The fear of inflation is back. The economic recovery after Corona and the Ukraine crisis have made natural gas in particular much more expensive. In Germany and Europe, there are concerns about general price stability. The market-oriented climate policy, which has only just really got off the ground, is also increasingly coming into focus. “Green inflation” is the motto.
It is interpreted as follows: It is now necessary to stabilize prices on the electricity market, among other things by limiting CO2 pricing in EU emissions trading for energy and industry. Behind this is a new climate policy paradigm: not market-based control as the key instrument, but subsidies. Despite the recent price swings, emissions trading is by far not the strongest driver of the high electricity price. The cost push comes primarily from the gas market.
And if the state consistently and appropriately reimburses the income generated by emissions trading, it will almost have the effects on the price front under control. But the focus is now shifting from the most efficient form of limiting emissions of the most important greenhouse gas, carbon dioxide, to an instrument that only makes sense in special cases: the so-called contracts for difference. How do contracts for difference work?
The state determines which technologies are to be promoted, for example green steel, i.e. the firing of blast furnaces with hydrogen produced with green electricity. Since these technologies are not worthwhile at the current CO2 prices, the state is willing to pay subsidies.
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In doing so, it sets the marginal abatement costs for the promoted technology – i.e. the CO2 price from which a fossil-free steel production plant would be economically more attractive.
The subsidy decreases when the carbon price increases
The determination is made with scientific expertise, in consultation with the company or by tender. The difference between the current CO2 price and marginal avoidance costs then flows as a subsidy: The company converts to green technology, saving the money for emissions trading and receives just enough money on top of that to make it worthwhile. The joke is: the subsidy decreases when the current CO2 price increases, since the state only pays the difference to the predefined marginal avoidance costs.
At some point it will be zero, the company will have to get by without help again, emissions trading will once again fulfill its function – to price and avoid greenhouse gases.
So it seems at first glance that the idea of contracts for difference goes well with emissions trading. In fact, they can be useful when it comes to promoting technologies temporarily. For example, because it is to be expected that the costs will fall quickly as a result of learning effects or the upscaling of production. The emission certificates are supposed to be gradually reduced, so the price of CO2 will rise and the volume of subsidies will fall.
However, it becomes problematic when contracts for difference are used extensively. This is when the waterbed effect comes into play: the companies nurtured in this way with subsidies avoid emissions with fossil-free technology, but since they no longer need certificates, the scarcity is thwarted and the CO2 price rises more slowly or not at all. Which in turn reduces the incentive for climate protection for companies without a contract for difference. It seems unrealistic that politicians will neutralize the waterbed effect and reduce the number of certificates faster than planned.
In any case, the industry would storm against it. Because the more contracts for difference she has or is promised, the greater her interest in a low CO2 price, i.e. high compensation payments. The industry’s support for emissions trading, which is emerging, would quickly erode. CO2 pricing would gradually be overridden in favor of subsidies through contracts for difference.
Present and future generations are burdened
The price of this policy is high. The state tries to comprehensively plan technical progress, although it does not have the necessary information for this. The danger of rising costs and thus rising prices, which is used to justify this paradigm shift, is only superficially averted: Controversial discussions about the “right” technology path, with strong influence from interest groups, are slowing down progress in climate protection and making it more expensive.
Government spending on subsidies burdens current and future generations. Private households and small companies, which are difficult to organize as interest groups and get the least of the subsidy cake, pay the most. In addition, with the lower income from CO2 pricing, the scope for social burden sharing is dwindling. Widespread contracts for difference in the switch to fossil-free power generation are just as damaging.
However, this is key, because a climate-neutral economy is achieved through direct and indirect electrification. Here the justification for contracts for difference is as follows: In an energy system largely determined by renewables, the investment costs would no longer be factored in, because the marginal costs (“What does an additional hour of energy from sun and wind cost?”) are naturally close to zero and so are the electricity prices. So the capital costs would have to be financed via contracts for difference, which roughly corresponds to a return to feed-in tariffs that are independent of what is happening on the market.
This also shows that the “new climate policy” has not been thought through economically. Because after the nuclear and coal phase-out, gas power plants are definitely needed that can be started up at short notice when the sun isn’t shining and the wind isn’t blowing. They then have to recover their costs through high prices during these hours. This ensures that the wholesale electricity price is by no means always zero.
The coal phase-out will succeed around 2030
In some hours it is driven by the price of gas and the cost of the emission certificates that are incurred when using fossil gas. In addition, scarcity prices will make the flexibility of load and storage technologies attractive. All of this makes it possible for renewable energies to earn their capacity costs on the market. The interaction of emissions trading and electricity trading plays a key role, especially in the area of conventional power plants.
Due to the increase in the price of CO2, the phase-out of coal will initially succeed around 2030 without this being politically delayed. The greenhouse gas-neutral operation of gas-fired power plants, for example using green methane, is also being gradually initiated. The coordination of consistent CO2 pricing is central to the smoothest possible transformation and cannot be replaced by individual measures. Despite rising energy prices, politicians should strengthen the socio-ecological market economy and resist the temptation to allow themselves to be driven into an unproductive spiral of intervention.
The authors: Ottmar Edenhofer is Professor of Economics of Climate Change at the Technical University of Berlin, Director of the Potsdam Institute for Climate Impact Research (PIK) and the Mercator Research Institute on Global Commons and Climate Change (MCC).
Veronika Grimm is a professor of economic theory at the Friedrich-Alexander University in Erlangen-Nuremberg and a member of the Advisory Council for the Assessment of Macroeconomic Development.
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