The Carbon Price Floor in Europe: What Impacts for Inequality?


The current carbon pricing mechanism in the EU insufficiently addresses the need to incentivise greener industrial practices in the region. A carbon price floor has been suggested as an alternative to the current system, in order to provide a stronger price signal and ensure higher overall cost to carbon emissions. The measure effectively makes carbon-heavy industry costlier, the expense of which may be passed on consumers. This article examines how this dynamic affects inequality in the EU by reviewing household expenditure on products of carbon-heavy industries. It subsequently finds that an EU-wide carbon price floor will have at least a short-term perpetuating effect on inequality, both within and between countries. However, an argument is ultimately made in favor of the measure based on environmental necessity, with the condition that it is part of a wider policy package to account for the short-term impact on inequality.

Introduction Reaching the Paris Agreement goal of keeping global warming below 2oC is massively challenging, but not impossible (Intergovernmental Panel on Climate Change 2018, 14). As a global climate frontrunner, the European Union (EU) has established ambitious environmental objectives with targets of a 40% emissions reduction by 2030 relative to the 1990 level and an 80-95% reduction by 2050, led by decarbonisation of the electricity sector and followed by the broader market (Newbery et al. 2019, 1). The EU is not only leading by example, but also claiming rightful responsibility for the region’s historical and current high emissions-per-capita level (Chancel and Piketty 2015, 11, 15). In order to fulfil its ambitions, carbon pricing plays an essential role in incentivising desirable investment, production and consumption patterns (Stiglitz and Stern 2017, 1). Because the current system for carbon pricing in the EU has failed to deliver sufficiently low carbon prices and a clear price signal to facilitate investment in low-carbon technology, a carbon price floor (CPF) has been one of the policy measures debated in the reform process. In short, a CPF would raise the effective price of carbon in the EU, making it more expensive to run a high-emission enterprise. The policy has several potential benefits: economists and environmentalists largely agree that a CPF is an efficient tool for the EU to reach their climate objectives (see, for example, Taschini, Dietz, and Hicks 2013; Jenkins 2014, 486). However, the CPF remains controversial due to potential distributional effects of increased costs on carbon-heavy industries that may be borne by consumers (Moorey 2012; Hirst 2018, 15). The additional costs may be regressive, hitting lower-income households relatively harder than higher-income ones because of the former’s higher proportional spending on fossil fuels and the “income-blind” or flat-rate nature of a CPF without supplementary policy measures (Wang et al. 2016, 1127). In this paper, we review the current carbon pricing mechanism in the EU and consider the effects of implementing a CPF within this framework. Our overall research question is as follows: first, what are the effects of an EU-wide CPF on inequality in the short term and in the long term, and can the latter justify the former? Second, do measures exist to account for potentially negative impacts on inequality that are feasible in an EU context? We start by providing an overview of the current EU carbon pricing mechanism and how a CPF may be implemented. This is followed by a literature review, before we dive into our analysis of the effects of an EU-wide CPF. Carbon Pricing Policy in Europe The current mechanism for carbon pricing in the EU is the Emissions Trading System (ETS): a cap-and-trade system of quantity control that sets a cap on total carbon allowances, trade of which is permitted between regulated firms (Newbery et al. 2019, 4). In the first phase of the policy (2005-7), all allowances were freely traded without restrictions. After these first two years, the total emissions cap was tightened and up to 10% of allowances were auctioned. Still, there has been a major surplus of allowances, particularly after the 2009 recession when emissions fell (Clò et al. 2013, 478). This has made the policy incapable of fulfilling its purpose, namely to increase carbon prices and the costs associated with a carbon-heavy production accordingly (Clò et al. 2013, Newbery et al. 2019, Brink et al. 2016). Rather, the carbon price in the EU has been continuously low at around €5-10[1]/tCO2 since its implementation (Newbery et al. 2019, 2). This has raised questions regarding the ETS’ ability to incentivise low-carbon practices, as the weak price fails to stimulate greener investment (Brink et al. 2016, 603). There has been one recent agreed-upon attempt to address the structural issues: starting in 2019, the Market Stability Reserve (MSR) mechanism will go into effect. This new measure is the result of years of ETS reform negotiation, and works as follows: as long as the allowance surplus is above €833 million (it was €1.7 billion as of late 2016), 24% of those will be removed annually until 2023 and placed in a reserve. After 2023, 12% of excess allowances will be removed (Newbery et al. 2019, 4,5). Although any reasonable reform to the current system may be warmly welcomed, scholars argue that the MSR increases the system’s complexity and may still not ensure a clear and durable carbon price signal (ibid, 2). Reforming the ETS has proved to be difficult, as a sufficient number of Member States to prevent a qualified majority have a coal-intensive energy sector that benefits substantially from the low carbon price (Newbery et al. 2019, 4). However, a number of policy changes have been put forth in the discussions, including the CPF. As mentioned in the introduction of this paper, a CPF would raise the effective price of carbon allowances under the ETS, making high-emission business more expensive to run, and potentially also to buy. A CPF can take several forms. It can be a mechanism whereby the government commits to buy back carbon allowances at the floor price, restricting the allowances available in the market (see Hepburn, 2006). Alternatively, an auction reserve price could be set, below which the government withholds all allowances (Clò et al 2013, 480). Finally, a “top-up” carbon price may be designed, where firms have to pay the difference between the ETS allowance price and the set floor, either through a carbon tax or a fixed fee (Newbery et al. 2019, 7). There are several good reasons for implementing a CPF in the EU. Perhaps most importantly, it adequately addresses the ETS’ problem with price signalling: the current system is structurally rigid on the supply side, as the ETS cap is known and fixed, while the market price of carbon varies and is vulnerable to demand shocks, resulting in the above-mentioned weak price signal (Clò et al., 2013: 478). A signal, along with regulatory certainty, would encourage investment in low-carbon technology (ibid). In addition to ensuring higher certainty for investors, a price floor can provide revenue for governments, and of course, heighten incentives for industries to operate on lower emissions. It also follows the “polluter pays principle”, in