“A Europe-wide carbon pricing system would send a strong signal”

Interviewed by Astrid Dähn and Jörg-Rainer Zimmermann, 23 Aug 19
... says Ottmar Edenhofer, Director of the Potsdam Institute for Climate Impact Research. Edenhofer believes that the likelihood of Germany introducing a carbon price has increased of late, in light of the success of the Fridays for Future movement and the shifts in the political landscape evidenced in the recent European elections.

new energy: German Federal Chancellor Angela Merkel recently announced that Germany would become carbon neutral – i.e., reduce its net carbon emissions to zero – by 2050. How can this be done?

Ottmar Edenhofer: Carbon neutrality by 2050 is a colossal leap. First, we need to worry about meeting our 2030 goals. Essentially, these can be divided into two main groups: our commitments within the EU to reduce carbon emissions by 38 percent on the one hand, and the targets set out by the coal exit commission on the other. The public perception seems to be that the success of the coal phase-out is already enshrined in law. However, just because we have a schedule for the decommissioning of power plants does not mean that we will achieve the necessary emissions reductions as a result.

ne: Why not?

Edenhofer: Shutting down coal-fired power plants could have two consequences. The first is known as the rebound effect: if we take some lignite or hard coal power plants offline, electricity prices go up. This makes the remaining coal-fired plants more profitable, which could cause them to ramp up production. The second is the waterbed effect, whereby the decommissioning of German power plants leads to greater availability of emissions allowances, reducing the cost of emitting carbon. This could ultimately give other countries an incentive to rely more heavily on coal for power generation.

ne: Can’t emissions trading solve this problem?

Edenhofer: Many experts claim that the waterbed effect is no longer a cause for concern, because the market stability reserve provides a mechanism to absorb the excess allowances. However, this is not the case. Experience shows that not enough allowances are absorbed, and the rebound effect does not just apply at the national level, but across the entire European market. There are two methods that could be employed to counter this. One is to cancel German allowances. This would require the finance minister to play along, however. It is by no means clear that he would, as the measure would lead to revenue losses. The other option is to advocate a minimum carbon price in the emissions trading system. In any case, it is vital that we institutionally safeguard the reduction targets of the coal exit commission. However, we also have another important task to accomplish.

ne: Which is?

Edenhofer: We must comply with the reduction targets imposed by the EU. And this task is fundamentally different from the goals set by the coal exit commission in one respect: whereas the coal phase-out is a national endeavour that we have undertaken as part of our own climate action plan, the carbon reduction targets in transport, heating, buildings and agriculture are not self-imposed targets – they constitute an obligation at the European level. For each year from 2021 to 2030, Germany has been allocated a specific carbon budget for the sectors not covered by emissions trading in line with the European effort sharing scheme. And this system is enforced by means of penalties: if we overshoot our budgets, we have to buy surplus allowances from other member states under the emissions trading scheme.

ne: Is Germany on course to avoid these costs?

Edenhofer: No. As far as the targets set out by the coal exit commission are concerned, we possibly have a rough idea of how they might be implemented. But when it comes to the European targets, we do not even have the necessary institutional conditions for compliance. I am convinced that the only way to meet these targets is to introduce a carbon price – in all of the affected sectors.

ne: How might this be done?

Edenhofer: It would be relatively simple to tax oil and gas in relation to their carbon footprint, for example. The problem is that it is hard to predict in advance the extent to which this would reduce emissions. Accordingly, variable tax rates would be needed, to be adjusted as necessary according to the targets aimed for. Enacting this kind of legislation is a huge political challenge. Another option would therefore be to expand the existing trading scheme to include the remaining sectors in the carbon allowance system, ideally with a floor and ceiling price. This would provide the necessary flexibility: if the carbon savings are not achieved, the floor price rises.

ne: Should this expanded emissions trading scheme apply only to Germany, or to all of the EU?

Edenhofer: Implementing this kind of system is no simple matter, institutionally speaking. However, it would be conceivable for Germany to first introduce a national trading scheme, and subsequently include its reduction commitments in the European emissions trading scheme. With enough political will, a gradual transition could be made from this system to one encompassing the whole EU.

ne: Which form of carbon pricing do you think makes the most sense?

Edenhofer: In the long term, all sectors could be subjected to an EU-wide emissions trading system, given that a unified European carbon tax is unlikely. If Europe is to become carbon neutral by 2050, then we must aim for a solution at the European level. This would also substantially strengthen our position in international climate negotiations: if we can say that we were able to establish a Europe-wide carbon pricing system, that would send a strong signal to the rest of the world.

ne: But there would undoubtedly be a great deal of resistance to begin with. Even at the national level, implementation would presumably be very difficult...

Edenhofer: That’s true, not least because expanding the emissions trading system would have an important consequence: if we include the remaining sectors in the system, this will cause the price of allowances to rise. That would probably mean abandoning coal far sooner than anticipated by the coal exit commission. A unified system allows more flexible effort sharing across sectors. And as experts unanimously predict that the cost of carbon avoidance will be much lower in the electricity sector than in transport, to begin with the bulk of the savings are likely to occur in electricity generation. And I don’t see this as a problem: for instance, widespread electrification in mobility only makes sense from a climate perspective if the electricity sector is decarbonized first.

ne: But pushback from power plant operators is inevitable.

