Germany's federal government has been working for some time on introducing a new Building Energy Law, or Gebäudeenergiegesetz in German. It is slowly making its way through the legislative process, and is expected to pass soon. If it passes, it will ban the installation of oil and natural gas furnaces in all new homes in 2027, after municipalities can provide more local guidance on suitable alternatives specific to their communities. Buildings are responsible for around 15% of carbon dioxide emissions in Germany, where about 80% of residential heating demand is powered by fossil fuels. Among the 41 million households in Germany, about half use natural gas, a quarter uses heating oil, and about 14% are connected to district heat. Very few homes (less than 3%) heat directly with electricity or use heat pumps. Germany has ambitious targets to change that.

Despite its good intentions, the new Building Energy Law is marred in controversy. On one hand, it is heralded as a major step towards lowering emissions from households and fighting climate change. On the other hand, telling home owners to make expensive new investments has led to a political backlash, in part because not all the provisions and timelines are readily understood and misconceptions persist about when existing installations would need to be replaced with cleaner alternatives. Nobody is forced to get rid of existing heating systems for a long time yet, but if a completely new system is needed it will need to be replaced with a new fossil-fuel free alternative—or more precisely, any system that is powered 65% or more by renewable energies. If an old fossil-fuel powered system breaks, it can still be repaired without replacement. There is a long-term hard limit for replacing conventional oil and natural gas furnaces: all systems need to be converted eventually to meet the 65% renewable energy target by 2044. Interim steps require that existing natural gas and oil furnaces use at least 15% renewable energy by 2029, 30% by 2035, and 60% by 2040.

There are numerous possible alternatives. Where it is available, connecting to a district heating system can provide a suitable solution. Most home owners will consider an air-source (or ground-source) heat pump. Hybrid solutions are also possible as long as they meet the 65% requirement. Even new natural gas boilers are permitted as long as they can be retrofitted to run 100% on hydrogen when a municipal gas system is converted. Boilers and furnaces can also use biomass, in particular renewable natural gas [biomethane], that meets the 65% requirement.

The government is subsidizing the transition generously. There will be a minimum 30% subsidy for new climate-friendly installations. Households with an annual income below €40,000 [CAD 58,000] will receive another 30%. Accelerated replacement will be eligible for another 20%, with the total subsidy not to exceed 70%. Just how expensive this new law will is hard to predict, but it is clear that it will be significant. Germany's Minister responsible for the economy, Robert Habeck, estimated a cost of €130 billion through 2045. Other sources claim much higher costs, up to €600 billion. Homeowners are not the only ones affected by the new law. Municipalities also need to upgrade their own building stock, including hospitals and schools, and many municipalities have no easy ways of raising revenues to cover the extra cost.

Extraordinarily high natural gas prices during 2022 have prompted many German households to invest in heating alternatives already, mostly heat pumps. However, heat pumps remain more expensive than conventional systems despite the generous subsidies. Some homes also lack the space to install the compressors outside, and there are significant challenges for multi-unit residential buildings, which are more common in Germany than in North America.

What can we learn from Germany's experience about this new environmental policy? Prescribing a hard target such as the 65% renewable energy minimum seems to assure concrete results. It looks like a policy that can be depended upon environmentally—unless there is widespread non-compliance. The “grandfathering” mechanism is meant to ease the transition, as only replacements and new homes are affected rather than the entire building stock. The law itself also has noticeable loopholes. Which technologies should be favoured or allowed was negotiated fiercely, resulting in a compromise that includes hydrogen-ready heating system that continue to run on natural gas. Natural gas heating may still be installed as long as it can be converted to hydrogen down the road.

Politically, the law has become a source of frictions between the three political parties that form the centre-left governing coalition of the federal government in Germany. Environmentalists complain that it is not strict enough, while far-right activists denounce the bill as “heating ideology”. The law has become a target in the “culture wars” that befuddle Germany as much as the United States and Canada. While there are economic grounds to criticize provisions of the new law, much of the protest against the new law is simply directed against climate change policy in general. Opponents simply reject all climate policies that appear burdensome or inconvenient to their lifestyle.

