“From carbon policy to consumer prices: The economic impact of carbon caps in the Euro Area☆”
“The results are clear: a shrinking output, a devalued Euro, a deepening trade deficit, and soaring unemployment." Bjorn Lomborg
From carbon policy to consumer prices: The economic impact of carbon caps in the Euro Area☆
Author links open overlay panelHugo Morão
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https://doi.org/10.1016/j.eneco.2024.108175Get rights and content
Highlights
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EU ETS impacts inflation and key macroeconomic variables in Euro Area.
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Post-2020 ETS changes contribute to recent price increases.
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More flexible climate policies needed to balance environment and economy.
Abstract
This study quantifies the impact of European Union Emissions Trading System (EU ETS) on inflation and key macroeconomic variables in the Euro Area (EA). Using a structural vector autoregression (SVAR) model, the analysis reveals that stricter climate policies significantly affect industrial production, unemployment, and inflation in transportation, utilities, and food sectors. Furthermore, the post-2020 regulatory adjustments in emissions caps and allowances have contributed to recent consumer price increases, an effect amplified by the COVID-19 pandemic and geopolitical tensions. The findings suggest the European Commission underestimated the macroeconomic consequences of EU ETS Phase 4. This highlights the need for a more flexible climate policy approach that balances environmental goals with macroeconomic stability.
Introduction
The issue of climate change has become increasingly urgent in recent years, necessitating the reduction of greenhouse gas emissions and the mitigation of global warming’s impacts. Cap-and-trade systems have emerged as the leading climate policy for pricing carbon emissions and incentivizing reductions. However, the implementation of these carbon pricing mechanisms is facing new challenges. 2020 brought the COVID-19 pandemic, which caused logistical problems and labor shortages. In 2022, the ongoing invasion of Ukraine by Russia disrupted many global supply chains and led to a decrease in the supply of carbon-intensive goods and services. Simultaneously, carbon prices more than tripled, contributing to the rise in energy inflation and adversely affecting energy-intensive sectors such as utilities and food, which disproportionately impacts lower-income households. These regressive effects present a significant challenge for policymakers who must find ways to mitigate these negative impacts while remaining fully committed to reducing emissions. This paper addresses two main questions: how do rising carbon prices affect inflation rates and their components, and how are they transmitted to the rest of the macroeconomy? To study these questions, the analysis uses a Bayesian Structural Vector Autoregression (SVAR) to analyze how inflation and other significant economic variables respond to shocks in carbon prices, and to ascertain if they can explain the sharp variations associated with substantial changes in climate policy and recent economic and geopolitical events.
This analysis will provide policymakers with a better understanding of the potential impacts of carbon pricing on the economy, including the potential for regressive effects so that they can make informed decisions about implementing such policies. Fig. 1 illustrates the positive association between carbon prices and inflation rates in recent years.
Carbon policy shocks have a significant impact on the inflation rates in the Euro Area. Historical decomposition analysis reveals that carbon prices account for a significant portion of the variation in inflation rates following the introduction of Phase 4 in 2021. This contribution is marked and enduring for energy and non-durable goods, but more restrained for other components. The evidence shows that the European Commission was too optimistic in introducing Phase 4. It did not fully consider the effects of COVID-19 and the war in Ukraine, as the evidence shows. To further understand how the carbon policy affects the economy, the analysis expands to include the components and sub-components of inflation. Industrial goods are more affected by a tightening in the carbon regime than services, though not to the extent one might expect. Transportation, Utilities, and Food are the sub-components with the highest pass-through rates. In the opposite direction, Communications is the only component where prices fall after two years. On the broader macroeconomy, higher carbon prices lead to higher inflation, even after excluding food and energy prices. This is followed by a decline in industrial production and an increase in unemployment and trade deficit. Financial markets also experience adverse effects, with stock prices falling and rates on sovereign and high-yield corporate debt rising. The results are also robust to various changes in the model structure.