which polluters themselves are charged for their social costs on the climate (Newbery et al., 2019: 11). In other words, the CPF contributes to internalising the cost of the key market failure that is “the climate externality” (Stiglitz and Stern, 2017: 3), and thereby functions as a Pigouvian tax (see Pigou 2013 (1920)). Finally, there is empirical evidence that a CPF helps transition away from carbon-heavy industries such as coal-powered energy, exemplified by the UK’s national CPF leading to a 90% reduction of coal-sourced emissions between 2012 and 2017 (On Climate Change Policy, 2018). However, such national CPFs may result in a “waterbed effect”, meaning they may indeed reduce national emissions, but as long as the ETS cap remains the same, they simply frees up carbon allowances for others to use and thus have a minimal EU-wide effect (Maxwell, 2011). Despite these advantages, the CPF remains a controversial policy proposal. The opposition often stems from concerns about distributional effects, raising, for instance, energy and fuel prices, which would likely be harder for a low-income household economy to absorb than high-income ones (Wang et al. 2016, 1123). This widely-held (and also, according to vast literature, correct) belief makes implementing a CPF politically difficult. The challenge is well-exemplified by the “Gilets jaunes” in France, a national movement violently outraged by increased fuel prices (Dianara 2018). An oft-cited agitating factor of the “Gilets jaunes” is the group’s feeling of distance to the French decision-makers (Nossiter 2018). With the so-called “democratic deficit” of the EU (see Miklin 2014), there is a risk that an EU-wide CPF could lead to protests across the continent if the measure is introduced standing alone. However, as this paper will show, there are supplemental policies that can be co-introduced alongside a CPF that may lighten the impact on inequality. Literature Review In their simulation study of a CPF in 12 EU member states, FTI Consulting finds that a CPF in combination with the current EU ETS would reduce CO2 emissions, support coal-to-gas switching, and stimulate investment in renewable energy production (2018, 14–17). However, it should be noted that this study was backed by energy firms calling for the EU-wide CPF (Simon 2018) and an earlier study on the price floor in five European countries concludes that the reduction in CO2 emissions differs greatly between countries (Lin and Li 2011, 5144). Moreover, to examine the impacts on inequality, we must consider the economic distributional effects. The literature in this area is vast and includes economic models of carbon taxes to estimate effects in certain countries and regions, as well as difference-in-difference studies using cases where a CPF or carbon tax has already been implemented. The key findings can be simplified into three main conclusions. Firstly, many studies assume that carbon pricing makes carbon-intensive goods more expensive and that this burden weighs most heavily on lower-income households as they spend a larger fraction of their budget on fuel-intensive basic goods like heating homes and using cars (Grainger and Kolstad 2010, 373; Wang et al. 2016, 1126). Recent studies on CPFs in developed economies such as Canada, Ireland and the United States confirm this, even where richer households pay more in absolute terms (Grainger and Kolstad 2010, 368; Harrison 2016, 44; Farrell 2017, 32). In other words, a CPF would be regressive if the price burden is passed on to consumers. Some studies also identify distributional use-of-income impacts along other socioeconomic lines. In his study on Ireland’s CPF, Farrell finds that education levels affect types of home-heating and therefore energy bills: the more educated a household is, the more likely is it to have lower-carbon home-heating (2017, 43). Rausch et al. find that black households feel a heavier burden on budgets than white households, as black people tend to have higher expenditures on electricity and natural gas (2011, 26–7). While these differences are mitigated when incomes are controlled for, they do perhaps indicate a problem of access to low-carbon technology among underprivileged groups that would have to be tackled alongside a CPF, especially if its incidence is regressive. Secondly, some studies find that the effect of carbon taxes on sources of income – rather than uses – is important (Dissou and Siddiqui 2014, 88). Instead of being passed on to consumers, the increase in carbon prices may weigh on production factors i.e. labour or capital. The distributional impact of the possible decrease in wages and/or capital returns will depend on from where different income groups derive their income (Rausch et al. 2011, 20). In Harrison’s above-mentioned study of the CPF in Canada, she finds that where increased carbon prices lead to decreased wages, richer households lose a larger share of their income than poorer households (2016, 44). This is because poorer households tend to derive a larger share of their income from government transfers than from labour, in comparison to middle-class and richer households. Dissou and Siddiqui argue that fuel-intensive industries are capital-intensive and therefore an increase in carbon prices would lead to a fall of the relative price of capital to labour (2014, 99). Again, this would be at greater detriment to wealthier households who derive a larger share of their income from capital than lower-income households. In these cases, contrary to the bulk of the literature, a CPF leading to an increase in the price of carbon may be progressive. Thirdly, many studies agree that the way in which carbon tax revenue is used can have a major impact on the economic distributional effects (Fay et al. 2015, 141; Harrison 2016). Income-based redistribution such as cash transfers can counteract the regressivity of carbon taxes (Wang et al. 2016, 1128; Farrell 2017, 42). In their study of the CPF in Ireland, Callan et al. argue that even small increases in welfare payments would offset the negative impacts that high energy prices have on lower-income households (2009, 411). Padilla and Jordi reach similar findings using their model of a CPF in the EU, arguing that the worry about equity impacts ought not to deter efforts for a minimum carbon price in Europe (2004, 292). In the US context, studies indicate that lump-sum rebates to households would offset regressivity, but that this is an inefficient way of recycling carbon tax revenue in comparison to labour or capital income tax cuts (Rausch et al. 2011, 31; Williams et al. 2015, 210). However, in comparison to many EU countries, the US has a more stringent tax system that might make it difficult to incorporate these cash transfers. Here, we note that there is no EU-wide system of tax revenue redistribution directed to households, which may be an administrative point of contention should a European CPF be implemented. While we have now only scratched the surface of the wealth of literature, we have outlined the central conclusions that a CPF that results in increased prices for consumers is regressive, a CPF that results in lower factor prices is progressive, and that the way in which revenue from a carbon tax is recycled is important for distributional impacts. Impacts on Inequality

