The economic effects of carbon pricing

Part 4 in our series Putting a Price on Carbon

Carbon Pricing makes CO₂ emissions more expensive and therefore drives them down. In this installment of our series “Putting a price on carbon,” we take a closer look at the short-term and the long-term economic effects of the price hike.

1 What are the effects on consumers?

Higher prices on carbon-intensive products  – either via a carbon tax or an ETS system – increase the costs that consumers must bear for this product. Therefore, they will reduce their demand by either switching to less carbon-intensive alternatives or by refraining from consumption altogether.

So, for example, instead of using the car for a weekend trip, they might choose the train or stay at home. A carbon tax will hit small and poor households harder since investments in durable goods such as fridges or TVs or in utilities such as heating and electricity have to be made irrespective of the size of the household.

Over time, higher carbon prices will likely induce consumers to rely more heavily on collaborative consumption, such as car-sharing. As repairing things becomes more attractive than buying new stuff, we should also see a more significant shift toward circular economies.

2 What are the effects on companies?

Companies that produce carbon-intensive products (mostly capital-intensive industries manufacturing tools or machinery) will face lower demand, high sunk costs, and lower profits. They will cut down carbon-intensive consumption, for instance, by reducing business travel via plane. Companies that produce substitutes, such as video conferencing, will see their profits rise.

In addition, all companies will try to switch to cheaper, more carbon-efficient production. Their best path to do so is to invest in new green technologies. However, doing so takes time, and the results are only realized in the long run. Important examples include using more 3D technology or using renewable energy. As the transportation sector is affected the most by rising carbon prices, we are likely to see significant steps in innovation here, such as aircraft using green fuels.

3 What are the effects on employees?

The effects for employees are a function of the impact on companies. As companies reduce their production because of higher carbon prices, they need fewer employees, putting pressure on wages. The effects will vary greatly depending on how companies in different sectors can deal with rising carbon prices in the long run. Employment opportunities in carbon-intensive industries will go down while low-carbon or carbon-neutral sectors will add jobs.

Given the need for technological and digital transformation, it is likely that a low carbon economy will require ample skilled workers. As a result, the pay gap between skilled and unskilled workers might increase further, contributing to more inequality.

4 What are the effects on economic growth and international competitiveness?

In the short run, the production and consumption decline on the household and company level translates into lower GDP growth. In the mid and long run, positive effects should predominate. As we see more investment in emission-efficient technology, demand for investment goods increases and creates new jobs.

Even if these investment goods need to be imported, domestic demand goes up to produce the export revenues to pay for foreign investment goods. However, to achieve a positive long-term effect, higher resource productivity is critical. Economies that pick up on this trend and shift to low carbon production early will experience a first-mover advantage which gives them a comparative edge.

This is particularly true for states who have introduced carbon prices early on and raise them over time, such as Sweden).

5 What are the effects on trade?

For the effects on trade, the price differences between countries are what matters. If a country introduces a higher carbon price, its carbon goods become more expensive relative to other countries’ goods, and imports become cheaper.

In other words: Country A experiences a shift in its terms of trade). From an environmental perspective, this might be counterproductive. As production – and emissions with it – shifts to countries with a lower price on carbon, a measure to reduce emissions in country A might even increase overall global emissions since they are more than offset in the production location, which might use less energy-efficient technologies. The process of emissions shifting to other countries is known as carbon leakage.

6 What are the effects on global inequality?

A country that introduces a carbon price is likely to find itself on the losing side of the economic equation – at least in the short run. As production shifts to other countries, countries with high carbon prices will experience a decline in GDP, while the new production locations can increase their GDP.

This means that countries with carbon-intensive sectors profit from rising prices on carbon in other countries – as others try to protect the environment, they reap the economic rewards. In addition, more demand for biofuels will drive up prices for agricultural products. As developing countries are often major exports of such products, we might even see a tilt towards more global equality.

But this effect is likely to be small compared to the huge costs that developing countries will have to bear  – a disproportionately high share of the adverse effects and costs of climate change).

Table: A lot of short-term unintended effects to overcome

7 What could states do to support the positive and mitigate the negative effects?

There are several measures that states can take to accompany higher carbon prices:

• Use revenues from carbon pricing to compensate citizens using a lumpsum payment or according to their needs,
• Lower social security contributions or taxes or provide subsidies for companies that have been hit particularly hard,
• Support offsetting schemes, i.e., save carbon emissions elsewhere, when it is not possible to avoid emissions,
• Support the transition to sharing and circular economies with lower value-added taxes on repairs for durable goods,
• Invest in public infrastructure to make it easier to transition to more energy-efficient modes of transportation,
• Spur investment in carbon capture and storage capacities and reforestation measures to draw carbon from the atmosphere

In our next blog post, we will take a closer look at the issue of carbon leakage.