Climate Policy and the Economy: Evidence from Europe’s Carbon Pricing Initiatives

This paper examines the impact of carbon pricing on the economy, with a focus on European carbon taxes and the carbon market. Our analysis reveals three key findings. First, while both policies have successfully reduced emissions, the economic costs of the European carbon market are larger than for national carbon taxes. Second, we explore four factors that explain this difference: fiscal policy and revenue recycling, pass-through and sectoral coverage, spillovers and leakage, and monetary policy. Our findings point to important differences in pass-through and revenue use that help reconcile the differential effects between the two policies. Third, we document substantial regional heterogeneity in the impacts of the carbon market, which depend on the share of freely allocated emission permits and the degree of market concentration in the power sector.