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In the previous blog, I started with the version of climate regulation I find easiest to understand economically. Carbon creates a cost that the market doesn’t see, so put a price on carbon and let businesses decide how best to respond. The EU ETS broadly follows that logic. Europe determines how scarce the right to emit should be, but once that constraint exists, companies retain considerable freedom to decide whether they want to reduce emissions, change technologies, improve efficiency or pay for allowances.
The obvious question is why Europe didn’t stop there. If the carbon price is high enough, fossil fuels become more expensive and lower-carbon alternatives become relatively more attractive. Businesses invest, technologies compete and, in theory at least, the cheapest ways of reducing emissions should win. Yet when you look at the rest of the EU Green Deal, that is very clearly not the approach Europe has taken.
Europe doesn’t merely make fossil energy more expensive. Through the Renewable Energy Directive, it requires renewable energy to occupy a growing share of the energy system. It doesn’t merely increase the cost of conventional aviation fuel through carbon pricing. ReFuelEU Aviation requires an increasing share of Sustainable Aviation Fuel. In industry and transport, Europe has gone further still by creating specific targets around renewable hydrogen and Renewable Fuels of Non-Biological Origin, or RFNBOs.
These are fundamentally different interventions from carbon pricing. Instead of only telling the market what problem needs to be solved, the regulator has started saying something about what the solution should look like. I don’t think that automatically makes them good or bad interventions, but it does make the economic question considerably more interesting: what is Europe trying to achieve through these mandates that it doesn’t think a carbon price will achieve on its own?
The Renewable Energy Directive predates the Green Deal, but the Green Deal and Fit for 55 substantially increased its ambition. Under RED III, the EU has set a binding target of at least 42.5% renewable energy in gross final energy consumption by 2030, with an ambition to reach 45%.
From a climate-policy perspective, the logic sounds straightforward: Europe wants more renewable energy, so it sets a renewable-energy target. Economically, I find that answer slightly unsatisfying because Europe already has another mechanism intended to make high-carbon energy progressively less attractive. If carbon is being priced correctly, why does the regulator also need to specify how much renewable energy the economy should consume?
Imagine, very simplistically, that Europe consumes 100 units of energy and that carbon pricing, technology costs and ordinary market demand would result in 30 of those units becoming renewable. Now suppose regulation requires the system to reach 42.5 units instead. The additional 12.5 units don’t appear because consumers and businesses independently decided that they were the most attractive options available at prevailing prices. They appear because regulation has decided that the market outcome isn’t sufficient and has required the energy system to produce a different one.
That is deliberate interference with the market outcome, but I don’t use “interference” as a synonym for bad policy. Governments interfere with markets for plenty of legitimate reasons. Calling the mechanism what it is simply allows us to ask a more useful question: what is wrong with the 30-unit outcome that justifies requiring 42.5?
One possible answer is speed. Europe has a legally defined climate timetable and may simply not believe that a carbon price alone will transform electricity, heating, transport and industry quickly enough. Another is investment certainty. Someone deciding whether to build renewable generation, an electrolyser or a new fuel plant isn’t making that decision solely on today’s energy and carbon prices. They are investing capital based on what they think demand, infrastructure, regulation and competing technologies will look like over many years. A legally created market can make that future demand considerably easier to believe.
There are also situations where the individual pieces of a new market depend on one another. Hydrogen is an obvious example. Nobody wants to build a pipeline without hydrogen moving through it, producers are reluctant to build large plants without infrastructure and buyers, and buyers may hesitate to convert industrial equipment when they aren’t confident that affordable hydrogen will be available. Every participant can be behaving perfectly rationally while the overall market fails to get moving. A mandate, subsidy or infrastructure programme can sometimes break that coordination problem.
Technology development provides another justification. Early projects can be expensive because supply chains are small, engineering is bespoke, financing is risky and everyone involved is still learning. The first company to solve these problems bears a large part of that cost, while later competitors can benefit from what the industry has collectively learned. Creating demand early can therefore help move a technology down its cost curve faster than an entirely unassisted market might.