Edenhofer: Yes, but they will have to cut back coal capacity in any case. Sometimes I have the impression that certain people favour emissions trading because they assume that such a system will ultimately be cheaper for companies than a tax. But that is not the case. The two instruments can be configured to have the same effect.

ne: Perhaps the advocates of an allowance system hope to benefit more from loopholes. After all, the current emissions trading scheme is riddled with exemptions for industry...

Edenhofer: This is true. However, a tax would also provide plenty of opportunities for loopholes. Any system can be designed to have more holes than a Swiss cheese.

ne: Is there a cross-sector emissions trading system in place anywhere in the world that could serve as an example for Germany or Europe?

Edenhofer: There are a few cases around the world. California – which, it is worth noting, constitutes the world’s fifth-largest economy – has a working system, for example. In the UK, a floor price for carbon has all but eliminated coal from the country’s energy mix within a very short period of time. I am convinced that regardless of whether they are based on a tax or an allowance system, carbon pricing systems can always be designed in such a way as to be effective. And there is no getting around the fact that when all sectors are taken into account, Europe’s carbon market is the largest in the world. It is crucial that we find the political will for ambitious pricing measures.

ne: But a few months ago, German state secretary for economic affairs Andreas Feicht announced that a carbon price would not be introduced until the next legislative period at the earliest. Even this vague prediction was later retracted by the economics ministry. In early June, economics minister Peter Altmaier suggested that the issue was on the table after all...

Edenhofer: There is no mention of a carbon price in the coalition agreement. The coal exit commission also failed to endorse a floor price for carbon, which was only backed by a minority of the commission’s members. However, there are now three convincing new reasons for the political class to engage with this issue. The first is of course the momentum generated by the overwhelming success in the European elections achieved by the Green party, which is perceived by voters as a champion of climate action. The second is the Fridays for Future movement. In the past, politicians would often say to me: “Yes, a carbon price may well be a wonderful academic idea. But it is not something that people are out on the streets protesting for.” It is now clear that the younger generations are indeed clamouring for precisely such a mechanism. The third reason concerns the European commitments we discussed earlier. These commitments bring a whole new dynamic into the debate, which many politicians have yet to fully appreciate.

ne: In what sense?

Edenhofer: Many politicians treat the introduction of a carbon price as if it were merely an attempt by Germany to regain its status as the EU’s star pupil. But this is not the point. The effort-sharing directive is European law, plain and simple. We were a part of the legislative process, and we must now abide by the rules like everyone else.

ne: So we basically have no choice?

Edenhofer: To intentionally miss our European climate targets is not a viable option. And as far as I can tell from the political landscape, this is not what anybody wants. The current government does not want to be seen as a spanner in the works by the rest of the EU. And the poorer member states won’t want to get rid of the targets either, as they stand to gain if wealthier countries fail to meet their emissions objectives, incurring penalties as a result. In this light, to willfully disregard our commitments would be a dangerous choice.

ne: All well-functioning carbon pricing models are built around a relatively low starting price which increases reliably over a number of years. Sweden, for instance, introduced a price of EUR 24 per tonne in 1991, which has now risen to EUR 114. In Switzerland, the price has risen to around EUR 86 since 2008. This requires extended periods of political stability - the system can’t be put on the line each time there is a change in government. How can this be guaranteed?

Edenhofer: If I had a good answer to that question, I wouldn’t hesitate to tell you. The issue of political commitment is indeed the crux of the matter. The starting price is unimportant. What really matters is the commitment to steadily increase it. And in light of the rise of right-wing populism we are seeing in Europe at the moment, this is going to be a key obstacle. Political decision-making has become highly unpredictable. We need to restore some stability in this regard so as to give the economy a robust planning framework.

ne: Is the starting price really that irrelevant?

Edenhofer: Of course you need to come up with a sensible starting point, but the most important thing is for the price to go up reliably. Investors need to know what they can count on up to 2030 and beyond. If they expect the next government to simply call off the whole thing anyway, then they will have no great incentive to invest in technologies that help bring down emissions.

ne: Pricing still has to start somewhere. What amount would you suggest if Germany were to introduce a carbon price in the next legislative period?

Edenhofer: I would recommend starting with a floor price of EUR 30 to 40 per tonne of carbon dioxide, to rise steadily between now and 2030. In order to meet our European targets, it will probably have to reach EUR 60 to 80, though this is impossible to quantify exactly as we cannot know how the markets will react.

ne: Thinking even further ahead, with a view to climate neutrality by 2050, wouldn’t a much higher price be needed?

Edenhofer: Yes, beyond 2030 we are undoubtedly looking at a carbon price in excess of EUR 100. But that is dependent on technological developments that no one can predict. We therefore need a flexible system.

Ottmar Edenhofer
is director of the Potsdam Institute for Climate Impact Research and founding director of the Mercator Research Institute on Global Commons and Climate Change (MCC). He also holds a professorship in the Economics of Climate Change at the Technical University of Berlin. From 2008 to 2015, Edenhofer was co-chair of the IPCC’s Working Group III, devoted to climate change mitigation strategies.