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Carbon needs a price – and proactive economic policy measures

Hardly any topic gets people more riled than the price of gasoline and diesel. A few additional cents at the pump – then tempers flare and the political grandstanding begins. Surging fuel costs are caused by constantly rising carbon prices, which are directly affected by the increasingly ambitious climate policies adopted by many countries and the EU. The Kiel Institute for the World Economy conducted a simulation on behalf of the Bertelsmann Stiftung to see how an increase of $50 per ton of CO2 would affect carbon emissions worldwide, and which long-term income effects would occur in different countries.

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Foto Thieß Petersen
Dr. Thieß Petersen
Senior Advisor
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Thomas Rausch
Senior Project Manager

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The first finding: “By unilaterally raising the price of carbon, the EU can contribute very little to climate protection efforts, since global emissions would only fall by 2.5 percent,” says Thomas Rauch, economic expert at the Bertelsmann Stiftung. “But if many countries joined together in a global climate club, a $50 increase in the carbon price would cause greenhouse gas emissions to fall by almost 40 percent – and the economic costs would be moderate.” If the resulting tax revenues were redistributed on a per capita basis, every country would experience a long-term decline in its gross domestic product of just 0.5 percent on average. And if only the three largest emitters – the US, EU and China – were to join forces, emissions would still fall by 23 percent.

Since global or transregional cooperation of this sort is currently unlikely, the risk exists that, whatever form they take, regional responses like the EU’s unilateral effort would lead carbon-intensive sectors – the steel and cement industries, for example – to relocate their production to other regions in which CO2 emissions are not taxed at all or only slightly. This phenomenon is known as carbon leakage. To counteract this problem, the EU plans to present a carbon border adjustment mechanism (CBAM) this July that would compensate for the difference between the price of carbon in the EU and the price in the countries it trades with that have less stringent climate policies. All goods sold in the EU would thus reflect the EU emissions price – regardless of whether the product in question originates in the EU or somewhere else. While the CBAM would prevent carbon leakage and increase the competitiveness of Europe’s carbon-intensive industries, it would have little impact on global emissions, since the production that would have migrated abroad without the mechanism would take place in the EU once again. Instead of a 2.5 percent decline in global emissions, the EU’s border adjustments would achieve a reduction of 2.7 percent.

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Even if, in the long run, an ambitious climate policy offers competitive advantages for national economies by providing incentives for research and investment, and even if the financial costs are bearable, the short-term economic and social impacts of rising carbon prices cannot be ignored. Higher carbon prices place a heavy burden on energy-intensive manufacturing sectors, the people they employ, and lower-income households, leading to a massive structural shift. That means not only do social disparities increase within countries, so do the disparities between them, especially between the EU’s eastern and western member states and between developed and developing countries. “That is why any initiative to form a climate club should also be accompanied by social policy measures, e.g. temporary financial burden-sharing for sectors and national economies that are affected to a significant degree,” says Thieß Petersen, economic expert at the Bertelsmann Stiftung.

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The simulation was run using a modified version of a foreign trade model, the Kiel Institute Trade Policy Evaluation (KITE) model. The foreign trade flows of 141 countries captured by the model were supplemented with data on CO2 emissions. Taking 65 sectors into account, the model calculates the volume of emissions by looking at intermediate goods and the components in each product, thus quantifying the amountt hrough to the end consumer. The pricing of fossil fuels affects the international competitiveness of a country’s individual sectors, leading to a long-term change in gross domestic product. The extensive data required for the model are currently available for the year 2014. All calculated effects thus represent changes relative to that equilibrium and based on the relevant technology. Price increases should therefore be understood as additional increases above and beyond the carbon prices of 2014.

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Dr. Thieß Petersen, Prof. Dr. Sonja Peterson, Thomas Rausch, Prof. Dr. Joschka Wanner