Climate ambitions are running into macroeconomic headwinds in the European Union and the United Kingdom.

Speaking in late May, French Minister of the Economy Bruno Le Maire adamantly rejected the idea that France’s transition to a net-zero economy should be financed by issuing more debt. Then, just days later, Rachel Reeves, the UK’s shadow chancellor, backtracked from an earlier campaign pledge to borrow 28 billion euros ($35 billion) per year to finance climate investments. She now promises that, if elected, a Labour government would be fiscally “responsible,” increasing the country’s green investments only gradually. And in Germany, a draft law promoted by Vice Chancellor Robert Habeck of the Greens was watered down after Finance Minister Christian Lindner of the Free Democrats came out against a previously agreed ban on new gas boilers in homes.

It is no accident that climate commitments are beginning to feature prominently in the broader macroeconomic debate. Massive investments are needed to reduce greenhouse-gas emissions -- to the tune of 2 percent of GDP annually in countries that are serious about reaching climate neutrality by 2050 -- and anywhere from one-third to one-half of the outlay (depending on the country) will need to be financed by public budgets.

This was not a major concern when interest rates were low or negative. But now that borrowing costs have risen, a sense of economic uncertainty prevails. Fiscal hawks are on the offensive, and advocates of climate investment are increasingly engaged in a rearguard fight to maintain their earlier momentum.

So far, this issue has been avoided in debates about reforming the EU’s fiscal framework. Those debates are already complex enough, which is why neither the European Commission’s legislative proposals nor the latest reform orientations by the EU’s finance ministers make much mention of climate investment and how to finance it. And yet, with the EU having already committed itself to reducing emissions significantly by 2030, the question of whether climate action should take priority over debt reduction obviously cannot be ignored.

The answer is easy for countries where fiscal sustainability is in doubt. Obviously, a government that lacks fiscal space should not jeopardize its solvency in the name of climate action. Rather, it should first restructure its public spending or receive assistance from the EU. But most advanced economies do not fall into this category. They enjoy at least some fiscal space, and there is a growing need for guidance on how it should be used.

The backpedaling from previous commitments reveals a lack of systematic reflection on the pros and cons of relying on either taxes or debt to finance climate investments. To the extent that such investments end up paying for themselves (through lower operating costs or a better overall environment), the case for debt financing remains strong, even under tighter financial conditions. For example, a heat pump may entail high upfront costs, but it eventually will result in a lower fossil-fuel bill and cleaner air, not to mention the positive impact on emissions. And the same goes for replacing internal-combustion-engine vehicles with electric ones.

But the tax receipts needed to service new debt will not be generated automatically. Converting a potential benefit into an actual revenue flow requires either an explicit decision to tax or the creation of a dedicated financing scheme. In practice, the future savings from climate action should be earmarked in a way that provides for repayment of the debt incurred to finance the upfront investments.

This approach should be quite easy to implement in the case of, say, renovating public buildings for improved efficiency. To be sure, financial institutions could substitute for local governments in the financing of renovation works and receive repayment later from the savings on heating bills. Yet this would be financially costly, if not absurd. In all countries but those with unsustainable debt, governments remain the benchmark borrowers, and thus pay less on their liabilities than private investors. Rather than committing to paying more in present-value terms, thereby eroding their solvency, governments should issue debt and service it by drawing on future savings on their heating costs.

A more difficult challenge is to minimize the cost of renovating housing, which constitutes the bulk of Europe’s transition cost. Some 70 percent of EU households own their homes (a proportion that reaches 90 percent in Romania or Slovakia). While private sources can help provide adequate channels for financing, thereby avoiding direct involvement by governments, the cost of such schemes is likely to be high for individual households. Private finance is simply not effective in dealing with small-scale investment, especially when borrowers are low-income or middle-class households and the private return on investment is meager. In such cases -- the majority in EU countries -- the reluctance to involve governments could lead to costly detours.

While there is no one-size-fits-all solution, a strong case can be made for financing part of the required climate investment by issuing public debt. Some climate investments are private in nature, and some are inherently public. Those in between can either be privately financed or supported by public budgets, but cost reduction should be the guiding principle.

Over half of EU countries had debt-to-GDP ratios above 60 percent at the end of 2022, and these governments are facing contradictory demands both to invest in emissions reductions and to lower their debt ratios. The EU cannot keep ignoring this policy dissonance, nor can it expect member states to solve the problem by themselves. Europe urgently needs to have a serious discussion about the role of debt financing in meeting its climate commitments.

By Jean Pisani-Ferry

Jean Pisani-Ferry, a senior fellow at the Brussels-based think tank Bruegel and a senior non-resident fellow at the Peterson Institute for International Economics, holds the Tommaso Padoa-Schioppa chair at the European University Institute. -- Ed.

(Project Syndicate)