Germany takes a page from US playbook with new climate subsidy

Welcome back.

Brussels and Washington have historically represented opposing sides in the eternal struggle over how to best tackle climate policy: with regulations or subsidies? US policymakers tend to see the EU as lashed to a rigid technocratic rule book. Europeans, meanwhile, see the US as an improvisational adhocracy that doles out spending to favoured sectors, before backsliding.

There’s a glimmer of truth in each depiction. But my dispatch today cuts against those conventional narratives. I looked into a new German subsidy scheme that sidesteps the sagging EU carbon market and aims to rival US support for green heavy industry.

Even as Germany takes a page out of the American playbook, it also seems that a US price on carbon — long seen as politically unworkable — could come to fruition.

With Donald Trump’s income tax cuts set to expire at the end of next year, there will be “huge room for negotiation” on alternate revenue sources such as a carbon tax, according to Sheldon Whitehouse, the Democratic senator from Rhode Island. Even economist Arthur Laffer, a champion of the Trump tax cuts who has been floated as a Trump pick for Fed chair, has advocated for a carbon tax. Perhaps Brussels and Washington aren’t as far apart as once thought.

Also in today’s newsletter, my colleague Aiden has looked into a new tool from the Bank for International Settlements, aimed at helping central banks understand the financial risks posed by climate change. 

Thanks for reading. — Lee Harris

the price of carbon

A novel way to catalyse industrial decarbonisation

Last year, Germany’s greenhouse gas emissions fell to their lowest level since the 1950s. But environmental policy played only a minor role in that reduction. The fall in pollution was caused mostly by Germany’s stagnant industrial output.

With factories hobbled by high energy prices, many plants sold off their EU Emissions Trading Scheme permits. That fits with historic trends, Jan-Justus Andreas of the Bellona think-tank told me, as “the big jumps in certificate selling have come with economic crises”.

Partly as a result, carbon prices have crashed. After peaking in February 2023 at just over €100/tonne, the price of a CO₂ allowance as of Wednesday was €63/tonne. The ETS permit glut has also been intensified as the EU sells extra carbon permits to fund the energy transition. This decision has a certain irony, since the resulting fall in carbon permit prices has weakened corporate incentives to decarbonise.

In this torpid environment, Germany has just launched “carbon contracts for difference”, (CCfD) a new subsidy to help businesses hedge against future price movements. Under the scheme, industrial producers will submit a notional CO₂ price that they say would allow them to invest in decarbonisation, while remaining competitive against fossil-fuelled rivals.

For example, a steel producer replacing coal with hydrogen might say that it requires a carbon price, or “strike price,” of €100 per tonne to be competitive. At an ETS carbon price of €50, the state would pay it €50 per tonne of CO₂ avoided. But if the carbon price later rises to €110, the company would pay €10 per tonne to the state. Contracts will be awarded through an auction process, intended to incentivise companies to submit competitive prices.

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Germany last week launched bidding on the first round, which will be worth up to €4bn and be open to sectors such as steel, glass, paper and chemicals. Support is capped at €1bn per bidder.

Germany is not the first EU member state to pass a CCfD. The Netherlands runs a similar scheme (although in that case, the government just sets a price floor and the firm is not required to pay back surplus).

The UK has also used similar “contract for difference” agreements, in effect, guarantee energy prices for offshore wind developers — a scheme that has suffered recent setbacks as project costs have surged.

In an unusual move, the German CCfD will cover not only capital expenditures but also operating expenses, de-risking the input costs of greener industrial production, such as the cost of electricity and hydrogen. That looks much more like US support for green production — namely Joe Biden’s landmark climate legislation, the Inflation Reduction Act.

Indeed, at a June press conference, Germany’s deputy chancellor and economy minister Robert Habeck said: “We associate with this instrument not only climate protection, but also a response to the American Inflation Reduction Act,” as Euractiv reported.

Carbon price fails to spur action

In the immediate term, however, the CCfD could work at cross-purposes with carbon pricing.

Michael Pahle, a researcher at the Potsdam Institute for Climate Impact Research, told me that the CCfD could dampen the ETS price signal, since businesses included in the scheme will no longer buy permits.

On its own, he said, the ETS requires investors to bear considerable volatility and uncertainty about long-term carbon prices. “So you want to transfer some of the risk away from new investments [with the CCFD]. But if you subsidise too much, and transfer risk away too much, you cut into the functioning of the market.”

