Emission impossible: Balancing Environmental Concerns and Inflation

TL;DR

This paper develops a theoretical model to analyze how carbon pricing policies impact inflation and goods prices, emphasizing that emission reduction should be the primary policy goal despite inflation concerns.

Contribution

It introduces a framework for balancing environmental and inflation targets, showing that emission reduction costs outweigh inflation savings under various regulatory priorities.

Findings

Emission reduction costs exceed inflation savings.

Regulatory priorities shape equilibrium outcomes.

Emission goals should be the primary focus for policymakers.

Abstract

We provide a theoretical framework to examine how carbon pricing policies influence inflation and to estimate the policy-driven impact on goods prices from achieving net-zero emissions. Firms control emissions by adjusting production, abating, or purchasing permits, and these strategies determine emissions reductions that affect the consumer price index. We first examine an emissions-regulated economy, solving the market equilibrium under any dynamic allocation of allowances set by the regulator. Next, we analyze a regulator balancing emission reduction and inflation targets, identifying the optimal allocation when accounting for both environmental and inflationary concerns. By adjusting penalties for deviations from these targets, we demonstrate how regulatory priorities shape equilibrium outcomes. Under reasonable model parameterisation, even when considerable emphasis is placed on maintaining inflation at acceptable levels or grant lower priority to emissions reduction targets, the costs associated with emission deviations still exceed any savings from marginally lower inflation. Emission reduction goals should remain the primary focus for policymakers.