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POLICYBRIEF ISSUE 2 | JULY 2020 GREENING THE RECOVERY BY GREENING THE FISCAL CONSOLIDATION

Ben McWilliams THE ISSUE Research Assistant at The long road to economic recovery from the COVID-19 shock is just beginning. European Bruegel countries are considering how best to reboot their economies, with fiscal stimulus plans at the core of the consideration. Meanwhile, the European Commission has put forward its Simone Tagliapietra own stimulus plan. These stimulus packages will amount to several percentage points of Research Fellow at GDP, and can therefore influence the future orientation of the economic system. For this Bruegel reason, policymakers aim to incorporate long-term goals into recovery packages, most fundamentally a just transition towards a climate-neutral economy. Georg Zachmann Senior Fellow at Bruegel POLICY CHALLENGE Greening the recovery is a significant policy challenge. While there are clearly recovery policies that have positive effects on greening the economy, such as promoting energy renovation of buildings, there is a limit to the proportion of stimulus that can be explicitly greened. Beyond focusing on the explicit greening of stimulus policies where possible, greater emphasis should thus be placed on altering expectations, so that market agents anticipate higher future pay-offs from low-carbon investment. The needs to announce today a significant increase in carbon prices after 2021, to be engineered through revisions of the Emission Trading System and the Energy Taxation Directive. Such reforms could provide annual additional revenues of €90 billion. This could make a major contribution to the post-COVID-19 fiscal consolidation requirements, which might be in the order of one percent of GDP per year.

TWO PILLARS FOR A SUCCESSFUL GREEN RECOVERY

• Some stimulus policies have dual benefits: quick, Green stimulus targeted, effective, while cutting carbon emissions packages • These must be at the core of stimulus packages

Why? How? Green fiscal • Much stimulus spending • Price floor guarantees consolidation cannot be greened mean higher ETS price (by committing to • Major consolidation needs • ETD reform with stronger higher future • Carbon pricing makes big link to carbon content of carbon prices) contribution to both fuels and higher prices

Recommended citation: McWilliams, B., S. Tagliapietra and G. Zachmann (2020) ‘Greening the recovery by greening the fiscal consolidation’, Policy Brief 2020/02, Bruegel 2 POLICY BRIEF GREENING THE RECOVERY BY GREENING THE FISCAL CONSOLIDATION

1 COVID-19: THE ECONOMIC POLICY Amid the chorus of voices calling for the RESPONSE post-COVID-19 recovery to be a green re- covery1, it is often overlooked that a sim- The economic policy response to ilar narrative was developed in 2008, as COVID-19 involves three phases: relief, Europe and the world designed their re- recovery and fiscal consolidation. covery plans in the aftermath of the great In phase 1, governments put in place financial crisis. The rationale for a green indiscriminate and national-based approach was clear then and is clear now: measures to keep firms and workers the disruption, in this case caused by the afloat in the face of near-universal pandemic, offers an opportunity to build cash shortfalls. As the economic crisis a new eco-friendly system, for the benefit becomes longer and bankruptcy risks of current and future generations. loom, governments will also have to But pursuing a green recovery might provide solvency support through direct not be as straightforward as one might recapitalisation to certain, selected, firms think. Trade-offs must be weighed (Anderson et al, 2020). between the need to provide a short-term In phase 2, governments – along with stimulus to the economy and the need to EU support – will put in place measures address the long-term challenge posed to reboot their economies from the severe by global warming. In the short term, contraction, with interventions aimed at there is a clear limit to the proportion of stimulating both aggregate demand and effective short-term stimulus that can supply. This can be attempted directly via be explicitly greened. Green conditions increases in government expenditure, or can be attached to public investment indirectly via incentive mechanisms to and the support given to companies, increase investment/consumption from but the experience of 2009-2010 in the the private sector (Bénassy-Quéré et al, euro area showed that about half of the 2020). As a second wave of the epidemic total stimulus comprised cuts to direct is possible, this phase might be at certain and indirect taxation, social security points be also accompanied by a return contributions, or direct income support – of phase 1 measures2. in other words, measures to keep current In Phase 3, governments will have activities going, rather than to give them to implement fiscal consolidation a new green direction. measures. Relief and recovery policies For this reason, in order to turn the will significantly increase public debts green recovery vision into practice, it across Europe. Darvas (2020) has shown is important in response to COVID-19 how European countries with higher to do what was not done sufficiently initial levels of debt might see alarming in 2009-2010, which is to have a clear increases. Typical measures would understanding of both the economic include increases in taxation or cuts to impacts and the economic policy public spending. Already in the relief response, and to then properly integrate and recovery phases, the expectations of the green component into the recovery. companies and households about future 1. See for example https:// www.europarl.europa. In particular, greening the recovery consolidation measures are important eu/news/en/press- needs to be thought of as a long-term and will guide investment decisions. room/20200419IPR77407/ project, and measures should be taken This is where the concept of ‘green eu-covid-19-recovery-plan- now to alter expectations so that market consolidation’, specifically commitments must-be-green-and-ambi- agents receive the clear message that made today to higher carbon prices in tious-say-meps. low-carbon investment will from now the future, will be pivotal for stimulating 2. Questions must also be on generate the largest pay-offs. In the green investments today. asked about how effective European Union setting, the main avenue As the economic policy discussion government stimulus can be at boosting aggregate via which a ‘green consolidation’ – or an advances towards the design of the demand in an environment embedding of the green recovery – can be recovery phase, it is important to in which agents suspect achieved would be to ensure a significant integrate the green element into the that another lockdown and and durable rise in carbon prices after complete set of criteria that policymakers stop to business might be 2021. will use to inform their recovery policies. around the corner. 3 POLICY BRIEF GREENING THE RECOVERY BY GREENING THE FISCAL CONSOLIDATION

