How a high EU carbon price can divide the EU economically

This summer, we published a study on the consequences of a higher carbon price in the EU. The effects on the real gross domestic product (GDP) of the EU as a whole were small. In contrast, above-average GDP declines were calculated for the Eastern European economies. Economically, the EU is in danger of drifting apart as a result.

Consequences of a higher carbon price for the EU

To ensure that the EU can achieve its ambitious climate protection targets, the prices for greenhouse gas emissions will rise noticeably in the coming years. In the study mentioned above, we simulated the effects of a $50 higher carbon price in the EU.

A higher carbon price makes carbon-intensive products more expensive. Consumers reduce their demand for these products. Companies adjust to lower demand. Production declines, and so does GDP.

Low-emission products, e.g., services, on the other hand, are becoming cheaper in relative terms. As a result, demand for these products is increasing, and so is production. Therefore, real GDP rises.

It is not possible to say in advance which effects will predominate. The simulation calculations show: On average, real GDP in all 27 EU countries remains virtually unchanged, falling by just 0.01 percent. However, there are regional differences.

Change in real GDP in the EU as a result of a $50 higher carbon price in the EU, data in percent. Source: Mahlkow et al. 2021.

The Eastern European economies suffered the sharpest declines in GDP. In Latvia, the decline is almost 0.4 percent, Poland 0.33 percent, and Bulgaria 0.25 percent. The reason for these above-average declines is the fact that these economies have a particularly emissions-intensive economic structure.

In addition, there are also EU member states whose real GDP increase as a result of a higher carbon price. These include, for example, EU countries with a relatively high share of services, e.g., Ireland, the Netherlands, and Cyprus.

Although there are noticeable differences in GDP development, all countries’ calculated GDP losses are quite moderate. The situation is different when the effects on individual sectors of the economy are taken into account.

Sectoral effects of a higher carbon price

A look at the sectoral effects of a $50 higher carbon price in the EU reveals – unsurprisingly – that the fossil fuel sectors suffer the most significant production declines. Regionally, the Eastern European economies are again the most affected. The table below shows the 20 largest overall sectoral production losses across all 141 economies and all 65 sectors covered by the simulation model.

The 20 largest sectoral output losses of all 141 countries and 65 sectors in the case of a $50 higher carbon price in the EU, data in percent.

Source: Mahlkow et al. 2021. Explanation: The “gas” sector includes all natural gas production activities. The “gas production” sector includes the further processing of gas, e.g., the production of liquefied gas and the distribution.

Carbon price plus carbon tariff

To reduce the outlined economic losses in the EU, a carbon tariff is an option. Products imported from a non-EU country and sold in the EU would be subject to an emissions levy or carbon tariff. The EU proposed this instrument in summer 2021, but initially only for a few emissions-intensive products such as cement, iron and steel, aluminum, fertilizers, and electricity.

The tariff corresponds to the carbon price applicable in the EU. The total amount payable is based on the volume of emissions resulting from the production of that product abroad. All products sold in the EU are charged the emission price that applies in the EU – regardless of whether the product originates in the EU or the rest of the world.

The following table shows the GDP changes with and without a carbon tariff for the most affected Eastern European EU countries. At first glance, the comparison is surprising: Above all, the energy-intensive Eastern European economies are protected by a carbon tariff. However, their GDP losses will be even larger.

Change in EU real GDP as a result of a $50 higher carbon price in Eastern European EU countries, with and without carbon tariff, data in percent. Source: Mahlkow et al. 2021.

At second glance, however, this result is not surprising. It is an outcome predicted by foreign trade theory: when a country introduces an import tariff to protect a particular domestic industry, it comes at a cost to the economy as a whole.

• Carbon-containing intermediate inputs from abroad are becoming more expensive. The costs of production for the companies that use these inputs are rising. As a result, the prices of products manufactured in the EU rise, so demand for domestic products falls.
• In the rest of the world, demand for EU products also declines because of higher prices. EU exports therefore decrease.
• In addition, higher consumer goods prices reduce the purchasing power of a given income. Therefore, the consumer demand of EU households decreases. EU companies adjust to these declines in demand.

Overall, the global average decline in real GDP is slightly higher in the case of a carbon tariff imposed by the EU than without it (0.09 percent instead of 0.07 percent). For the 27-EU member states, the average decline in real GDP is also higher with a carbon tariff (0.04 percent instead of 0.01 percent).

The benefit of lower economic activity levels is a reduction in global CO2 emissions. They fall by 2.7 percent. This is 0.2 percentage points more than in the scenario without a carbon tariff.

Economic policy options

A higher EU carbon price affects the economies of individual EU member states differently. The most significant GDP losses occur in the emissions-intensive Eastern European economies. However, this should not be an argument against higher carbon prices in the EU, as doing nothing on climate policy would have much higher costs.

To reduce opposition from the social groups affected – i.e., especially those employed in emission-intensive industries in Eastern Europe – all EU states should bear the adjustment burdens. For example, in the case of a carbon tariff, the resulting revenues could be paid primarily to the Eastern European countries.

Reading recommendations

Mahlkow, H., J. Wanner, G. Felbermayr and S. Peterson. EU-Klimapolitik, Klimaclubs und CO₂-Grenzausgleich. Gütersloh 2021.

Petersen, T., S. Peterson, T. Rausch and J. Wanner. Fact-Sheet Carbon Pricing. Gütersloh 2021.