German coalition proposals de-risk the path to higher carbon prices

This week, Germany's new coalition government announced a series of climate and energy proposals that will guide their policies over the next four years. Notably, the agreement includes a proposal to “ideally” phase out coal by 2030, eight years earlier than previously committed.

In order to achieve this the German government plan to rely on high carbon prices to incentivise the complete shift away from coal. Using the carbon price to leverage change is a vote of confidence in the EU ETS as a tool for decarbonising the power generation and industrial sector of the EU.

Nevertheless, the proposals also include the option of introducing a national floor price. This would come into operation if the EU ETS carbon price falls below €60 per tonne. Meanwhile, the coalition partners have agreed to push for an EU wide floor price (also set at €60 per tonne) as part of the EU ETS.

It’s important to note that simply because Germany has warmed to the idea of a minimum carbon price, doesn’t mean that other EU member states will be as keen. Previous efforts by some member states such as France, to implement a minimum price in the scheme have failed to gain support.

In the hours following the announcement the price of carbon increased by around €3 per tonne to reach a record level of over €73 per tonne. The €60 per tonne floor price now seen as reducing the downside price risk for obligated market participants and investors.

On the face of it a minimum carbon price is a bullish development for the market. However, there are a number of reasons why there’s reason for doubt. For one, carbon prices are already over €60 per tonne and so there may never be a need to introduce a floor price. Recall that Germany only plans to introduce a national minimum carbon price in the event that the EU carbon price falls below this level.

Secondly, the €60 per tonne might also become a target for market participants wanting to test political resolve at this level. Political capital is high at the moment in the honeymoon period following the German election, but all political parties know that this starts to dwindle as time goes by.

The third reason why its not necessarily bullish for carbon prices relates to reduced uncertainty. If market participants now believe that carbon prices will be at least €60 per tonne then they may be more likely to bring forward decarbonisation investment. The carbon price becomes even more ‘bankable’ when there is a minimum price attached to it. If this reduces emissions earlier, and faster than the market expects then there will be less demand for emission allowances in the future.

The counter to this is that €60 per tonne really isn’t anywhere near high enough to achieve the EU’s aims. Phasing out coal several years earlier than previously planned will require carbon prices to be much higher than €60 per tonne. Meanwhile, the much more challenging task of decarbonising the industrial sector will require even higher carbon prices.

The finer details of the policy proposal matter. The proposal did not include any mention of the timing for the introduction of the minimum price. How long for example will carbon prices need to be below €60 per tonne for the floor price to be activated? Also, will the floor price increase in real terms (or by some other factor), or will it remain in nominal terms at €60 per tonne?

In summary, the proposals increase the likelihood of much higher carbon prices in the short to medium term since the path to higher prices has been de-risked by a degree. But the floor price will be tested at some point in the future. Whether it holds or not will depend on Germany’s, and the EU’s political resolve.