its size and its focus on digitalisation and greening. The solutions for the repayments are also entirely commensurate with what the European Commission wants to achieve with this support package; there is an element of positive stimulus accompanied by the introduction of sanctions.
Where is the upside?
If we consider the aspect of recovery and resilience, there are a number of countries that will derive a disproportionate benefit from the support package. What the "frugal four" are worried about seems to be a natural result of the criteria outlined above. The European Commission estimates that Italy, Spain and Poland will benefit most from the recovery and resilience mechanism.
Figures have not yet been announced officially, but EU Commissioner Paulo Gentiloni has named the top three countries that will receive most aid. From the €560 billion, €127.7 billion will go to Italy, €140.4 billion to Spain and €63.8 billion to Poland. The support for these three countries will instantly soak up half of the total recovery and resilience facility. The "frugal four" are missed out on here, because they are doing too well compared to other European countries; it is felt that they can look after themselves.
One concrete example is the unemployment rate in 2019 and the difference between the Netherlands and Spain. The Netherlands reported an unemployment rate of 3.4% compared to Spain, where the rate stood at 14.1%. Spain, Italy and Poland will gain disproportionately from the support package. This means it is possible that the stock exchanges in those countries will generally also start seeing benefits from this support package, but the businesses to keep an eye on will specifically be those focussing on digitalisation and greening.
The Netherlands as one of the “frugal four” is (largely) excluded. The emphasis within the support package is therefore on building the resilience of EU member states. If we would look at achieving the climate targets and digitization, the Netherlands would take a different position within the EU. The Netherlands is at the top in Europe in the field of digitization and the Netherlands is one of the countries that seem to meet the 2020 targets on climate.
Although the Netherlands is on track to meet the European targets for reducing greenhouse gas emissions and energy consumption (provided the current course is maintained), the European Energy Agency states that the Netherlands will not achieve its renewable energy target in 2020. Despite this critical note by the European Energy Agency regarding the renewable energy targets, the Netherlands is therefore relatively good positioned when it comes to digitization and the reduction of greenhouse gas emissions. The Netherlands will therefore hardly qualify for the support package. The Dutch economy in general and Dutch investors in particular will have to focus more on the investment vehicle that is now being introduced by the EU and not on any financial support through the recovery and resilience facility from the Next Generation EU.
The remainder of the Next Generation EU money will work out well for those businesses already in sectors involved in mitigating climate change and that are prepared to anticipate the situation. Consider, for instance, the wave of renovation included in the "Green Deal", where insulation firms will profit from investments in greening of existing buildings and from the requirements that are to be imposed for construction. Greening is also required for infrastructure. Other obvious sectors include manufacturers of solar panels, wind turbines and managers or manufacturers of electrically powered cars. There will also be an emphasis on digitalisation throughout Europe, including for instance a rapid roll-out of the 5G networks across the entire Union; businesses already regarded as front-runners in the extension of 5G will be in a position to benefit from the package. Much of the upside in this sector has already been factored into prices, or the market will quickly accomplish this. Certainly if we look to the price movements of the green vanguard, where we can now barely see any impact on stock values as a result of the corona crisis. This phenomenon has been developing for some time now. The graph below shows that an index made up exclusively of clean tech businesses has done significantly better than the global, general index. It therefore looks like the market has already anticipated a government stimulus for these firms and the impact of such a stimulus on profitability.
Indexed stock price history for Clean Tech
It will be even more interesting for those businesses operating in industries that are unable to adapt quickly enough to the energy transition. Businesses that are slowly but surely taking steps towards greening of their production methods or product offer might be able to take advantage of the package and take much larger steps with the extra capital they have available.
However, it is unlikely that the EU will invest in the greening of these sectors. That said, an acceleration of greening would be particularly interesting in these lagging sectors. Why? If the sectors that are lagging start to speed up their greening efforts, this will have a bigger impact on the climate than if increasingly more money is consistently pushed into existing green industries. The point here is when we will reach the peak of CO2 emissions. If the "dirty" industries clean up their act faster, there will be more time for a transition than if we wait for a peak, a point when there has to be an overnight halt to further CO2 emissions in order to make sure that we achieve the 2 degree scenario.
The later emissions peak, the harder it is to limit warming below 2°C
One good example is the oil sector, often regarded as lagging behind and more likely to be causing than mitigating climate change. The front-runners in the provision of liquid natural gas (LNG) form an interesting sub-group in this sector. This is because the European Union's greening strategy can allow for increased use of this gas, leading to an accelerated transition. The International Energy Agency (IEA) indicates that LNG can play an important part in the reduction of CO2 emissions by swapping coal-fired power stations for gas-powered generation.
