The Dilemma of Climate Policy

Tensions were high when Robert Habeck announced his ban for household gas and oil heaters. After a gruelling days-long negotiation, the reform was pushed through in a watered-down form. This case is emblematic of a larger, systemic problem facing the government: when CO2 prices are set too low and subsidies remain uneconomical, climate goals can only be achieved through sweeping bans. Such measures are not only unpopular, but also inefficient.

Germany’s goal of climate-neutrality by 2045 heralds prodigious changes for the country. The complete electrification of all energy usage forms the brunt of the government’s strategy – from electric vehicles to electric heating.

Still, so long as fuel, oil and gas remain comparatively cheap, switching appliances will be uneconomical for most households. Three possible policy instruments could invert this relationship: Price increases for fossil fuels, subsidies for electric vehicles or appliances and an outright ban on fossil fuels. Only the first is efficient.

Price increases must, however, be instituted where emissions are generated. To this end, the EU introduced an emissions trading scheme in the energy and industrial sectors. All companies in these sectors must purchase emissions certificates corresponding to their CO₂ output. The number of certificates is capped to make sure yearly climate targets are achieved. A certificate costs approximately 100 euros per tonne of CO₂ emissions. This incentivises companies to invest in technologies and equipment to reduce their carbon footprint and thereby their spending on such certificates. With a reduction in emissions of 35 per cent between 2005 and 2021, these sectors serve as a strong proof of concept.  

The European Commission is now arranging a second such trading scheme for the transportation and housing sectors with a price cap of 45 euros per tonne of CO₂. The German government had already instituted its own national trading scheme for these sectors in 2021 with prices capped at 65 euros per certificate. Both caps are far too low to encourage a disciplined abstinence of companies and households from fossil fuels.

The government’s hesitancy is due to the effect drastic price hikes would pose for many households.  Subsidies for green technology present one alternative. Due to the nascency of such technologies and the targeted nature of subventions, they are liable to promote non-starters. Still, beyond this, the fundamental problem with subventions stems from their inability to match the complexity of economic activity.

The financing of renewables under the Renewable Energy Sources Act is an example par excellence of this problem. Natural gas is now considered “greener” than coal but did not receive any financing. Due to low CO₂ prices, coal prices never rose. As a result, coal was more economical than gas for a long time, with the latter writing off losses for a long time. The UK, on the other hand, instituted higher CO₂ prices early on, rendering coal power plants unprofitable from early on.

The same “hyperfocus” problem is also inherent to bans. While CO₂ prices subject all carbon-generating activities to the same incentive scheme, a ban on oil and gas heaters can only alter the behaviour of those wishing to purchase a new appliance. This recent winter proves that households are willing to reduce their energy consumption. A focus on CO₂ pricing could further encourage this behaviour.

What to do? The government should take trading schemes seriously and propose a new pricing model that relies on slowly rising prices but ultimately eliminates price caps. Households would face a manageable burden initially but remain aware that the strain would steadily increase. An awareness of these rising costs would naturally incentivise households to opt against heat pumps when investing in a new heating unit. Government revenues from the trading scheme should, in turn, be used to finance complementary social programmes.

Various economic studies demonstrate that an effective emissions trading scheme is the most economical way to facilitate green transformation. All other instruments, i.e. subsidies or bans, are a comparatively expensive way to electrification. The challenges we face are too large and expensive to allow for such inefficiencies.