Additionally, he said, the role of the carbon price is as much about setting political expectations as economic incentives. As firms develop transition strategies, he argued, they need to believe that subsidy will not be available forever — and that the carbon market will eventually squeeze.

“In order to make this [CCfD] credible, and to clearly negotiate with industrial firms that this cannot be subsidised forever, you need to have the carbon price in your back pocket,” he said.

Business lobby groups have already pushed for an expansion of the new scheme.

Jörn C. Richstein, an electricity market expert at the German Institute for Economic Research, argued that the subsidy is compatible with the efficient functioning of carbon markets, even short-term. Governments rolling out CCfD schemes are actually giving themselves a reason to keep market carbon prices high, he pointed out, since they will owe money to companies if the ETS price falls below the agreed strike price.

In a statement, Germany’s economic ministry also disputed the notion that the CCfD is at odds with market-based carbon pricing.

“The CCfD allows quicker market deployment of carbon neutral production technologies as it insures companies against uncertainty regarding the development of ETS carbon prices,” a spokesperson said.

‘A very expensive schedule’

Payouts to companies will be adjusted to compensate for fluctuations in input prices, such as electricity and hydrogen. The decision to include operating expenses in the subsidy has ruffled some feathers among German economists.

Pahle argued that while it makes sense to de-risk carbon prices, which are subject to political risks, it is harder to justify the decision to eliminate uncertainty stemming from input costs. Other companies are also exposed to the price of green energy inputs, he pointed out, so “what is the economic justification?”

Another question raised by the arrangement is how much of a profit margin companies will build into the “strike price” they submit, or whether they will merely aim to break even.

Germany’s economic ministry declined an on-record interview, but said in a statement that “the auctions are designed in such a way that oversubscription and thus effective competition is ensured. Consequently, there is a strong incentive for companies to tender the lowest possible price. This mechanism ensures that the CCfD scheme will not subsidise industrial firms’ profits”.

The success of the CCfD will also depend upon companies actually producing lower carbon alternatives, since they are paid only if they deliver.

However, Andreas told me, “if the hydrogen doesn’t arrive, or I don’t have anywhere to put it, all of this just becomes a very expensive schedule”. (Lee Harris)

Artificial intelligence

AI-enabled climate risk assessments are not far away

This week the Bank for International Settlements, the umbrella group for central banks, announced the test run of an artificial intelligence application focused on assessing climate risks.

Project Gaia, developed by BIS with the Bank of Spain, the European Central Bank and the Deutsche Bundesbank, was created to test whether an AI tool could help central banks and financial institutions to understand the financial risks posed by climate change. 

Analysts have long complained that differences in corporate climate-related disclosures across companies, countries and industries make it difficult to assess financial systems’ vulnerability to climate risks. Corporate reports often bury climate-related data among other financial data; or companies will split this kind of disclosure across multiple reports.

The Project Gaia large language model (LLM) can scan financial reports and banking releases to identify climate commitments and risks across different documents, disclosures and legal systems. Its test run showed promise.

Gaia assessed 187 financial institutions across 20 climate risks, such as carbon emissions or green bond issuance. It scanned more than 2,328 documents, including financial statements, ESG reports and public reports, and compiled the results for each company and national financial system.

And it was remarkably accurate.

When compared to the findings of ESG experts who went through the same files, Gaia was 98 per cent accurate in identifying instances where there was no relevant climate risk information in a document, and was 80 per cent accurate in identifying and categorising climate risks within a scanned document.

While AI’s arrival in this space may excite bankers and scare ESG consultants in equal measure, there is reason to temper excitement. The BIS only created Gaia as a proof of concept, and has not announced plans to release a similar product for commercial use.

But it is fair to say that we are not far off from AI-enabled climate risk assessments, making reporting easier and cheaper, and likely disrupting the burgeoning ESG reporting industry in the not too distant future. (Aiden Reiter)

Smart reads

• Last month we highlighted an investigation by The Bureau of Investigative Journalism that raised concerns about Santander’s lending for an oil project in Peru. In a follow-up, TBIJ revealed that the Spanish bank “exploited loopholes in its own climate policy in order to help raise billions for facilities relying on fracked US gas”, before watering down that same policy.

• Fatih Birol of the International Energy Agency reminds us to pay attention to progress on clean energy technology.

• Does the Biden administration’s response to the US Steel deal go too far? Our colleague Alan Beattie weighs in.

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