This has already led to significant reductions in CO2 emissions between 2010 and 2018. Also, the LNG infrastructure can also be used for hydrogen, the Holy Grail of climate demand. Examples of front-runners in LNG include Koninklijke Vopak and Total. These companies are adaptive in a less adaptive industry. We can obviously see that there are other companies moving towards LNG although at the same time still retaining considerable stakes in coal or oil. These businesses are fairly unlikely to benefit from the EU investments, since the entire stimulus plan is closely intertwined with sustainability and businesses' other activities will also be considered before any investment is made in them.
CO2 savings through the shift from coal-fired to gas-fired power stations, by regions, from 2010 to 2019
Source: IEA. All rights reserved.
Where is the downside?
The bitter often comes after the sweet, and that is certainly the case with Next Generation EU. The support package will be used between 2021 and 2024 and repaid from future EU budgets between 2027 and 2058. These repayments will come from new revenue, as proposed by the European Commission in the Next Generation EU plan. While the plan contains 3 proposals for extra taxes on emissions, one specific proposal seems to be aimed at the likes of Apple, Facebook and Google.
This is a Digi Tax on companies with a turnover exceeding €750 million, where at least €50 million of this comes from the EU. This Digi Tax is designed to pull in €1.3 billion per annum for the purpose of repaying the bonds. A previous version of the plan (see table below) suggested that €5 billion could be raised from the Digi Tax, applying a tax rate of 5% on turnover. It seems that a less stringent variant has been chosen for the Next Generation EU plan.
Source: European Commission, own calculations based on data from UNCTAD (2017b), SimilarWeb and Bureau van Dijk Orbis database. Note: Estimates are based on a set of 112 global multinationals, including the top 100 digital multinationals identified in UNCTAD (2017b) with revenue in excess of $ 1 billion in 2015.
As well as large internet companies, a number of sectors also appear to receive a double hit. The aviation sector, which has been brought to its knees by the corona pandemic, will also be impacted, over and above the current crisis. Reason is that the current emissions trading system is being extended to aviation and the maritime sector (these sectors make up around 2.5% of the European index). Companies such as Airbus or TUI will suffer a double hit through the lack of demand for aircraft and flights as well as the associated extra tax on CO2 emissions, because greening of the fleet is not expected anytime soon. Needless to say, the same will apply to cruise liner operators such as Carnival. Replacing these ships will also have to remain on the back burner, meaning that extra payments will also eventually be due for emissions (on top of the loss of revenue).
We could mention further examples of businesses that will be harmed by the bill for Next Generation EU. Businesses that depend on importing goods from other regions or exporting goods to Europe might see extra taxes being charged on these imports and exports if they originate in an area where there is no CO2 price (as things stand, that effectively amounts to the rest of the world). The accelerated transition embarked upon by the EU will also affect companies that are lagging behind in terms of greening or sectors that will not be included in the support package, even though the demand for their products is affected. Mining companies, like Glencore, whose business is extracting coal will be hit by both the EU's accelerated greening strategy (through extra taxation and diminishing demand for their products) and the lack of any extra support due to the package's conditions.
The European Commission is living up to the motto "never waste a good crisis", now requiring the ambitious climate objectives that had previously been included in the Green Deal to be achieved sooner. At the same time, investments within the European budget will now be made faster than over the past decade. If we take a look at the impact this will have on individual countries, it is those on the periphery of the EU and Poland that will derive the greatest benefit from the recovery and resilience package. The money that is pulled in will benefit the economies of those countries to a disproportionate extent. Investments in sustainability and digitalisation will benefit the front-runners in greening (Orsted, Vestas or Rockwool), but will also benefit companies doing well in non-adaptive sectors if they are looking into sustainability within those sectors (Total, Vopak or Neste). Businesses that will undoubtedly have to start making a contribution are those such as Facebook, Google and Apple, which will be hit hard by a Digi Tax as part of the package. All of this is of extra importance with passively managed investment products. In the long run, the sustainability scheme of Next Generation EU will impact the most adaptive companies. However, also the non-adaptive ones will be influenced and the effects created as a consequence will also offer opportunities for investors. At the same time, for example, excluding non-adaptive businesses through the accelerated introduction of this policy will enhance the risk mitigation within the investment portfolio, while investment in the broader market will still be safeguarded.