2 GREEN, FAIR AND EFFECTIVE: also the highest employment multipliers. A SET OF CRITERIA TO ASSESS Furthermore, the multiplier also depends RECOVERY POLICIES on a variety of other factors, including A wide range of policies can contribute the specific situations in which recovery to economic recovery. The decision on measures are applied4, the speed the right policy mix will depend on which with which recovery programmes are policies are most effective at stimulating deployed5, the size of the measures6 and the economy, and on what other short- their eventual targeted nature7. and longer-term effects they might have. Although the main focus of stimulus Here, we list three criteria for policy- packages is to boost aggregate demand makers to consider when determining a through anti-cyclical stimulus, govern- portfolio of recovery policies: effective ments must consider the effects of stim- promotion of economic growth, fairness ulus on long-term sustainable economic and the green recovery. growth. In the same way that the Great Depression accelerated a large structural 2.1 EFFECTIVE PROMOTION OF ECONOMIC shift in the US automobile manufactur- GROWTH ing sector (Bresnahan and Raff, 1992) it The basic idea behind recovery poli- is likely that the current economic crisis cies is use of public money to stimulate provides an opportunity for structural aggregate demand. The expectation is supply-side shifts. As businesses rethink that each euro of public money will not value chains, and as governments inject only imply an increase in demand for stimulus into depressed economies, goods and services worth the exact same their role in shaping future growth is 3. See, for instance, Tenhofen euro, but that the suppliers of the goods larger than during normal times. In 2020, et al (2010) on the macro- economic effects of exoge- and services will use the extra income the key challenge for governments is to nous fiscal policy shocks in to themselves demand additional goods provide effective signals encouraging Germany. and services, and so forth. The greater supply-side restructuring and rationalisa-