All of these are reasonable arguments for intervention, but they also contain an assumption that deserves more attention than it often gets: if we force demand today, the technology or industry we create will become more economically attractive tomorrow.
Solar is perhaps the most persuasive version of the story. Governments supported deployment, markets expanded, manufacturing scaled, technology improved and costs fell enormously. What once needed substantial policy support has become one of the cheapest sources of new electricity in many parts of the world. It is therefore tempting to construct a general theory for the energy transition in which governments create early demand, companies invest, production scales, costs fall and eventually the market can stand on its own.
The theory is perfectly plausible. The problem is assuming that every technology has the same economics as a solar panel. A solar panel has a large upfront manufacturing component in its cost, but once installed, sunlight does not send an invoice. Manufacturing scale, process improvements and technological learning can therefore have a dramatic effect on the cost of the electricity produced over the panel’s life.
An e-fuel has a different cost structure. Producing it requires renewable electricity, equipment and multiple conversion steps, and some energy is lost every time one form of energy is converted into another. Electrolysers can get cheaper and conversion efficiency can improve, but the electricity input doesn’t disappear. A biofuel made from a genuinely limited waste feedstock has a different problem again. Building more processing plants doesn’t create an unlimited supply of waste. Once the easily available feedstock is being used, additional demand may simply make the marginal feedstock more expensive.
This doesn’t mean that e-fuels or biofuels cannot become considerably cheaper. It means that “costs will fall with scale” is an empirical hypothesis rather than a law of the energy transition. Markets can squeeze inefficiency, improve technology and create scale, but they cannot guarantee that every low-carbon pathway eventually becomes cheaper than the fossil product it is replacing.
That distinction matters enormously when we justify mandates as temporary market creation. If a technology is expensive today because its market is immature, intervention can potentially help move it towards competitiveness. If the technology remains substantially more expensive after infrastructure, scale and learning have done most of what they can do, continuing to mandate it is a different policy choice. Society is effectively deciding that the emissions reduction or another strategic benefit is valuable enough to justify paying a persistent premium.
Both choices can be defensible. I just think we should be clear about which one we are making.
ReFuelEU Aviation is where this tension becomes particularly interesting. Under the regulation, aviation fuel suppliers at EU airports must supply an increasing share of Sustainable Aviation Fuel, beginning at 2% in 2025 and rising over time, with a separate trajectory for synthetic aviation fuels.
At first glance, this raises the same question as RED III. If Europe already prices carbon and has broader renewable-energy requirements, why does aviation need its own fuel mandate? Why not allow the market to find the cheapest place to use every available unit of renewable energy?
Consider a deliberately simplified example. Suppose Europe has a limited quantity of sustainable biofuel available and using it in road transport costs €100 for every tonne of CO₂ avoided, while using it in aviation costs €400. If the only objective is to maximise the amount of emissions reduction achieved for every euro spent today, the market has a fairly obvious answer. Use the fuel on the road.
The problem appears when we extend the time horizon. Road transport has another increasingly credible pathway in direct electrification. Long-haul aviation has a much harder energy-density problem and no equivalent scalable alternative waiting around the corner. If every scarce low-carbon molecule keeps flowing towards whichever sector can use it most cheaply today, Europe could arrive twenty years from now having spent valuable renewable fuels decarbonising vehicles that subsequently electrify while failing to develop the production capacity, infrastructure and supply chains required for aviation.
ReFuelEU deliberately prevents the market from making that allocation entirely on today’s economics. Europe is effectively saying that it is willing to pay more for some tonnes of carbon reduction today because it believes aviation will need those pathways tomorrow. The policy is therefore not trying only to optimise the current cost of decarbonisation; it is making a bet about the future structure of the energy system.
I find this a much more useful way of understanding ReFuelEU than simply describing it as a SAF mandate. It is an example of Europe choosing intertemporal efficiency over purely static efficiency. The cheapest tonne today may not be the tonne that helps build the capabilities needed to eliminate the hardest tonne tomorrow.
Whether that bet works is a separate question.
