17. February 2022 By Georg Benhöfer, Stephen Lorenzen and Lars Zimmermann
Introducing carbon contracts for difference to transform the energy industry
Achieving Germany’s ambitious climate targets is currently the talk of the town. Federal Minister for Economic Affairs and Climate Protection Robert Habeck recently announced the ‘opening balance sheet on climate protection’ (in German), making it clear that annual greenhouse gas emissions in Germany must decrease drastically in the future. All the necessary legislative projects and measures should therefore – as we outlined in our last blog post – be set in motion before the end of this year. One of the measures announced by the German Federal Ministry for Economic Affairs and Climate Protection (Bundesministerium für Wirtschaft und Klimaschutz, BMWi) as part of this are carbon contracts for difference (CCfD). This is a concept borrowed from the world of finance to create investment security in volatile market conditions. But what does it mean exactly? And what has a financial product got to do with the energy industry? We will give you a brief overview in our blog post.
What problem do carbon contracts for difference address?
Technical investments in industrial plants are mostly long-term investments. They have relatively long planning times, high investment costs and only pay for themselves after several years. This means that facilities built a few years ago will not be renewed for many years to come. If you want to reduce the greenhouse gas emissions produced by the industrial sector, you need to ensure that the investments made in industrial plants from now on are in climate-friendly ones, where possible. There are two main reasons why this is a challenge:
1. Investments in climate-friendly technologies are usually significantly more cost-intensive than investments in technologies that do not protect the climate.
2. The climate and the atmosphere are a public good. This means that they are both non-excludable and non-rivalrous – so they can be used by several consumers at the same time without any problems. In turn, this then means that users do not have to pay to use a public good per se. Therefore, from an economic perspective at least, industrial companies do not benefit from protecting the climate. Quite the opposite, in fact: they are impacted negatively if they do so since there is no equivalent value for the additional investment in climate-friendly technology. The introduction of the EU Emissions Trading Scheme is attempting to create this equivalent value by issuing carbon certificates, thus putting a price on the climate. In a perfect world from a climate protection perspective, the price of carbon would be so high that it would be economically worthwhile for companies to invest exclusively in climate-friendly technologies. This is currently not the case, however.
To summarise: on the one hand, in order to achieve Germany’s climate targets, new investments in industrial plants must be climate-friendly from now on, where possible. On the other hand, the current instrument, the Emissions Trading Scheme, does not provide sufficient incentives for this. This is the exact gap that carbon contracts for difference are supposed to close.
How can carbon contracts for difference create the incentives that are lacking at the moment?
The carbon contracts for difference (CCfD) are intended to serve as a funding instrument to support climate-friendly investments in industry. To this end, they address the problem that climate-friendly investments are only worthwhile for industrial companies if the carbon price remains high in the long term, but speculation on high carbon prices represents a high risk. CCfDs are therefore contracts between the Federal Republic of Germany and industrial companies in which – to put it simply – the state covers the risk of investments in carbon reduction in the long term.
In essence, the German government and an industrial company agree on a fixed reference price for one tonne of carbon for a specific contract period. This reference price is set in relation to the actual carbon price during the term of the contract. This creates two different scenarios depending on the difference between the reference price and the actual price. Either the actual price is lower than the reference price (low-price scenario) or the actual price is higher than the reference price (high-price scenario). In the low-price scenario, the federal government is obliged to pay the industrial company the difference between the actual price and the reference price. In the high-price scenario, on the other hand, the industrial company pays the difference to the federal government. This should reduce the risk of carbon costs that are too low and make an investment in carbon reductions uneconomical.
A simpler explanation
Let’s say you want to invest in a new car. You have two choices: 1) Buy a modern car with average fuel consumption or 2) Buy an innovative car with a new engine that consumes only half as much. The innovative car is significantly more expensive than the modern one, so you are only going to buy the innovative vehicle if the fuel savings are so high that it is worth it. You get out your calculator and work out investment costs plus fuel consumption for both models. You will only choose the innovative model if both totals end up being the same or the total for the innovative vehicle is lower.
You calculate that the innovative car is worthwhile if you assume an average fuel price of at least two euros per litre over a period of five years. You just paid €1.70 per litre at the petrol station. The question is then would you be willing to take the risk and speculate that the price of fuel will rise enough in the next few years to make the innovative car worthwhile? The risk will probably be too high for you, and you would rather invest in the modern car.
Or: you enter into a carbon contract for difference with the federal government. You agree on a fixed fuel price of two euros per litre for the next five years, a rate at which the investment in the innovative car is worthwhile for you. In reality, you then go to get petrol as usual and pay the price that appears on the display board. If it has remained at €1.70 per litre, the federal government will pay you 30 cents for every litre. But if, for example, it has risen to €2.30 per litre, you have to pay the federal government the difference, that is, 30 cents per litre.
This means you have gained investment security, which makes the innovative vehicle economically more attractive to you than the modern one. At the same time, the state has protected the public good of the climate and the atmosphere to a small degree.
Where do we go from here?
We will have to wait and see for the time being, as concrete details on the design of the CCfDs are not yet known. What seems certain is that investments that lead to a reduction in carbon will be subsidised in the future. Industrial companies that are currently planning to make these types of investments should follow events closely and possibly wait to start construction. It remains to be seen whether funding can also be approved retroactively, that is, after construction has started.
Furthermore, the question remains open as to when we can expect CCfDs to be introduced. Habeck has announced that all procedures surrounding the introduction of the new climate protection measures are expected to be completed by the end of 2022. The first package of these measures should be published by the end of April. This could mean that the first wave of carbon contracts for difference will be concluded this year. We can remain curious.
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