Numerous scientific studies have shown that the costs of combatting climate change are far less than the economic damage it causes. This is especially true when the tool to combat it utilises market forces that reduce greenhouse gas emissions cost-effectively and promote sustainable solutions through appropriate economic policy. A proven tool in this regard is CO2 pricing, which has become a central tool of climate action in Germany and the EU generally. CO2 pricing cuts emissions while allowing the economy to grow. Since the introduction of the European Emissions Trading System (EU ETS) in 2005, greenhouse gas emissions have fallen by 32 per cent in Germany and 31 per cent in the EU. At the same time, real GDP has risen by 24 per cent in Germany and 21 per cent in the EU.

Climate neutrality in Europe’s sights

The climate neutrality goals set by Germany and the EU require extensive decarbonisation. Starting in 2027, an additional emissions trading system (EU ETS 2) will come into effect, covering emissions from fuels and combustibles that were previously regulated at the national level. Once it is in place, 86 per cent of all greenhouse gas emissions in the EU will be subject to CO2 pricing. Given this scope, it is all the more important that this key climate policy instrument be designed properly for the challenges ahead. Doing so will mean thinking about climate action in an even more European way. National climate measures to curb greenhouse gas emissions that are already covered by the EU ETS or the EU ETS 2 may only shift emissions between EU member states, leading to higher costs but without any effect on the EU's overall emissions. By contrast, the decarbonisation aimed at by the EU-wide emissions trading systems is controlled by the EU’s internal CO2 market and thus avoids unnecessary economic costs in achieving climate targets. In view of the enormous pressure to bring about a green transformation and the difficulty that government agencies have had in designing efficient climate measures, such a market-based approach would seem eminently sensible.

Fragmentation, double regulation and incomplete pricing

But whether a market-based approach to decarbonisation is sustainable depends primarily on whether it covers as many emissions as possible and enables economic transactions between as many players as possible. Even after the introduction of the second emissions trading system, the European CO2 markets will remain highly fragmented. First, the two trading systems (EU ETS and EU ETS 2) will each set their own CO2 price. There are currently no plans regarding how or when this schism is to be overcome. A second source of fragmentation comes from the national CO2 markets of the individual EU member states implicitly enabled by the EU-wide Effort Sharing Regulation (ESR). For emissions that are not covered by the EU ETS, the ESR assigns the EU-wide CO2 target to individual EU countries. In this way, each EU member state receives a national CO2 budget for these emissions. At the same time, 100 per cent of the emissions covered by the EU ETS 2 will fall under both the ESR and national CO2 budgets. This double regulation has the potential to undermine the effectiveness of the new EU ETS 2, for it is not market incentives created by the EU ETS 2 that determine were to abate emissions, but rather the politically defined allocation of national CO2 budgets. Third, the carbon pricing systems currently do not cover greenhouse gas emissions from agriculture, which makes up around 11 per cent of the EU’s total carbon emissions. In order to achieve the EU’s climate targets, the European Court of Auditors in 2021 recommended examining the potential of applying the polluter-pays principle to agricultural emissions and rewarding farmers for long-term carbon abatement.

More than one European CO2 price

Every tonne of CO2 counts equally towards achieving EU climate targets, regardless of where it is abated. However, the cost of abating a tonne of CO2 varies greatly depending on the industry, sector, EU country, or fossil fuel. A consistently implemented market-based approach would set only a single CO2 price in the EU at any given point in time. Contrasting this with the current European architecture for CO2 pricing shows: In addition to one CO2 price for EU ETS and one CO2 price for the EU ETS 2, there is also an implicit CO2 price for each of the 27 EU member states based on their respective national CO2 budgets – as well as a CO2 price of zero for CO2 emissions in agriculture. The larger the differences between explicit and implicit CO2 prices, the higher the economic costs of decarbonisation in the EU.