4. Buchheim et al (2018) the impact on GDP of each euro of public tion, to be based upon a shift away from found that a solar spending (the so-called multiplier), the carbon-based production. photovoltaic installation stronger the recovery will be, given a programme created many fixed amount of spending. 2.2 FAIRNESS jobs in labour markets that But estimating the multiplier of Individual recovery policies can have featured a lot of slack, but individual recovery policies – let alone very different distributional effects. For close to none in empty labour markets. entire recovery programmes – is complex. example, lump-sum transfers to low-in- Theoretically, we know that the lower the come households are progressive, while 5. If the crisis runs too long share of money leaked from the domestic state aid to capital-intensive industries is then self-reinforcing cycles might draw the economy economic cycle in the form of savings regressive. There can be positive and neg- unnecessarily low. How- or imports, the higher the multiplier of ative interactions between the fairness ever, policies take time to a policy will be. We know that policies criteria and other objectives. For in- implement and to become that are able to stimulate demand that is stance, helping poorer credit-constrained effective, and multipliers passed through extensive national value households can reduce inequality and take time to kick-in. chains will have high multipliers. For generate above-average multipliers 6. Even well-balanced poli- example, a policy stimulating demand (Palagi et al, 2017). On the other hand, cies with many positive and for automobiles will have significant reducing energy taxes can be a stimulus limited negative spillovers might not help much if they knock-on demand effects for industries policy that quickly supports low-income cannot be brought to the feeding into the final product, such as households much more than high-in- necessary scale to increase steel, aluminium, plastics and rubber. come households, but might imply in- aggregate demand in a Meanwhile, if stimulus is absorbed creasing energy consumption and hence country. by those with high savings rates, the emissions. We know that 7. Some policies allow target- multiplier will be lower. An example income tax cuts disproportionately help ing of specific regions, sec- would be a cut to the highest income tax the rich, social contribution cuts help the tors or population groups. bracket, benefitting wealthier people middle class, and most consumption tax Such targeting cannot only 3 be helpful for the political with relatively higher saving rates . It is cuts help the poorest. economy, but it might also also not necessarily the case that policies Despite the high volume and political increase effectiveness. with the highest GDP multipliers have importance of fairness in the design of 4 POLICY BRIEF GREENING THE RECOVERY BY GREENING THE FISCAL CONSOLIDATION

programmes, the distributional effects of reasonably quickly, while contributing to stimulus measures should not be over- reducing Europe’s emissions. stated. The big-envelope programmes in particular are typically temporary and 3 GREEN THE RECOVERY BY only modestly redistributive (a six-month COMMITTING TO HIGHER cut even of the most regressive taxes PRICES will do little to tackle inequality). Struc- While the first step toward a green re- tural measures such as education or the covery is to promote green policies that design of consolidation policies will have conform to necessary stimulus criteria, longer-lasting effects. the greatest emphasis should be placed on altering market expectations. While 2.3 GREEN the target of fiscal stimulus is to encour- In designing recovery policies, govern- age consumption and investment today, ments should seek to prioritise low-car- the overarching objective in terms of bon sectors, or to support carbon-inten- greening the stimulus should be to show sive companies only when ‘green strings’ market agents that higher future pay-offs are attached (von der Leyen, 2020; will arise from low-carbon investment. Gewessler et al, 2020). Ideas have already There is a clear limit to the proportion emerged about how to structure a green of effective short-term stimulus that recovery: focus on energy efficiency of can be explicitly greened. In order to buildings, clean-energy infrastructure fulfil the typical criteria for a successful and clean transport to create well-paying stimulus, a significant proportion of local jobs that boost economic growth recovery packages is likely to be made up in the short-term, while at bringing of broad-based, technologically-neutral long-term climate gains. In addition, measures, and measures that perpetuate investment in hydrogen and batteries status-quo economic activity, but neither should be boosted, to position Europe at clearly increase nor cut greenhouse gas the forefront of two technologies that are emissions. Examples include temporary widely expected to be the next decade’s cuts to indirect taxation, wage subsidies, breakthrough (Birol and Timmermans, and increased generosity of social 2020; La Camera, 2020)8. security payments. All this is sensible, but a caveat is A European Central Bank (ECB, 8. Given the difficulty in -es necessary: it’s been tried before. In 2010) decomposition of stimulus timating recovery policies the wake of the great financial crisis of budgetary measures adopted by the multipliers, Hepburn et al 2007-2008, the European Commission euro area in 2009-2010 illustrates this (2020) tried to identify pol- published a European Economic point. Half of the total stimulus was icies with high potential in terms of both the economic Recovery Plan aimed at speeding up the for household measures: typically cuts multiplier and climate shift towards a low-carbon economy, to direct and indirect taxation, social impact by surveying 231 with a focus on clean infrastructure, security contributions, or direct income high-level policymakers energy efficiency in buildings and green support. A little more than a quarter and economic experts cars (European Commission, 2008). But (28 percent) of stimulus came through from G20 countries. The the results of such initiatives have been public investment. Here, there are result was largely in line with what have become the unconvincing, with limited progress in substantial opportunities for explicit standard green recovery housing renovation and clean cars since greening, though the pre-COVID supply- ideas: clean infrastructure, then (Tagliapietra et al, 2019). side position of the economy limits the building efficiency retrofits, Can it be different this time? Brought proportion of public investment that can investment in education to the fore by growing public pressure be explicitly green (ie the extent to which and training, natural cap- ital investment, and clean on policymakers to green their recovery the necessary green skills and businesses research and development. plans (Ipsos, 2020), and by low-carbon currently exist to allow for green In their attempt to identify technology developments and cost infrastructure programmes to be brought policies with high climate reductions (Lazard, 2019), the green quickly to significant scale). Furthermore, and recovery impact, the policies now widely accepted as provid- public investment in green infrastructure IEA’s Sustainable Recovery ing the necessary energy savings and new projects will compete with similarly plan (IEA, 2020) also point- ed to similar investment energy sources are now poised to effec- desirable investment in areas such as areas. tively deliver large economic multipliers healthcare (inevitably higher than usual 5 POLICY BRIEF GREENING THE RECOVERY BY GREENING THE FISCAL CONSOLIDATION

