Distributional implications of carbon pricing: energy costs, revenue recycling, and co-benefits (DICaP)

Climate change is the defining global policy issue of our time. The European Union and its member states strive to reduce greenhouse gas emissions by at least 55% by 2030 and to decarbonize the economy completely by 2050. However, the EU and many member states are finding it increasingly difficult to deliver on their climate pledges given increasingly vocal popular resistance to higher energy costs leaving over 40% of EU emissions underpriced. The public perceives climate policies as providing long term climate gains through higher energy costs in the short term, which can disproportionately affect low-income households. Yet, distributional concerns are not a prominent feature of the European Green Deal.

In this research project, we will examine how two understudied effects of carbon pricing can shift its distributional arithmetic. First, carbon pricing generates revenues and some forms of revenue recycling can soften the distributional implications of climate policy. Second, since fossil fuel combustion simultaneously releases greenhouse gases and local air pollutants, carbon pricing can improve local air quality and health outcomes. These so-called air quality co-benefits generally benefit low-income and socioeconomically vulnerable populations, who are exposed to higher levels of air pollution and other environmental hazards.

We will use empirical methods to estimate the distribution of co-benefits and include them in a microeconometric simulation model of carbon pricing and tax reform to study the distributional implications of carbon pricing policies in Austria and Germany.

Carbon taxation and its impacts across the income distribution are widely debated in society. Yet, the scientific community has not advanced on the important question of whether it is feasible to gain popular support for green tax reform. It is generally argued that: (i) carbon pricing is regressive (as poorer households spend a larger proportion of their income on energy goods and services), (ii) that transfers to poorer households (e.g. via the indexation of welfare payments to inflation) can compensate for the adverse effects of carbon pricing at the lower end of the income distribution, and (iii) that distributional impacts should not alter carbon pricing. 

Research questions

DICaP will increase our understanding of the distributional implications of carbon pricing. Given important gaps between existing research and pressing policy problems, we formulate the following two research questions and design a research program to address them:

• What are the distributional implications of carbon pricing in Austria and Germany?
• How do higher energy costs, the distribution of revenues, and co-benefits of improved air quality affect households of varying socioeconomic backgrounds?

Carbon pricing, i.e. the imposition of the costs of pollution on emitters via direct taxes, emission trading systems, or legislation and direct control, has an immediate and direct negative impact on households via its effect on prices of goods requiring fossil fuels as an input in their production. Since the policy benefits of climate stabilization take years to decades to materialize, there is a temporal disconnect between the incidence of costs and benefits. In DICaP, we broaden this perspective on carbon pricing by including two understudied effects, which tend to soften its negative impact and can even make climate policies progressive even in the short run: (i) the availability of revenues from carbon pricing, which can be used to fund programs related to climate policy; and (ii) the benefits of lower fossil fuel combustion on air quality, which tend to disproportionately benefit socioeconomically disadvantaged communities.

In order to add regional, socioeconomic, and temporal resolution to our research questions, we ask the following auxiliary research questions:

• How are air pollution damages distributed across neighborhoods by socioeconomic characteristics in Austria and Germany? 
• What is the spatial correlation between high-emitting industrial facilities and the socioeconomic status of neighborhoods? 
• Can carbon pricing reduce environmental inequality via its air quality co-benefits? 
• What are the direct and indirect distributional implications of carbon revenue recycling in Austria and Germany? 
• How do the negative effects of climate policy on energy costs and potentially positive effects of revenue recycling and co-benefits interact in (welfare-maximizing) climate policy proposals?
• Which elements of climate policy combine to minimize adverse distributional impacts?

During our research project, we will involve stakeholders and potential end-users of our econometric models to ensure their suitability and applicability to political decision makers. If needed, we will also adapt our research questions accordingly.

This project has received funding from the Jubiläumsfonds of the Austrian National Bank (OENB) under grant agreement 18889.