Economically, the law is not a first-best economically efficient solution. The efficient solution involves a price on the pollution that equals the marginal damage: the social cost of carbon. Households will adapt new technologies when it makes economic sense given the higher cost of natural gas and oil due to the carbon price placed on these fuels. However, subsidies for heat pumps are not based on reductions of carbon dioxide per tonne, but on their installed cost. Command-and-control interventions force some households to replace furnaces when doing so remains economically too costly: the implicit carbon price exceeds the social cost of carbon. Other home owners receive subsidies where a replacement with a carbon-free alternative amortizes even without the subsidy: the subsidy is wasted. Other households will install heat pumps regardless simply because they provide beneficial cooling services, not just heating. These households would install heat pumps even without the subsidy, especially the more affluent households. In a nod towards fairness, at least the subsidy scheme differentiates between low-income and high-income households.

Why does Germany's government resort to a command-and-control intervention when pricing carbon higher would be the better approach? Germany participates in the European Emission Trading System (EU-ETS), but this only covers industrial emitters—not households. Some of Germany's neighbours, notably France, covers the sectors of the economy that do not participate in the EU-ETS with a carbon tax. But even there carbon prices remain too low to make much of a difference when it comes to upgrading buildings.

There is a generic problem with environmental policies that are aimed at upgrading existing buildings: retrofitting is more costly than putting clean systems into new buildings. Forcing retrofitting that is too costly (when the implicit carbon price exceeds the social cost of carbon) makes no economic sense. The better solution would have been to price natural gas correctly. One Gigajoule (GJ) of natural gas emits about 50 kilograms (kg) of carbon dioxide when burned. The social cost of carbon is estimated at US$185/tonne [€173/tonne]. This translates into a carbon price of €8.65/GJ, equivalent to 3 euro-cents per kilowatthour [kWh]. Typical households in Germany pay something like 18 cents per kWh already, due to the exceptionally high cost of natural gas in the wake of the energy crisis that was induced by Russia's war of aggression against Ukraine and Germany's pivot away from cheap Russian gas. The wholesale price of natural gas in September 2023 hovers around €30-40/MWh (equivalent to about €10/GJ). So essentially the hypothetical carbon price would roughly double the wholesale price. At the peak of the natural gas crisis in 2022, wholesale prices topped €150/MWh.

Consider a household that uses 100 GJ of natural gas per year. At the aforementioned social cost of carbon, the annual carbon cost of this gas would amount to €865. At a 5% interest rate, the net present value of this carbon cost over a 25-year lifetime for a replacement is €12,200. That is the difference that a household should be willing to pay extra for a carbon-free heating system. So if the difference in lifetime cost (including fuel or electricity, net of any carbon price) is less than €12,200, the household should install the carbon-free system. But if a heat pump generates beneficial new air-conditioning services on top of replacing heating, many households may be prepared to cover an even larger gap.

Germany's subsidy scheme remains awkward and has inefficiencies baked in right from the start. Administration of the scheme will be costly and complex. A carbon price would be simpler and easier to administer, and the revenue could be returned to households to help the neediest households financially. Governments are prone to fall into the subsidy trap, which I define as an incentive scheme that trades off economic efficiency for political expediency and ultimately makes the policy outcome more expensive than needed. Decisive climate action is badly needed. While I applaud Germany's federal government for taking bold climate action, the Building Energy Law relies on a haphazard mix of command-and-control interventions with somewhat arbitrary target levels and target timelines. Updating the building code to mandate carbon-free heating systems in new buildings makes good sense; it prevents new buildings from getting stuck with costly retrofitting later. Retrofitting old buildings is a different matter, though. Here, appropriate carbon pricing should direct where retrofitting makes the most sense—and where retrofitting remains too costly. It all starts with setting the right carbon price across all sectors of the economy and all types of emitters. And here Germany (and most other countries) remain far off the mark.