on the list of priorities) or education. effect of increasing carbon prices on their The next largest share (17 percent) investment projects. For instance, a high came in the form of business support, enough might encourage typically accelerated payment of VAT companies to invest in capital for refunds, subsidies and export promotion. producing technologies which will be key In this category, some explicit greening for low-carbon economies, such as heat might be possible, but governments will pumps, smart meters and electrolysers, largely take a broad approach, hoping to rather than internal combustion engines. protect as many jobs as possible. Finally, Governments and financial insti- at just 5 percent in 2009-2010, labour- tutions will take the carbon price into market policies are likely to make up a account when evaluating the business larger share of stimulus spending this models of firms that seek debt restructur- time. There are indeed many valuable ing. And the decisions of some investors jobs that can and will be created within might encourage others to also pursue green industries, but governments will new low-carbon investment. want to match as many unemployed From a macro-economic perspective, workers to jobs as quickly as possible. stimulus measures aim to kickstart the Given the significant difficulty economy now but will result in higher associated with the explicit greening of debt levels later. Consolidation will be a large proportion of recovery funds (ie needed, but it should only start after the everything outside of public investment), recovery gained enough momentum. the most efficient tool to encourage The fiscal consolidation need might be broad cooperation in a green recovery greater than 1 percent of GDP per year will be strengthened efforts to increase for several years9, meaning about €140 the price of future carbon emissions. billion per year for the EU. While today’s carbon price affects decisions on the use of carbon-intensive 4 ALTERING EXPECTATIONS equipment, expected future carbon For a successful ‘green consolidation’, prices affect investment and divestment in which governments seek to reduce decisions. The size of stimulus packages high levels of public debt while placing a about to be unleashed within the EU, and significant emphasis on raising revenue the fact that many businesses will look through taxation of carbon, EU carbon to restructure their business models and prices must increase significantly after supply chains, mean that now more than 2021. In practice there are two major ever carbon prices can play a significant tools to engineer this: the emission trad- role in shaping future economic systems. ing system (ETS) and the energy taxation This is a key lesson from the response directive (ETD, 2003/96/EC). to the great financial crisis, when rela- tively unsuccessful efforts were made to 4.1 THE SYSTEM launch clean infrastructure programmes The ETS covers large installations that 9. This is a rough estimate within economic environments with are responsible for about half of EU based on Barrios et al (2010), who wrote “a carbon prices that were unsupportive of emissions. Increasing the price in the fiscal consolidation is those programmes. One of the lessons emission trading system can be achieved considered as successful if from the attempts to green the recovery by reducing the number of allowances it brings down the public in 2008-2009 is that stimulus funding will put onto the market by member states. debt level by at least five be most effective when aligned with long- The price effect should largely exceed the percentage points of GDP in term price signals (IEA, 2020). volume effect, resulting in higher state the three years following a consolidation episode”. The When well communicated, revenues. An increase in the allowance exact figures will depend households will take the future price from about €25 /tonne of carbon on many factors. Countries carbon price into account when using dioxide currently to around €50 could be will not want to consolidate stimulus money to invest in new cars, engineered by accelerating the annual so quickly that is damages housing renovation or heating systems. linear reduction factor (currently 2.2 GDP growth, while an envi- ronment of low borrowing Companies that might be encouraged to percent). With a doubling of the carbon costs might reduce consoli- invest by loose monetary conditions and price, expected revenues in 2022 would dation requirements. broad fiscal support will consider the increase from less than €25 to €50 billion. 6 POLICY BRIEF GREENING THE RECOVERY BY GREENING THE FISCAL CONSOLIDATION

