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Can we make carbon markets fair for people and the planet?

Diego Känzig argues that carbon-pricing policies risk being derailed if the costs aren’t fairly distributed

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In 30 seconds:

  • A common approach to combating climate change is to give carbon a price that better reflects the cost to the planet
  • Pricing this external effect of our use of carbon can be achieved through taxes or cap-and-trade systems
  • But carbon markets, such as the EU’s Emissions Trading System, disproportionately impact low-income households, who suffer a loss in income because they work in areas that are more exposed to a fall in economic activity
  • A potential solution is to redistribute some of the carbon revenues, so the economic costs of carbon-pricing policies can be offset without lessening the reduction in emissions.

Every day, we all take steps to use fossil fuels less and minimise our carbon footprint, but there is a limit to what we, consumers, can do. The economy needs to be weaned off its reliance on fossil fuels systematically.

A common approach to this challenge is to give carbon a price that better reflects the cost to the planet. Pricing this external effect of our use of carbon can be achieved through taxes or through cap-and-trade systems. In doing so, green technologies become more cost-effective.

The oldest and largest carbon market is the EU’s Emissions Trading System (EU ETS), which covers around 40% of the EU’s greenhouse gas production.

A new paper by Diego Känzig, a PhD student at London Business School, focuses on climate change and inequality. Thought to be one of the first research papers to consider the EU ETS’s performance and its impact on different tiers of society, ‘The unequal economic consequences of carbon pricing’ examines whether the EU ETS is achieving its environmental aims – and its impact on people and the economy.

Tackling the big questions

“I’m passionate about the big questions,” says Känzig. “Climate change and inequality are two of the most pressing challenges we face. They are also interrelated. Ultimately, climate change is an inequality issue. Ensuring a fair transition to a low-carbon economy is crucial to the success of the process. If we don’t share the cost, support for it could be undermined.”

The market evolved in stages, governed by policies that gradually tightened and refined the cost of carbon. The paper carefully selects 113 of the regulatory updates to the EU ETS and measures the change in the carbon futures price in a tight window around them. By isolating the series of carbon-policy shocks, Känzig found significant economic and social effects.

Each time policymakers updated the market, energy prices rose immediately and greenhouse gases persistently fell. However, consumer prices rose and economic activity, as measured by lower output and higher unemployment, also fell. Importantly, the fall in activity is less persistent than the fall in emissions. Simultaneously, the higher carbon prices led to more green innovation, as shown in patent records.

However, using household data, low-income households reduced their expenditure sharply and persistently. They also experienced a sharper loss in income. This is because they work in discretionary areas that are more exposed to a fall in economic activity.

‘There is no redistribution scheme in place that could offset the strongest negative effects felt by low-income households’

Surprising magnitude of effects

Känzig says, “In economic terms, the magnitude of the effects is surprising. It also shows that the inequality effect influences the aggregate economic effect. Lower- income households must spend more of their income on fuel and they tend to work in jobs that rely on discretionary spending, which are more exposed to carbon-price shocks.

“If you look at shocks to oil prices now and the geopolitical shocks, politicians are taking steps to mitigate the effects on lower-income households, but there was no response to the shocks that I looked at in this study.

The revenues from EU ETS have all been spent on technology and innovation, which is great, but there is no redistribution scheme in place that could offset the strongest negative effects felt by low-income households.”

Känzig believes this is the key policy implication of his work: “By redistributing some of the carbon revenues, the economic costs of carbon-pricing policies can be offset without reducing the reduction in emissions. This is because the energy demand of poor households is very inelastic; they need to heat their homes or drive to work and make up only a small share of aggregate emissions. If they’re compensated for the rising cost of these activities, the goal of reducing emissions is not compromised.”

Accounting for social impact

A carbon tax in British Columbia already takes social impact into account. The Canadian province offsets its carbon tax by reducing income taxes in the lowest brackets and targeting compensation to the most exposed households; research has shown that the measures mitigated damage to GDP.

“Green investments are good in the long run, but we do need to mitigate these inequality effects in the medium and short term,” argues Känzig. “We’ve seen with the French gilet jaune movement, for example, how public opposition can be an impediment to carbon-related policies.

“The movement started as an opposition to higher fuel taxes, but now it’s also about fighting elites, and the green initiative has been lost. Politicians should take that seriously. You need public support because the economy will take a hit in the short term and people will feel aggrieved if that cost isn’t fairly distributed across society.”

Känzig cites the European Commission’s ‘Fit for 55’ climate targets and its allied Social Climate Fund as a move in the same direction. It is a debate in Europe that this research will inform and push forward. Diego Känzig is a PhD candidate in Economics at London Business School.

Diego Känzig is a PhD candidate in Economics at London Business School.

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