Carbon Critical

09. Aug. 2021

Pricing vs Rules: The EU’s Balancing Act

Price-based or quantity-based mechanisms, which offer the more effective and fairer way to achieve carbon neutrality? In fact, the debate is somewhat artificial—EU climate policy needs both.

A graph showing projected electric vehicle adoption in the EU 2020-2035
Namensnennung CC BY

One thread runs through the giant package of climate legislation that the EU released on July 14: the tension between carbon pricing on the one hand and rules and standards on the other.

Pricing is an important pillar of the package known as “Fit for 55.” The European Commission is proposing to enhance the EU’s existing carbon market, the ETS, by reducing the number of permits available and thus raising their price. The ETS will also be expanded to cover maritime emissions and, if only indirectly, industrial emissions outside of the EU: a proposed carbon border adjustment mechanism will require EU firms to pay for the pollution embedded in carbon-intensive imports. The EU also wants to set up a separate ETS covering emissions from the buildings and transport sectors. Finally, the commission intends to increase taxes on petrol, diesel, kerosene, and heavy oil.

But the EU is not only relying on price signals to transform the economy. It is also setting rules. It will mandate the increasing use of sustainable aviation fuels, both biofuels and e-fuels made from hydrogen and captured carbon. These are quantity-based instruments: the EU stipulates that jet fuel providers at EU airports must blend a certain share of sustainable aviation fuel into their supply (5 percent by 2030), and the market is meant to respond and find the right price. The European Commission also wants to require member states to install charging points for low-emission vehicles: by 2025 there should be an electric car charger every 60 kilometers on major EU highways. The rule making the most headlines is an impending ban on new sales of fossil-fueled cars: a new regulation, if passed into law, would require the average emissions of new cars to fall to zero by 2035.

The Price of Action

Finding the right balance between pricing and rules is so difficult because the two policy approaches tend to irritate (or invigorate) different interest groups.

Take road transport, where the EU is planning both new rules and new taxes. The proposal to put a carbon price on transport fuels has come under heavy fire in Brussels. Pascal Canfin, the French MEP from the centrist, liberal Renew Europe group who chairs the European Parliament’s environment committee, has warned that this would be “politically suicidal.” “Do not make the mistake … we saw in France; it gave us the yellow vests.”

As the economic historian Adam Tooze has argued, the Macron administration’s announcement that it would continue to periodically raise the carbon tax on fuels was far from the only cause of the Gilet Jaunes protests—and there are many ways to recycle carbon tax revenue to low-income Europeans. (European Commission President Ursula von der Leyen did say Brussels would establish a social climate fund worth €144 billion to “compensate vulnerable groups” for higher costs.) Yet it is the perception that matters, and there has indeed been an ugly backlash against carbon pricing in places like Australia or the US state of Oregon.

In any case, it is not only the French who have concerns. Polish state secretary for climate Adam Guibourgé-Czetwertynski has said “The commission seems to be making the choice of taxing poorer households,” which he called a mistake. Danish Climate Minister Dan Jorgensen has admitted that it is “difficult for me to just point to a big number of other countries that support [the ETS for transport].” Germany is one of the few supporters, but the proposal has reportedly split the commission.

Interestingly, the skepticism about pricing comes from across the political spectrum, in Brussels and in national capitals alike. “We doubt that pricing is the right instrument. We are focusing on regulatory measures, in other words on clear rules,” Janine Wissler of Germany’s Die Linke (Left Party) told the weekly newspaper DIE ZEIT . On the right, CDU “candidate for chancellor” Armin Laschet said carbon pricing would “hit the little people harder.” The proverbial female care worker who drives hundred kilometers every day to work, stops for a sausage on the way, and needs dirt-cheap flights to Mallorca for her summer vacation is becoming the secret star of his electoral campaign.

Carbon pricing does have its supporters, of course. It made into the EU’s final proposals, after all. And it brings in tax revenue. In that same series of DIE ZEIT interviews with German top politicians, Christian Lindner, leader of the business-friendly Free Democrats (FPD) called it “the most effective measure out there,” and Green candidate Annalena Baerbock said it was an essential element of a balanced policy.

Rules Are Rules

What about the proposals for new rules? Those brought quite different responses. 