But as the allowance price is driven by essentially go beyond the ETS's automatic the interplay of a relatively complex stabiliser function13 because it would 10. Maybe with a slight dis- system, market expectations and political engineer a temporary price-reduction count for the capital cost of feedback loops, it will not be so easy to that goes beyond the effect of change carrying allowances, and hit a concrete price target. in long-term emissions. Moreover, it some discount for the re- One solution, which implies a would be an EU wide programme based maining uncertainty about stimulus of its own, would be to enable on an EU tool. The political problem is future price developments. the European Investment Bank to provide that this might sound like encouraging 11. That is, on the one hand higher government financial guarantees to private investors emissions in 2020-2021. Therefore, it revenues from auctioning that a certain level of carbon price will must be very carefully communicated allowances and on the be achieved in 2025 or 2030. This would that the short-term stimulus is included other hand higher costs set a soft floor price for the ETS (see only to counteract the backward-induced for companies that are Zachmann, 2013). The EIB would sell additional price increase. largely passed through options that would pay out the difference into the prices consumer have to pay for carbon-in- between whatever the ETS price is in 4.2 THE ENERGY TAXATION DIRECTIVE tensive goods – reducing 2025 and a guaranteed price (eg €50), The ETD sets EU-wide minimum rates for the disposable income of thus providing greater business certainty national energy taxes (which are outside consumers. around low-carbon investment. of the ETS). In 2015, the European Com- 12. Other options would be to However, credibly announcing a mission withdrew its 2011 proposal to (i) introduce a forced ex- tightening of the ETS for after 2021 will revise the ETD14 given the inability to find change of old (issued until 15 2021) into new (issued after not only lead to an increase in future agreement between all EU countries . 2021) allowances at a cer- emission allowance prices after the The file was opened again in November tain change rate, eg 0.9; or tightening is implemented, but will also 2019, when the European Council took (ii) instead of reducing the encourage current market players to not note of the European Commission eval- linear-reduction factor to sell/buy allowances below/above the uation, which concluded that the ETD of tighten allocation, reduce higher price expected beyond 202210. 2003 is outdated, and requested that the the carbon value of all al- lowances, eg to 0.9 tonnes Hence, today’s allowance prices would Commission should come up with a new 16 of CO2 equivalent. But converge to the expected higher future proposal . The those options might be le- price. This would act like an immediate communication (European Commission, gally more difficult as they tax increase11 and potentially counteract 2019a) scheduled the revision for 2021. imply reducing the value of short-term economic stimulus Accordingly, the speed and ambition property rights held by the current allowance owners. programmes. This undesirable near- of a compromise now largely depends term effect should be compensated on the political attention given to this 13. The fact that emission allowance prices were for, to avoid climate policy being held topic – which could in our view be the unaffected by the crisis responsible for a sluggish recovery. most crucial climate policy question indicates that the ETS We think the ETS can be adapted in of this Commission’s mandate. A key market stability reserve, order to actually provide a Europe-wide improvement will be to ensure a stronger introduced in 2019, stimulus in the short term without losing link between tax rates and the carbon essentially undid the 17 system's automatic its most important function as guiding content of fuels . stabiliser function. today’s investments towards ‘green’. The The main impact will be on transport 18 14. See https://eur-lex. idea would be to tighten the allocation of and heating fuels (Figure 1). In 2018, europa.eu/legal-content/ allowances after 2021 by increasing the transport and heating accounted for EN/TXT/?uri=CELEX- linear reduction factor from currently about 1.3 billion tonnes of CO2. Placing %3A52015XC0307%2802%29. 2.2 percent per year to a value consistent an additional €50 per tonne carbon 15. Taxation decisions require with a carbon price of €50/tonne in 2022. price on those fuels would result in unanimity. To counteract the backward-induced an additional €65 billion per year in 16. See http://data.consilium. price increase already in 2020/2021, revenues. In reality this number will europa.eu/doc/document/ST- emitters in 2020/2021 would temporarily be smaller, mainly19 because many EU 14608-2019-INIT/en/pdf. not need to surrender 100 allowances countries already apply higher tax rates 17. This was already part of the per 100 tons of CO2 equivalent, but than the European minimum. Some proposal that member states previously rejected. only a slightly lower number (eg 95 countries with higher rates than the EU 12 18. As electricity generation is allowances) . This would facilitate minimum might only have to slightly already covered by the ETS. an increase in carbon cost after 2021, increase their tax rates, generating 19. Short-term price elasticity without this increase in price holding limited additional revenue. However, by tends to be relatively low. back the recovery. This strategy would imposing a higher floor, minimum rates 7 POLICY BRIEF GREENING THE RECOVERY BY GREENING THE FISCAL CONSOLIDATION