A growing body of literature studies the various effects of climate policy on the economy and environment, a well-established result in this literature is that carbon pricing policies, such as EU ETS, can effectively reduce carbon emissions. This has been demonstrated through studies like (Bayer and Aklin, 2020), which found that the EU ETS mechanism contributes to lower carbon emissions even with low carbon prices. (Rickels et al., 2007, Knopf et al., 2014, Boersen and Scholtens, 2014, Hintermann et al., 2016) all find that the price of carbon allowances in the EU ETS is affected by at least one of the following factors: fuel prices, energy prices, political factors, and regulatory uncertainty. However, the extent to which these policies affect the price of goods and services remains debatable. This paper makes several contributions to this ongoing debate: First, it contributes to this debate by providing new estimates on the effects of EU ETS in the Euro Area. Previous studies have found mixed results, with some finding little to no impact on inflation or GDP (e.g., (Konradt et al., 2022)) and others finding contractionary output effects (see (McKibbin et al., 2017, Goulder and Hafstead, 2017)), disproportionate impacts on lower-income households (e.g., (Känzig, 2023, Mangiante, 2024)), or effects on inflation dynamics (e.g., (Santabárbara and Suárez-Varela, 2022, Pardo, 2021, Moessner, 2022, Krämer and Solveen, 2021)). Second, methodologically, this paper employs a novel SVAR model identified by zero and sign restrictions to model carbon markets, offering an advancement in this field. Third, this study examines the varied impacts of carbon pricing across different sectors of the economy, contributing to a more nuanced understanding of how these policies affect sectoral consumer prices. This builds on work by (Ho et al., 2014, Lee et al., 2008, Choi et al., 2010, Santos et al., 2018), who found varying effects across industries. Finally, it analyzes the interplay between the Russian invasion of Ukraine, rising carbon prices, and inflation rates, providing interesting insights into how geopolitical events can influence the effectiveness and consequences of climate policies. This contributes to the growing literature on the economic effects of the Ukraine conflict (e.g., (Tosun and Eshraghi, 2022, Boungou and Yatié, 2022, Morão, 2025)).
These contributions improve our understanding of how climate policies, economic outcomes, and geopolitical events interact. By analyzing EU ETS impacts across sectors and inflation rates, while accounting for major geopolitical disruptions, it provides valuable insights for both policymakers and researchers.
In what follows, Section 2 provides some background on the European decarbonization plans. Section 3 explains the methodology, data, and identification techniques. Section 4 examines the macroeconomic effects of climate policy shocks and their quantitative importance. Section 5 presents a series of sensitivity checks and model extensions. Finally, Section 6 fers concluding remarks and policy implications.
Section snippets
European union decarbonization agenda
The EU is firmly committed to decarbonizing its economy. It aims for net-zero greenhouse gas emissions (GHG) by 2050. This commitment reflects the EU’s climate and energy policy. It aims to set targets to reduce emissions, boost renewable energy in the energy mix, and improve energy efficiency. The EU Emissions Trading System (ETS) is a key component of the European Union’s decarbonization agenda. It was first proposed in 2000 as part of the EU’s efforts to address climate change and meet Kyoto
Data and methodology
SVAR models are a leading choice to analyze the macroeconomic impact of various commodity-related shocks. This study quantifies the effects of carbon policy changes on inflation rates and other major macroeconomic variables. To this end, the analysis considers the following structural VAR with lags: for , with , , where is an matrix of parameters for with invertible, is vector of parameters, is an vector of
The impact on the macroeconomy
To gain deeper insights into how climate policy affects the economy, this section examines the responses of selected macroeconomic and financial variables.
Additional results and sensitivity analysis
To further enhance the robustness of the analysis, the study conducts a series of robustness checks by testing the model under different specifications and data choices.
Conclusion and policy implications
The European Union pours massive resources into climate policies, yet little is known about their effects on inflation rates and their respective categories.
This study calculates the effects of the EU ETS policy on inflation rates since its launch in 2005.
Using an SVAR model with sign and zero restrictions, the research finds that stricter carbon standards have high short-term economic costs.
The results are clear: a shrinking output, a devalued Euro, a deepening trade deficit, and soaring
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I would have thought the simplest explanation is that if you cause the deindustrialisation of your economies by the implementation of policies that raise the cost of power in relation to the rest of the world, carbon emissions will drop.
I think it is known as the Law of Unintended Consequences.
" Communications is the only component where prices fall after two years. "
But what the hell are they "communicating"!!!#
I was impressed the the detail in this article, by "The Word Merchant"