The European Automobile Manufacturer’s Association welcomed the EU’s move to put a price on carbon because it “could help to make zero-emission vehicles competitive and attractive for our customers,” and it praised the new rules mandating national governments to install electric chargers. But it fumed at the rule banning new sales of combustion engines: “banning a single technology is not a rational way forward at this stage.” (FDP chief Lindner said much the same about a combustion engine ban.) The head of the German Association of the Automotive Industry complained the ban was “anti-innovation,” adding, “Consumers’ freedom of choice is unnecessarily restricted.”

Consumers themselves, or at least their representatives at the umbrella group BEUC, took a different view. BEUC said it, too, was skeptical about carbon pricing but pleased that car companies would have to offer Europeans better products: “the higher the target, the sooner people can drive in cleaner and cheaper cars.” The European Environmental Bureau, a network of 170 European environmental citizens’ organizations, put out a statement praising the new rules and regulations that affect industry and government, calling for even higher ambition. But it criticized the EU’s decision to use carbon pricing on the grounds it would “shift the cost of pollution from the actual polluter to the final consumer.”

Finding the Balance

There are real differences between taxes and rules. Price-based mechanisms generally drive the most efficient emission reductions; that’s why economists love them. But carbon taxes work best in markets where cleaner alternatives are available and price signals come through clearly. Airlines are very aware of their fuel costs and can work to keep them down, e.g. by buying more aerodynamic planes. However, when regular people decide whether to buy a gas-hungry SUV, they generally have no idea what their fuel costs will be in a few years, let alone what role carbon pricing could play. Pricing is also better at promoting incremental improvements, like more efficient ways to burn fossil fuels, than driving systemic change.

Rules and quantity-based mechanisms, on the other hand, are crucial for driving more transformational change, especially when they are flexible on which clean technologies are deployed. Thanks to the EU rule, producers of various sustainable aviation fuels now have a guaranteed market. And when the EU bans new sales of combustion engines, automakers cannot gradually innovate to make combustion engines more efficient—improvements that can result in “rebound effects,” when customers use savings on fuel costs to buy larger cars and end up consuming just as much gas. Instead, carmakers must completely change their product.

Moreover, rules for green infrastructure can help prevent “carbon lock-in,” the self-perpetuating inertia of fossil fuel systems: if gas stations are everywhere but electric chargers are nowhere to be found, people won’t switch to electric cars to save some money on fuel. On the downside, standards are less suitable for accelerating the phase-out of existing assets. What sort of rules could change how often someone drives the car in the driveway?

The truth is Europe needs both taxes and rules. The commission could not have proposed a target for renewables to make up 40 percent of the EU energy mix in 2030 if pricing mechanisms like the ETS and subsidies for clean power had not driven the development of renewables over decades. Similarly, the EU could never rely on pricing alone to drive the necessary change: in order for it to reflect its true environmental cost, the price of carbon would have to jump from about €50 per ton today to an unfeasibly high €180.

Where Do I Send the Bill?

Politicians and interest groups may couch their criticism of the “Fit for 55” package in the language of policy analysis, but for the most part they are fighting the usual political fights over the distribution of burdens and benefits. Automakers prefer carbon prices that they can pass on to their customers; customers prefer rules that force automakers to sell better cars. Some politicians oppose any taxes on low-income workers; others oppose rules that restrict their backers in business.

While taxes come with direct costs, and rules with indirect costs, in the end it is the economy as a whole that foots the bill. Airlines will pass on the cost of complying with the sustainable fuels mandate to their customers, just as gas stations will pass on the cost of carbon pricing to theirs. All of these measures can affect employment, tax revenue, and investment. It is possible to move the burden of the energy transition between individual citizens and the government budget—for instance, Germany is using its post-pandemic EU recovery funds to lower the fees Germans pay to support renewable electricity—but the citizens saving money on their electricity bills are still funding the German (and EU) budget with their taxes or bond purchases, in a system that is much less progressive than one might expect.  

The energy transition costs everyone money, wherever the bill is initially sent. And it costs much less to pay for it now than to deal with failure later.

Noah J. Gordon is INTERNATIONALE POLITIK QUARTERLY’s climate columnist.