Published as part of the ECB Economic Bulletin, Issue 5/2023.
1 Introduction
To help avert severe economic damage from climate change, the European Union (EU) has taken measures aimed at reducing greenhouse gas (GHG) emissions to net zero by 2050. The EU’s net-zero goal is set out in the European Green Deal, and comprehensive measures are outlined in the EU’s Fit for 55 package.[2] These aim to reduce GHG emissions by 55% by 2030 (compared to 1990 levels). The Fit for 55 package includes carbon price increases and regulatory measures and foresees massive green investments.
Among the measures aimed at reducing GHG emissions, carbon price increases are generally considered to be an effective instrument. Carbon prices factor the external social costs of carbon emissions into economic transactions. They are directly targeted at the carbon content of production and increase the price of carbon-intensive production relative to less carbon-intensive production. Carbon price increases thus provide an incentive to reduce carbon emissions.[3] In the euro area, the EU emissions trading system (ETS), national carbon taxes and other national environmental taxes, such as excise taxes on fossil fuels, put – directly or indirectly – a price on carbon emissions.
The economic impact of carbon price increases depends on multiple factors. Carbon prices affect economic activity and inflation primarily via higher energy prices. The effectiveness and impact of carbon price increases crucially depend on whether these are implemented in a credible manner and can be factored into the investment and consumption decisions of firms and households. The impact of carbon price increases on the economy also depends on distributional effects, particularly for households, as the regressive nature of higher carbon prices affects low-income households more than higher-income households.[4] Fiscal policies that funnel revenues from higher carbon prices back to lower-income households can mitigate some of these distributional effects and support their acceptance by the public. Alternatively, these revenues can be used to subsidise green investments. As carbon price increases give rise to an output/inflation trade-off, their impact is also influenced by the response of monetary policy. Finally, their