Once an aviation fuel supplier knows that SAF demand will be legally required, the effect travels upstream. A SAF producer can point to future mandated demand when trying to finance a plant. Feedstock suppliers have a reason to develop supply. Traders have a reason to secure future volumes and think about where they can be placed. Airports and fuel suppliers have a reason to consider storage and blending infrastructure, while airlines know that simply waiting for SAF to become as cheap as fossil jet fuel isn’t a long-term strategy.
This addresses one of the more frustrating problems in emerging markets: producers don’t invest because they don’t have reliable buyers, buyers don’t commit because there isn’t enough supply, infrastructure doesn’t get built because neither side is sufficiently certain, and financiers quite reasonably prefer to wait until somebody else has taken the first risk. Regulation can interrupt that circle by making future demand more credible.
The optimistic sequence is easy to see. Mandated demand supports investment, investment creates production, production creates learning and competition, costs fall and eventually the market becomes less dependent on the mandate that helped create it. If that happens, the temporary distortion has helped build a market that can increasingly function on its own.
But there are at least two other possible outcomes. The technology may improve substantially while retaining a persistent green premium, in which case the market continues to exist largely because somebody is required to pay that premium. Or policymakers may discover that the pathway they encouraged is not ultimately the best one, after significant amounts of capital have already followed the regulatory signal.
This is the risk Europe accepts when it moves beyond pricing an externality and starts shaping the transition itself. The regulator is no longer merely saying that carbon has a cost. It is making a judgement about which capabilities society is likely to need in the future.
It is easy to hear words such as “mandate” and conclude that regulation has replaced the market entirely, but that isn’t really what happens. Regulation may decide that a certain amount of renewable fuel must be used, but an enormous amount of competition and price discovery still occurs inside that requirement.
Fuel suppliers compete over which qualifying fuels to buy. Feedstocks compete with one another. Producers negotiate offtakes. Traders decide where a cargo has the highest value. Buyers compare price, GHG performance, feedstock, eligibility and availability. Investors decide which technologies and projects they believe can capture the value created by future regulation. The market remains extremely active, but the regulator has changed the question it is being asked to answer.
Without the mandate, the buyer might have been deciding whether to buy renewable fuel at all. Once an obligation exists, that decision has partly been made by regulation. The market instead gets to decide what qualifying fuel to buy, from whom, at what price, through what contract and, depending on the rules, which pathway is the most efficient way of satisfying the obligation.
This is why I don’t find the usual “markets versus regulation” debate particularly useful. Much of the Green Deal consists of markets operating inside politically constructed constraints. The interesting question is whether those constraints are correcting something the market genuinely cannot solve on its own or whether they are pushing economic activity towards outcomes policymakers prefer for other reasons.
For a business, there is another consequence. Once regulation creates a requirement, it can also create scarcity. A material that previously had limited value may suddenly become sought after because it satisfies a regulatory category. A production pathway can acquire committed demand. Infrastructure in the right location can become more valuable, and environmental characteristics that previously sat inside sustainability reports can begin affecting the price of actual commodities.
At that point, reading regulation purely as a compliance exercise starts missing half the story.
The question I want to carry through the rest of this series is therefore not whether a regulation interferes with a market. Almost every meaningful regulation does that in some way. I am more interested in what the market would have done without the intervention, why that outcome is considered inadequate and what exactly is preventing the preferred outcome from happening naturally.
If the obstacle is coordination, infrastructure, early-stage technology risk or knowledge spillovers, creating a market temporarily may make enormous economic sense. If the obstacle is that the preferred technology will remain permanently more expensive than another available way of achieving the same objective, the justification has to be different. We are no longer merely unlocking a market that wanted to exist. We are choosing an outcome and deciding that its wider benefits justify somebody paying for it.
Renewable fuels make this distinction particularly visible because, unlike sunlight, many of their inputs are physically scarce. The more demand regulation creates for a limited waste feedstock, the more interesting the question becomes of what happens to its price, who captures the regulatory premium and whether a growing mandated market is necessarily a profitable one.
That is where I want to go next, with used cooking oil, Annex IX and the rather strange economics of turning a waste stream into a valuable commodity.
