Carbon pricing and inflation: a dilemma?

Rising climate change concerns are putting carbon pricing in the spotlight. As the year 2023 is on course to be the warmest year on record, carbon pricing is increasingly seen as a key tool to reduce carbon emissions. A carbon price sets a signal to market participants to either reduce their emissions or pay to pollute. This allows the market to internalise the costs carbon creates on the environment such as air pollution and extreme weather events.

Many countries have already put a price on carbon, but it is still too little to mitigate the impact of climate change. Many developed countries have already put a price on carbon, reflecting growing ambition. As of March 2023, the World Bank Carbon Pricing Dashboard registered 73 carbon pricing initiatives implemented in 39 countries. Out of this total, carbon tax accounted for 37 and Emissions Trading Systems (ETS) for 36. The majority of implemented initiatives are covering developed economies, but carbon pricing initiatives are also active in developing economies such as Argentina, China, Colombia, Indonesia, Mexico, and South Africa. Direct carbon pricing, via ETS, carbon tax and carbon credit, is expanding at a faster rate than indirect carbon pricing. Despite their introduction decades ago, prices have been too low to prevent climate change, and coverage is limited to specific sectors. As a result, only 23% of greenhouse gas (GHG) emissions are covered by carbon pricing initiatives. Carbon taxes accounted for 6% of GHG.

As a result, we expected an increased interest in carbon pricing. As of March 2023, 35 new carbon pricing initiatives were already under consideration. Two-thirds of them are associated with developing economies and most of the initiatives are considering the implementation of an ETS. Concerns over climate change and the sharp reduction of fiscal space in several governments, will further push them to find additional source of revenues. ETS and carbon taxes are increasingly seen as an effective tool to raise revenue and finance the energy transition. In 2022, total carbon revenues from ETS and taxes increased by over 10% in 2022, hitting about US$95 billion (World Bank, 2023).

But, in a context of high inflation, higher carbon prices may stoke consumer prices, creating a policy dilemma. In a context of high inflation, central banks grapple with the dilemma of controlling inflation or fomenting green investment. But tightening monetary policy to bring down inflation may ultimately impede the pace of decarbonisation. Furthermore, the political feasibility of decarbonisation measures is challenging when households and businesses are already struggling with inflation.

Against this background, this report will analyse the effect of carbon pricing on inflation. It aims to answer the following questions.

• Will higher carbon prices accelerate inflation? If so, for how long?
• Is there any policy that could help to mitigate this inflationary shock?