5 CONCLUSION also reduce the extent to which certain member states can undercut those The response to the COVID-19 crisis who are prepared to implement higher comes at a pivotal moment for the EU energy taxes. Member states with higher in its own efforts to address the climate prices, which might now be hesitant crisis. Billions of euros of taxpayer’s about increasing such price differentials money is set to be spent over the coming within the EU (because of fears of lost months and years in an effort to alleviate competitiveness), would now be afforded the pain of what might otherwise be the more scope for increasing prices. largest recession since the Great Depres- Revising the ETD will be complex sion. To the greatest degree possible, and it will take time to find a balanced, governments must direct such revenues acceptable solution. But the European to stimulus policies that boost depressed Council can already today commit to link economies whilst contributing towards a CO2-component in energy taxes to the the transition to a zero-carbon economy. ETS carbon price (probably with some However, it is unrealistic to expect that delay for operational reasons). A credible governments are able to explicitly green announcement would give a strong indi- all (or even most of) stimulus policies. cation to companies, financial markets, A range of priorities, not least providing administrations and households. an immediate and sizeable boost to the economy, will compete with the green 4.3 LEGAL COMMITMENTS objective. The experiences of 2008-2009 Alongside explicit market mechanisms, show that much stimulus spending is the European Commission in March 2020 likely to be based on boosting demand proposed a law that would make binding within existing economic structures, in EU law the target of net-zero green- rather than pursuing aggressive sup- house gas emissions across the bloc by ply-side reform. This is where the concept 2050. The process of passing this through of a ‘green consolidation’ will be funda- the European Parliament and Council of mental to ensure a truly green recovery. the EU, and the accompanying noise it Where explicit greening is not possible, will generate, will provide a similarly im- implicit greening can be achieved by portant low-carbon signal to investors. In adjusting market expectations to a future EU countries, national governments can world of higher carbon prices. make similar guarantees. For instance, In order to effectively green the within the automobile sector, commit- fiscal consolidation, the EU will need to ments to phase-out internal combustion implement both a tightening of the ETS engines by certain dates provide strong and a reform of the ETD. In our example, signals. the annual additional revenue this could generate EU-wide could amount to €90 Figure 1: Energy tax revenues of EU countries as percentage of billion. Granted, some of this revenue total tax revenues, 2017 will be used to address the initial poten- 12 tially regressive effects of higher carbon Transport taxes Other energy taxes prices. Yet, even taking this into account, 10 it is clear that carbon pricing can make a non-trivial contribution to meeting the 8 fiscal consolidation needs, which could be about 1 percent of GDP (ie €140 bil- 6 lion) per year. 4 Carbon pricing has long been the economist’s favoured tool for reducing 2 carbon emissions. However, given the current circumstances, an EU strategy 0 . l s s k a a a a a a a a a a e e d d d y y y n n 8 9 K i i i i i a l i R i i i i r t m of effective stimulus measures today, r

c r l d e u c r t n n n n 2 1 v U k g a a n n a u r n n t a a h a e t d i a a a a n t a n a a u l p o U U s I e a l l p g e c e g g a a t a t m o v M l l l E E o u v S e u r r r m n n e L r s i r m n r o w u e o P h F o A G I C r l C y u l

E while allowing increases in future carbon F e t o e e S B B P i S C z S H h R D G L t e

N prices to play the role of greener-in-chief, Source: European Commission (2019b). appears more attractive than ever. 8 POLICY BRIEF GREENING THE RECOVERY BY GREENING THE FISCAL CONSOLIDATION

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