The EU is pursuing ambitious climate goals that can only be achieved by noticeably increasing the price of greenhouse gas emissions. However, this step means a loss of income and purchasing power for certain groups of people and regions in the EU. In order to alleviate the resulting social tensions, a balance will be necessary – both within and between the individual EU member states. If this does not happen, political blockades are the inevitable result.
Higher CO2 prices lead to lower greenhouse gas emissions. By pricing greenhouse gases, the output of the corresponding emissions is reduced through two main actions. On the one hand, products containing CO2 are to be made more expensive, with “CO2” being an umbrella term for all climate-damaging greenhouse gases that enter the atmosphere through human activity. With higher prices, the demand for products containing emissions falls, their supply falls and CO2 emissions fall accordingly.
Second, companies are adapting their production facilities to the higher CO2 price. If possible, you use lower-emission machines and production processes. They also accelerate the development of technologies that reduce emissions. Ideally, companies’ adaptation strategies lead to green growth, in which the amount of product increases and the volume of emissions decreases at the same time.
This is how CO2 pricing works in Europe
In order to achieve the EU climate targets, higher CO2 prices are inevitable. The EU’s goal is to reduce CO2 emissions by at least 55 percent by 2030 compared to 1990 levels. However, this will only succeed if the prices for emissions rise quickly and drastically. For this reason, in its “Fit for 55” strategy presented in mid-July 2021, the EU Commission defined measures that lead to such a price increase.
With regard to the future level of the European CO2 price, two measures should be mentioned.
On the one hand, the criteria for activities that require emission certificates will be expanded. This has an impact on emissions from road traffic, building heating and cooling, and shipping. These emissions were previously excluded from the European Emissions Trading System (EU ETS).
A higher emission price makes emission-intensive products such as energy and numerous consumer goods more expensive.
On the other hand, the EU ETS is now reducing the maximum annual emissions, i.e. the number of emission certificates, more quickly. Between 2013 and 2020, the upper limit for certificates was lowered by 1.74 percent per year. An annual reduction of 2.2 percent was originally planned for the period 2021 to 2030. It is now 4.2 percent and could be even higher in the coming years. In the event of a shortage of emission allowances, an increase in the prices for these certificates, i.e. a rising CO2 price, is to be expected.
Why redistributive policies are necessary
Higher carbon prices affect the distribution of income. A higher emission price makes emission-intensive products such as energy and numerous consumer goods more expensive. This can mean a noticeable loss of purchasing power, especially for low-income households, as they spend an above-average proportion of their disposable income on products with greenhouse gas emissions (especially energy). This increases the risk of poverty.
This results in sectoral hardship for companies and their employees. Sectors of the economy with high capital intensity are particularly at risk. A high use of physical capital (machines, buildings, etc.) usually goes hand in hand with high energy consumption, which in turn leads to high greenhouse gas emissions. Examples are energy supply and oil refining companies as well as metal, glass and paper production. In these areas there is a threat of a loss of competitiveness, which can lead to plant closures and unemployment.
An increase in CO2 prices that is imperative in terms of climate protection thus leads to a change in income distribution. This not only affects individual groups of people, industries and regions of a country, but entire economies.
For example, if the CO2 price is higher across the EU, the Eastern European economies would have to accept disproportionately high losses in production and income, since their production facilities work more with fossil fuels than those of the western EU member states. Political resistance is therefore inevitable – both within the individual EU states and between them. In order to mitigate these effects as much as possible, redistributive measures are necessary.
Compensation for people
Numerous instruments can be used to alleviate domestic political tensions: flat-rate payments to all citizens and businesses, needs-based transfer payments, subsidies, tax cuts and the provision of free public services, including the necessary public investments, to name but a few. These measures are to be financed from the income from the CO2 price. This serves the goal of reducing emissions and is not collected in order to increase government revenues. The reimbursement of this income to the population is therefore justified – and only logical.
Before choosing suitable political instruments, however, one crucial question needs to be clarified: Which income losses do society consider to be so serious that they have to be compensated for? The answer to this question depends on socio-political value judgments and cannot be answered purely scientifically. In a democracy, this decision must therefore be made within the framework of a political discussion that affects society as a whole. But it is also clear that a social consensus that satisfies all sections of the population will not be possible. Political decision-makers must therefore disclose and justify the criteria for their distribution policy decisions.
One thing is clear: the EU’s emission reduction targets cannot be achieved without higher CO2 prices.
Once the question of which groups of people or sectors are to be compensated has been clarified, the appropriate economic policy instruments can be selected. If all citizens are to receive financial compensation, a flat rate per capita is an option – as in Switzerland. Differentiated payments to households that are particularly badly affected are also conceivable – for example a subsidy for commuters who need more mobility or an increase in housing benefit for low-income households. The social security contributions could be reduced in order to relieve employees and companies financially. This would increase the disposable income of private households and at the same time reduce non-wage labor costs for companies.
Compensation for States
Due to the different emission intensity of production in the various EU countries, compensation payments between the EU member states are also necessary in the sense of burden sharing. They could be financed from the income from the planned CO2 border tax. With rising CO2 prices, emission-intensive EU companies lose their price competitiveness compared to providers from countries that have no or only low CO2 prices. To counteract this disadvantage, imports would be offset against the emission price applicable in the EU based on their CO2 content.
One thing is clear: the EU’s emission reduction targets cannot be achieved without higher CO2 prices. So that the mandatory pricing of climate-damaging greenhouse gases is accepted by society as a whole, social hardship must be cushioned.
However, this does not mean that any losses in purchasing power and income can be compensated for. Where the line between socially acceptable – and therefore non-compensable – losses and socially unacceptable costs lies is a normative question that cannot be answered with economic externalities alone. However, it is undisputed that households with low incomes should receive transfer payments in order to avoid serious economic disadvantages in terms of access to energy and mobility.