On Earth Day, 22 April 2016, the UNFCCC Paris Agreement was opened for signatures, aiming to limit the average temperature increase well below 2°C, or even 1.5°C below pre-industrial levels. With both the European Union and its Member States as signatory parties, collective action became imperative in Brussels. The urgency of designing a carbon-neutral Europe further grew as the Intergovernmental Panel on Climate Change (IPCC) concluded that the Paris Agreement’s objective could only be met if global emissions reach net zero by the middle of the century. It was under these auspices that the von der Leyen Commission announced the Green New Deal, making cleantech the new buzzword in Brussels and sparking debates about carbon capture and storage (CCS), carbon dioxide removal (CDR) or small modular reactors (SMRs). In this dynamic environment, a rather traditional instrument from the policy toolbox has gained and continues to gain traction: carbon pricing.

A quick primer to carbon pricing in the European Union

A majority of economists and political scientists support carbon pricing both as an efficient tool for decarbonization and as a cost-effective policy that generates minimal distortions to the market. However, no policy is without its critics, as radical figures have denounced carbon pricing as merely a neoliberal policy that cannot serve as the primary abatement strategy given the amplitude of the climate crisis. Nevertheless, successful climate policy needs not only to enable sustainable social practices but also to address the resistance of current economic interests that might otherwise work against the policy. Carbon pricing is embraced by policymakers across the political spectrum so even if combating climate change through taxes on greenhouse gases (GHGs) might be sub-optimal, it might also be the sole option that addresses divergent interests.

The EU recognized the merits of carbon pricing early on, creating the largest market for carbon in the world in 2005, the EU Emissions Trading System (EU ETS). The system limits emissions from more than 11,000 heavy energy-using installations and airlines operating in over 30 countries, thus covering 45% of the EU’s GHG emissions. The EU ETS functions based on the cap and trade principle. As such, a cap is set on the amount of GHGs that can be emitted by installations covered by the system, with the cap being reduced over time so that the aggregate number of tons of GHGs falls. At the end of the financial year, an emitting installation must submit enough allowances to cover for all its emissions, otherwise, fines are to be imposed by the EU. If a company manages to reduce its emissions beyond its legal obligations, it can keep the spare allowances to cover future needs or it can sell them to another company that is short of allowances, making a profit.

Like any form of taxation, carbon pricing, and thus the EU ETS, has distortionary effects on the economy, even if minimal. Rational agents, therefore, try to avoid incurring these costs by passing them on to the final consumer as much as possible given the market structure. While there is no concrete answer to the question: how much of the costs of carbon emissions is paid by the emitter and how much is paid by the final consumers, numerous studies have found out that indeed, a large part of the price is not inflicted on the moral polluter.

The wisdom of Pigou: the economics behind carbon pricing

A significant portion of economic activity involves the emission of GHGs that accumulate in the atmosphere and drive climate-change, imposing a series of costs to society. However, even if these negative effects result from the profit-driven activities of companies, costs are not borne just by the emitter, but by the entire society. In this sense, economists refer to anthropogenic climate change as being a negative externality, one that cannot be corrected through ordinary market interactions, thus requiring government intervention.

One immediate solution when dealing with negative externalities is to exclude the consumption of the affected good, an action that would lead to the optimization of the agent’s behavior. Nevertheless, in the case of Earth’s climate, we are talking about a public good, making it impossible to exclude polluters from enjoying its benefits and it thus requires policymakers to design more narrowly-tailored approaches towards combating the externality. The case of climate change is further complicated by a series of facts that make it a unique externality: its effects are persistent, with some GHSs remaining in the atmosphere for centuries; there is a high-level of uncertainty regarding the trajectory of climate change and the lack of mitigation might lead to significant setbacks of the global economy as a whole. 

It’s all about the economic incidence!

Increased reporting of emissions in the first phases of the EU ETS has allowed empirical studies of the incidence of carbon pricing to be designed, based on the first principles of cost incidence theory:

The statutory burden of a tax is different from its economic burden. The statutory burden is being determined by the legal requirement that an entity has to pay the government for a given action. However, statutory incidence ignores that given increases in costs trigger behavioral modifications that alter the quantities supplied and demanded by the firm. In turn, this leads to a new point of equilibrium that affects the way economic burdens are shared between producer and consumer. This means that the true burden of a cost cannot be derived from the legal obligation of an agent to pay that cost. In the case of the EU ETS, GHG emitting companies are statutorily responsible for getting the allowances that cover their emissions, but ultimately the price of the tax is shared by consumers and producers.

The side of the market with inelastic supply or demand will bear a larger proportion of the costs. The economic incidence of a tax depends on the responsiveness of consumers and producers to the price increase. For example, when demand is inelastic, consumers do not drastically alter their choice due to price increases, meaning that the demanded quantity remains relatively constant when the tax is introduced. Therefore, firms are capable of passing through the newly introduced costs in the price of the final product without fear of the sales decreasing. In the case of the EU ETS, the question is thus whether an increase in the price of emissions that leads to higher prices in industries like heating or transportation leads to consumers decreasing spending and reorienting to other alternatives. If not, theory predicts that the costs of carbon emissions are paid by final consumers.

A comprehensive study estimating cost pass-through in the EU ETS rates has been conducted in 2014. It analyzes multiple industrial sectors that are part of the ETS and model their cost pass-through as a function of the market share. Furthermore, to control for the structure of the market, they introduce a variable which predicts higher cost pass-through as the market becomes perfectly competitive and which reduces pass-through as the market becomes oligopolistic or monopolistic. This model is based on the largely accepted yet somewhat counterintuitive assumption that competitive markets pass-through higher rates of their prices. The ex-ante study ultimately concludes that cost pass-through for the EU ETS vary significantly by sector and country. Regardless of the variance, even the sectors with the lowest pass-through rates, like aluminium, still pass more than 20% of the costs to the consumers. Sectors that do not have extensive non-EU competition and for which there is no global sufficiency, such as malt, tend to have pass-through rates of over 80%. The high levels of variance in the cost pass-through across states and sectors in the EU ETS are mostly explained by national industry characteristics such as the import penetration, the level of product homogeneity, and the market power of domestic firms.

Moving from ex-ante to ex-post studies, empirical data from the first two phases of the EU ETS allowed for attempts to be made to estimate the rate at which costs have been passed through into final product prices. Multiple studies find that producers of cement and lime are capable of passing through a large majority of additional costs. They also identify a wide range of cost pass-through rates that exist across the different industrial sectors, with rates above 0 but below 75% in all the cases.

Conclusions

Carbon pricing through the EU ETS remains the most effective EU policy in the fight against climate change. However, what an analysis of the incidence of carbon taxes shows is that ultimately environmental policies have adverse effects that impact poorer groups in the society the most. While we should not abandon such policies, we must always take into account the unintended consequences and make sure that environmental protection comes with complementary social security measures.

The calls for a more synergic policymaking process is more relevant than ever, when sharing information between policy silos might be the only way to make the Green Deal a good deal for everyone and leave nobody behind.