To reach 2030 targets set by the new EU framework on climate and energy, I propose eliminating energy subsidies and instead using those funds to tighten the carbon market and reduce emissions cost-effectively
This is the fourth post in a series about the EU ETS
On January 22, the European Commission presented the new EU framework on climate and energy for 2030. The new document sets two binding targets: (1) 40 percent emission reductions from 1990 levels by 2030; and (2) 27 percent of energy produced from renewable sources.1
The path to meet these goals, however, is not so clear.
What is clear is that the EU Emission Trading Scheme (ETS) and various national climate programs and policies, as they exist now, will not produce the emissions reductions necessary to reach the 2030 targets, much less achieve levels of success that might persuade other high-emitting states to imitate the early adopters. Something must change.
I argue that European states should eliminate subsidies for renewable energy, instead deploying these funds to effectively lower the ETS cap. These subsidies for wind and solar power are popular among environmentalists, but simply providing financial incentives to carbon-free energy producers is an inefficient way to reduce greenhouse gas output.
What’s more, subsidizing certain emerging energy technologies undermines the cost-effectiveness of cap-and-trade. These two policies interact in a way that sabotages the economic benefits of a market-based climate solutions.
Even more absurdly, renewable energy subsidies in the EU don’t actually decrease total emissions.
In terms of social equity, subsidies spread the costs of reducing emissions across all taxpayers, whereas a strong, well-designed carbon-trading system can force polluters to pay the brunt of the costs of transitioning to a low-carbon energy economy.
A recent article from The Economist on European climate policy calls the current emission-reduction efforts “a mess.” The piece, entitled “Worse than useless,” laments that Europe’s carbon market and incentives for renewable energy have proven to be immensely expensive approaches that have achieved only modest results:
“The cost of subsidies has been far greater than anyone had expected: €16 billion ($20 billion) in Germany in 2013, which works out at a massive €150-200 per tonne of carbon dioxide. (Home insulation, in contrast, saves money while reducing emissions.)”
Sigmar Gabriel, Germany’s minister for economy and energy, estimates even higher costs — he calculates that private consumers pay an extra €24 billion per year on electricity to finance the country’s ‘feed-in tariff‘ program, which accelerates investment in new technologies by providing long-term contracts that pay renewable energy producers a fee above the retail electricity rate.
Meanwhile, the price of an emission allowance in the ETS hovers around 5 Euros per metric ton, which points to two clear corollaries: (1) the most expensive emission reductions necessary to meet the ‘cap’ of the cap-and-trade system cost just €5 per metric ton carbon dioxide-equivalent; and (2) this carbon cap — the overall limit on emissions within the system — can and should be lowered, a lot. I will elaborate both points.
First, how do we know that it costs industrial emitters in the ETS less than €5 to mitigate one ton of carbon? Well, if it were to cost more than €5 to avoid a ton of carbon emissions, then that company could simply buy another emission allowance for €5 and proceed with emitting that ton.
Firms will do whichever is cheaper: decrease their emissions or buy allowances from other firms to permit their emissions.
This is the way that cap-and-trade advocates claim that a hard limit and a system of freely tradable ‘pollution permits’ will automatically produce the most cost-effective set of emission reductions across the economy. Germany has huge subsidies for renewable energy, but it takes €150-200 of ratepayer money, collected through an electricity surcharge, to avoid the same quantity of greenhouse gas emissions that the ETS prevents with €5 of corporate money.2
To my second contention: the fact that carbon permits trade at €5 per ton shows that the cap is too high. As firms in a cap-and-trade system reduce emissions, they start with the least costly reductions and then work their way to more expensive strategies for decreasing greenhouse gases.
It’s clear that ETS companies are still working through cheap carbon fixes in their facilities, since market participants choose to perform the emission reductions necessary to meet the overall carbon limit rather than pay just €5 for an emission allowance.
If the cap is tightened, it will speed up the implementation of these low-cost emission reductions. And as it becomes more costly to make that last reduction — because the low-hanging fruit will have been picked — the price of an allowance will slowly increase.3
The Economist makes another good critique of clean-energy subsidies: because German emissions are constrained by the EU ETS cap, subsidizing solar and wind power does not decrease emissions at all. Instead, these incentives for renewable energy only shift emission reductions away from other potential carbon-abatement strategies, like improving energy efficiency or fuel-switching from coal to natural gas.
