The federal government has set itself an enormous task for the current legislative period: it wants to change Germany’s existing economic model to become a “socio-ecological market economy”. Though the building blocks are already being put in place, much about the ultimate form of such an economy remains uncertain.
In a widely viewed video from 21 August 2022, Robert Habeck, Federal Minister for Economic Affairs and Climate Action, reported on the climate measures that the government has introduced over the previous six months. He put particular emphasis on efforts to speed up permitting for the build-out of wind power and the electricity grid; the expansion of land areas designated for wind; the requirement that newly installed heating systems run on at least 65 per cent renewable energy; and the EU Commission’s approval of federal funding for efficient technology in new heating networks and in the retrofitting of existing systems.
It is true that streamlining the permitting process will give the private sector more incentive to invest in renewables and power grids. But the other measures mentioned by Habeck do not reflect market-based strategies. Yet there would have been a lot to report on this – and a lot more would have been necessary.
A second emissions trading scheme for Europe
For starters, consider Fit for 55, the EU’s ambitious programme for reducing greenhouse gas emissions. Habeck cited the plan but made no mention of the European initiative to create a European emissions trading scheme for fuel in the transport and buildings sectors, which would supplement the existing system for industrial emissions. Yet it is precisely the carbon pricing introduced by such a scheme that is essential for creating a market economy that is both social and ecological.
When it comes to efficient climate policy, there is scarcely an issue on which economists agree more than carbon pricing. In 2019, over 3,500 American economists called for the introduction of a carbon price. A similar statement issued by the European Association of Environmental Economists was signed by some 1,800 economists.
Prices are the steering instrument of any market economy, and this is no less true for the “socio-ecological” version envisioned by the German federal government. However, the “social” and the “ecological” elements take different approaches to pricing. Whereas social policy often imposes taxes on the results of economic activity – wages and income – climate policy must impose taxes on production and technology. As a result, activities that are harmful for the climate become more expensive while those that are cleaner become cheaper. Pricing in climate policy also brings about the efficient reduction of emissions: effects being equal, the economy will favour the most affordable measures for cutting CO2.
The advantage of carbon pricing is that it starts where pollution begins and accompanies it through the entire supply chain. By contrast, regulatory interventions and subsidies focus on single phenomena, and thus cannot achieve the same overall effect.
It would be helpful for Germany to make a clear public commitment to a second emissions trading scheme in the EU, particularly because the system currently under discussion is not without controversy. It would lead to higher prices for petrol, diesel, heating oil, and natural gas, and many decision-makers are reluctant to increase the energy burden for households. But there’s no way around fossil fuel price increases if Germany wants to make its economy ecologically sustainable. And what are restrictions and other environmental regulations if not efforts to impose high prices on prohibited behaviour? Either way, vulnerable households will need relief. The dividends from carbon taxes in an emissions trading system could be used for just this purpose.
Differentiated pricing for an efficient clean-energy transition
In his video message, Habeck emphasised the need to expand the power grid and renewable energy capacity if German was to transform its economy towards ecological sustainability. However, both measures suffer from a lack of pricing mechanisms, which gives consumers the illusion that Germany has a single electricity market. Prices that take into account grid bottlenecks would bring about a number of efficiency advantages. An economically consistent representation of the electricity market would have to include so-called nodal pricing, as is already common in parts of the United States. In Germany’s case, nodal pricing would tend to create electricity that is cheaper in the north than in the south on account of the high levels of clean-energy production in the former and the high demand for energy in the latter. As a result, wind power operators would have more incentive to settle in the south, because they would stand to make more money from wind power even if wind supply is lower. At the same time, industries would have an incentive to settle in the north, where more electricity is generated and electricity prices are cheaper. This would make the energy sector more efficient and reduce the need for grid expansion.
Competitive incentives for economic transformation
Habeck noted his surprise at the astonishing dynamic with which Germany has set about transforming its economy. In particular, he underlined the skyrocketing demand for green hydrogen. But whether and how green hydrogen will be sustainable in the long run is the key question when deciding on the form that an ecologically sustainable social market economy will take.
Among the instruments the federal government has planned for the promotion and use of green hydrogen are “carbon contracts for difference”. The idea is to reimburse companies for the cost difference between the production of “clean” goods and the production of “dirty” goods. The effectiveness of carbon contracts for difference relies on the price of EU allowances, also known as carbon credits. This price determines the additional cost of goods produced with high levels of emissions. The current price for an allowance is around 90 euros per tonne of CO2. At this price, however, the need for carbon contracts for difference, which first emerged in the political discussion when allowances cost less than 20 euros, is greatly diminished.
Carbon contracts for difference and similar instruments do offer companies long-term planning security and make them less dependent on fluctuations in allowance pricing. However, allowance pricing is precisely the climate policy signal that is needed for an ecological restructuring of the economy. With carbon contracts for difference, companies that the government believes are particularly important for the clean-energy transition – or those that manage to convince the government that they are particularly important – receive a de facto reimbursement. For small- and medium-sized companies this will be much more difficult. The instrument should therefore be used sparingly – for example, in competitive processes with short funding periods. And instead of reimbursing production costs, it would make more sense to promote research and development.
The political struggle regarding the form of Germany’s socio-ecological market economy has begun. If it is designed well, it has the potential – like Germany’s social market economy in years past – to become a successful model for other countries. Moreover, it would stand to advance climate action around the world. But achieving a well-designed economy will require more market-driven mechanisms and more trust in the market’s “discovery process”.
Some passages of this article were taken from the author’s new book on economics and climate policy, Klima muss sich lohnen: Ökonomische Vernunft für ein gutes Gewissen (Verlag Herder, 2022).