What is the effect of carbon pricing on inflation? This paper shows empirically that the consequences of the European Union’s Emission Trading System (ETS) and national carbon taxation on inflation have been limited in the euro area, so far.

This result is supported by analysis based on a panel local projections approach, as well as event studies based on individual countries. Our estimates suggest that carbon taxes raised the price of energy but had limited effects on overall consumer prices.

Since future climate policy will need to be much more ambitious compared to what has been observed so far, including the need for larger increases in carbon prices, possible non-linearities might make extrapolating from historical results difficult.

We thus also use input-output tables to simulate the mechanical effect of a carbon tax consistent with the EU’s ‘Fit-for-55’ commitments on inflation.

The required increase of effective carbon prices from around 40 Euro per ton of CO2 in 2021 to around 150 Euro by 2030 could raise annual euro area inflation by between 0.2 and 0.4 percentage points.

It is worth noting that the energy price increases caused by the rise in the effective carbon price to 150 Euro is substantially smaller than the energy price spike seen in 2022 following the invasion of Ukraine.

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This article first appeared at the IMF Blog, a forum for the views of the International Monetary Fund (IMF) staff and officials on pressing economic and policy issues of the day. The views expressed are those of the author(s) and do not necessarily represent the views of the IMF and its Executive Board. Reprinted with permission