Ultimately, the cap determines the total emissions from a carbon-trading system. Other climate policies like energy subsidies only alter the set of greenhouse gas reductions selected to meet the cap. Economists call this ‘distorting’ the market.
An example: let’s say I could renovate my German factory to use energy more efficiently — and thus reduce carbon emissions — for just €4 per ton of emission reductions. Alternatively, I could put solar panels on the roof for €5 per ton of emission reductions.4 But the German government will pay me extra for the electricity produced by my solar array — beyond what the power is actually worth — such that it effectively costs €3 per metric ton reduction. Well, I’ll choose the solar route, foregoing the less costly energy-efficiency project thanks to ratepayer-subsidized inefficiency!
The EU 2030 framework bridges near-term climate and energy targets toward the 2050 goal of reducing greenhouse gas emissions 80 to 95 percent below 1990 levels. The policy framework proposes reform of the EU Emission Trading System (ETS) to address the oversupply of emission allowances that has built up in recent years, but these changes — the creation of a ‘market stability reserve’ and the rise of the annual emission ‘cap’ decrease from 1.74% to 2.2% each year — will not take effect until 2021.
To meet the new objective of 40 percent carbon reductions by 2030, the ETS will have to be either overhauled or scrapped in favor of simpler, more direct climate policy. At the very least, the EU must revamp its approach this decade, instead of waiting for the next one.5
But the EU is a big, bureaucratic monster with an entire continent of stakeholders. Progress comes slowly for the multinational, multi-body institution, even without dissent. The “Next steps” listed on the 2030 document’s official press release say that the European Council “is expected to consider the framework at its spring meeting” in March.
And when competing interests do fight over EU decisions, the work-rate of change implementation decelerates nearly to the standstill we see in US Congress. Poland, which produces 90 percent of its electricity by burning coal, will fight tooth-and-nail against strengthening the ETS.
Effective cap lowering
How can the carbon limit be effectively lowered in the short run while the European Union slowly transforms its climate strategy to meet the ambitious 2030 goal?
Here’s one idea: Germany can cancel its €16 billion-per-year (or more) renewable energy subsidy program and use some of that money to retire emission allowances instead.
Consumers currently pay a surcharge on their electricity bill to finance the subsidies for wind power, biomass, hydropower, geothermal energy, and solar photovoltaics. I propose the German government redirect these funds toward paying itself to throw allowances in the shredder, essentially lowering the ETS limit by however many tons worth of allowances they are able to do away with.
This strategy of retiring carbon permits would actually reduce overall emissions, unlike the climate policies on which European states currently spend. Moreover, the effective cap lowering will drive up the price of allowances, as well as put energy efficiency on a level playing field with renewable energy, ensuring cost-effectiveness.
Yet redirecting government spending from encouraging climate-friendly energy to making emission allowances scarcer has two potential drawbacks, each of which I will address.
First, advocates of subsidizing renewable power argue that it drives the development of a young industry — one that must grow quickly if we are to transform our energy systems to run fossil fuel-free. By encouraging investment in low- and no-carbon energy production, these technologies advance more quickly and achieve higher penetration.
But the same argument can be made for energy efficiency. Emerging clean technologies allow us to attain the same energy services using fewer resources by simply reducing wasted energy.
Since these efficiency solutions decrease the need for burning fossil fuels, they are as effective as solar and wind power at reducing emissions — often at less cost. Thus the development of energy-efficient technology and expertise deserves to compete on even terms with renewable energy.
It could even be argued that reducing energy demand is more effective and better for the environment than replacing fossil fuel burning with renewable power, because solar and wind plants (1) provide electricity only intermittently; (2) use lots of land per unit of energy produced; and (3) require more resource inputs in their construction than the implementation of most energy-efficiency technology. From this perspective, fair market treatment of all emission-reduction strategies seems like the bare minimum for achieving optimal outcomes through cap-and-trade.
Secondly, the regressive nature of market-based climate policies like cap-and-trade fuels a strong argument against cutting subsidies for specific emission-decreasing technology and using the savings to tighten the overall carbon limit.
As the price of a permit to emit greenhouse gases rises, the price of goods and services whose production is emission-intensive rises too. Buying emission allowances costs producers; like any cost of production, firms pass this expense on to consumers.
