Environmental Social Governance European construction: Green shoots of growth?

Construction activity in Europe is poised for a gradual recovery at a time when evolving European Union (EU) policies could boost demand for locally produced low-carbon steel and cement. Here, we lay out three key considerations when investing in European cement and steel industries.

1. Optimism is cautiously building

Europe’s construction output had its worst two years since the pandemic, but expectations for infrastructure spending are driving hopes for a gradual upturn over coming years.¹ Germany is leading the region with a 12-year, €500 billion infrastructure fund for investing in transport infrastructure, climate change, digitalization and energy infrastructure, among other key areas.² The whole region’s infrastructure requires significant modernization and upgrades. For example, the EU has estimated that €1.2 trillion in grid investments is needed to modernize its electricity grids.

This bodes well for the demand outlook for essential building materials, such as cement and steel. In the EU, more than one-third of cement is used in civil engineering.³ Similarly, construction is the largest consumer of steel in the region, taking up over one-third of steel demand.⁴

Electrification is also a driver of cement and steel demand. Many steel products are essential for building renewable energy systems, such as advanced stainless steel for solar panels. And a wind turbine is comprised of between 84% and 90% iron and steel materials, according to the World Steel Association.⁵

Cement and steel demand may also increase from the rearmament drive in the region, from building barracks to producing weapons. 

2. EU climate and industrial policies are influencing the outlook

The built environment is one of the largest contributors to global emissions.⁶ Many European governments have implemented policies to tighten energy efficiency requirements, to support production of low-carbon building materials and to create a market for these materials.

These policies and regulations create both risks and opportunities for a wide range of companies — including those offering products that improve energy efficiency, innovators in manufactured housing and firms that are developing low-carbon building materials.

The EU has been a global leader in climate policy. Its 2050 climate target anchors the region’s decarbonization pathway. Meanwhile, economic competitiveness has emerged as a key issue, underlining the importance of pragmatism in climate policies.

Take the EU Emissions Trading System (ETS). The centerpiece of the region’s climate policy, the ETS sets a limit on greenhouse gas (GHG) emissions for certain high-emission sectors. It also requires firms to purchase “allowances” (one allowance is the right to emit one tonne of CO₂ equivalent) to cover their emissions. The limit is reduced annually in line with the EU’s climate target, and allowances can be traded or stored for future use. 

Sectors deemed at higher risk of losing production to countries with weaker emissions regulations, such as steel and cement, have received free allowances. But these free allowances are getting gradually phased out starting this year, as the EU has launched the Carbon Border Adjustment Mechanism (CBAM) which requires importers to pay the same carbon prices as EU producers, effectively creating a level playing field.

Some European countries have called to scrap the ETS or limit the steep rise in carbon prices amid energy market volatility in recent months, fearing that carbon costs will damage their competitiveness. Rather than moving away from its flagship policy, in response, the EU is in the process of making adjustments to protect the most vulnerable industries, such as mitigating carbon price spikes. Meanwhile, the EU has launched industrial and trade policies that aim to simultaneously address multiple strategic priorities, including economic competitiveness and decarbonization. The recently proposed Industrial Accelerator Act, for example, would introduce “Made in EU” and low-carbon requirements in public procurement, as well as measures to streamline and speed up permitting. Policymakers have also agreed on a significant reduction of import quotas and higher duties for imports exceeding those quotas. See a list of key policies below.

“We have seen the EU take small steps to help EU producers, by imposing import duties on steel and carbon taxes on imports of steel, cement and other materials,” says Wahid Butt, equity investment analyst. 

3. Decarbonization trailblazers may build longer term advantage

Iron and steel production account for about 8% of global GHG emissions, and cement and concrete production adds another 6%.⁷ Given the sheer volume of cement and steel consumption, decarbonizing their production at scale could significantly reduce global emissions.

Potential approaches to decarbonizing production include replacing fossil fuels with lower or zero-emission fuels, energy and material efficiency measures, carbon capture, as well as entirely new manufacturing processes. Commercializing these technologies requires significant investment. 

There has been progress. The world’s first commercially available carbon captured near-zero cement was produced last year in Europe from a plant equipped with carbon capture.⁸ Early-stage demand for its output has been strong. Several other cement projects with carbon capture are also under development. 

Speculation on the weakening of EU ETS has hurt sentiment on European cement stocks in recent months. But some of our investment team think the market may be overreacting, after EU leaders reaffirmed their commitment to the ETS, which underpins rising carbon prices over time. “With reduced free allowances, higher carbon prices will take up a larger share of total production costs and drive a steepening of the cost curve,” said Anna Zandi, equity investment analyst. “Combined with CBAM, this scenario will underpin the cement industry’s pricing power and drive consolidation as the dirtiest plants exit. Decarbonization leaders will likely benefit from both the structurally improved market and their relatively low costs.”

In contrast, decarbonization progress in steel is nascent. There is no commercially viable near-zero-emission steel today, and demand for lower emissions steel is muted. Carbon capture, green hydrogen and other innovative solutions hold promise, but it’s early days. And, unlike European cement producers who have gained pricing power in recent years through capex discipline in a highly localized market, European steelmakers have faced weak demand as well as threats from chronic global overcapacity and reliance on imports. Unsurprisingly, some steelmakers have delayed or paused green steel projects, citing policy uncertainties and high costs.

Without higher carbon prices, capital allocation to green steel initiatives will remain less attractive. However, lower emission alternatives are available commercially, such as electric arc furnaces (EAFs). Policies supporting local industries as well as their decarbonization efforts, such as those discouraging steel imports and creating demand for low-carbon steel, could help turn the tide. 

Final thoughts

Heightened geopolitical uncertainties, volatile energy markets and growing macroeconomic uncertainty may lead to some softening of EU’s emissions regulations. This may well reduce near-term incentives for the region’s cement and steel producers to prioritize decarbonization. For long-term investors, however, the linked goals of energy security, industrial competitiveness and emissions reductions mean that the companies with a thoughtful approach to decarbonization early on may build a longer term competitive advantage.