The lowest earners in an economy spend the greatest share of their income on necessities that entail emissions to produce, like electricity. So those with the least income are affected disproportionately as a rising carbon price drives up electric power bills.
The solution to this dilemma is simple. I will use Germany as an example once again: after getting rid of the €16 billion subsidy program, electricity prices will actually go down. Most of this money can be returned directly to the people through greatly reducing the surcharge on electric power.
EU member states like Germany get allocated allowances to auction to emitters, while some other allowances are freely distributed to firms, who can then trade them with one another. Therefore the German government need not purchase permits on the open market to drive up the price of carbon; instead, the number of allowances available for auction can simply be reduced.
Of course, some of the €16 billion saved by eliminating the feed-in tariff subsidies for renewable energy will need to be used to offset the decrease in government revenue caused by auctioning off fewer allowances. But not nearly all of it.
Auction sales in 2014 are expected to feed about €3 billion into Germany’s Special Energy and Climate Fund for ETS revenue. Even if Germany withholds a third of the allowances set to be auctioned, it will still cost them less than €1 billion because the prices fetched at auction will rise thanks to scarcity.
Thus if revenue from the surcharge on electricity is used to tighten the carbon cap instead of subsidize renewable energy, this extra fee on the power bill can be reduced to about one-sixteenth its current size. So in Germany, reallocating funds to strengthen the emission trading system will in fact lower the price of electricity in addition to benefiting the climate. That is a progressive change, not a regressive one.
Moreover, even when emission-reducing programs like cap-and-trade are regressive within states or the EU, these policies are progressive from a worldwide perspective, because the costs of climate change are far more regressive than the burdens of cap-and-trade. The poorest and most vulnerable people on Earth will be affected most as sea level rises, droughts lengthen, storms intensify, and food production slows.
Reducing emissions through market-based climate policies in wealthy, high-emitting states helps protect the world’s least-well-off populations, since global warming is just that: global. The lowest-income people whom the policy may disproportionately impact within the EU — though not as lopsidedly as with energy subsidies — have much more wealth than the impoverished millions who stand to benefit the most if we avoid catastrophic climate change.
Similar changes to my cap-tightening proposal can be implemented in many EU states that subsidize renewable energy. Saving money on subsidies can help countries like Spain achieve their budget goals without fudging the numbers.
If each state acts to remove energy subsidies and auction fewer allowances, then overall emissions within the ETS will drop like the Times Square ball on New Year’s. The price of carbon will increase, and businesses will undertake tons of new emission-reducing projects, starting with the least costly climate solutions.
To protect ourselves from worldwide ecological and economic devastation, we must drastically reduce the amount of climate pollution we emit. It matters much more that we save the climate than how we do it, but as long as economics exists, we may as well implement the lowest-cost emission reductions first.
Note: The policy proposal advocated in this blog post was developed from a lecture given by Western Washington University Professor of Economics Dan Hagen.
- A recent Ecofys study concludes that in order for Europe to contribute their ‘fair share’ to international emission-reduction efforts, the EU must set a 2030 target between 39% and 79%, with a median value of 49%. Sandbag’s effort sharing approach indicates that a goal of 65% below 1990 levels would be appropriate. ↩
- The cost of emission allowances is ultimately passed on to consumers through a tiny increase in the price of goods whose production is carbon-intensive. Economically, carbon trading works like any rise in the cost of production. ↩
- The cost to society of one CO2-equivalent ton of greenhouse gas emissions is more than 5 Euros. That much we can agree on, though climate economics nerds fiercely debate what the actual societal cost of carbon is. Many others think that putting a monetary value on climate pollution is silly, for a variety of reasons, including that catastrophic global climate change could destroy our entire economic system. In this piece I ignore the real value of reducing emissions and focus on how reductions can be achieved most cost-effectively. Read more about estimating the complete cost of carbon emissions in my blog post The Price Ain’t Right. ↩
- Obviously, energy projects are not priced by the amount of emission reductions they achieve, but skipping the calculations necessary to determine price-per-ton of carbon mitigation makes the example easier to follow. ↩
- In the meantime, the EU has approved a ‘backloading’ of allowances to reduce the cap the next few years, but this plan only shifts emissions to later in the decade (it’s a political compromise — take notes, US Congress). Read more about this weak attempt to resurrect the ETS in my blog post Band-Aid for a Broken Market. ↩