In light of the theory and evidence reviewed in the literature, we shall examine recent data to discuss the possible distributional impacts of an EU-wide CPF. The current ETS covers power and heat generation, energy-intensive industries like oil refineries and steel works and commercial aviation. Indeed, these kinds of industries are vital for entire economies and, therefore, carbon pricing would be expected to have direct and indirect effects on all businesses, consumers and investors. However, when exploring direct effects on consumers, possible increases in household energy bills are often the focus. Extending the ETS to road transport has been discussed (European Commission 2013) and applying a CPF to this sector would affect consumers through rising fuel prices which studies have found to be regressive (Speck 1999; Wier et al. 2005; Liang and Wei 2012). As mentioned, it was the environmentally-driven fuel-tax rise that sparked the explosive Gilets Jaunes movement among lower and middle-class individuals in France (Dianara 2018). Using Eurostat consumption data, Figure 2 shows the proportion of EU household expenditure that goes towards housing, water, electricity, gas and other fuels by income quintile. As expected, lower-income households – those falling in the first and second income quintiles – spend much larger portions in these areas. Indeed, we must recognise that this includes, for example, rent and water that would not be directly affected by the CPF. However, when looking at proportions spent on electricity, gas and other fuels, we still see regressivity, albeit less extreme (Figure 1). It should be noted that Figure 1 does not include home heating, for which Eurostat does not have specific data.

Figure 1: EU household expenditure on electricity, gas and other fuels (per mille) by income quintile for 2015 [or latest available data]. (Eurostat 2018)

Figure 2: The proportion of EU household expenditures on housing, water, electricity, gas and other fuels by income quintile for 2015 [or latest available data]. (Eurostat 2018)

*All other expenditure includes: Food and non-alcoholic beverages; Alcoholic beverages, tobacco and narcotics; Clothing and footwear; Furnishings, household equipment and routine household maintenance; Health; Transport; Communications; Recreation and culture; Education and Miscellaneous goods and services. Data confirms that if high carbon prices were passed on to consumers through increased household bills, the burden would likely weigh heavier on lower-income groups across Europe. However, there also exists inequalities within inequalities. For example, even in the lowest income quintile, the proportion of household expenditure on electricity and gas is 10% in Poland, but only 5% in France. Indeed, while the EU operates a single market and monetary union, the resulting distributions of income and wealth continue to differ both within and between countries. Well-documented is the economic differences between the rich “North and West” and poor “East and South” of Europe. The between-country equity impacts of a CPF must be considered. Indeed, Brink et al. (2016) warn of between-country inequalities in EU-wide carbon pricing due to the different industry and energy mixes, pointing out that poorer, newer member states tend to have more carbon-heavy industry and power generation. To illustrate: in 2017, nearly half of Poland’s energy generation was from coal, compared to 23% in Germany and only 4% in France and Sweden (Enerdata 2018). These unequally-distributed burdens not only between income groups but also between nationalities are akin to other socioeconomic inequalities outlined in the literature that signal a lack of access to low-carbon technology among under-privileged groups. As previously mentioned, climate change opponents suggest that the revenue generated from a carbon tax could be used to offset regressivity and may even make carbon pricing progressive (Stiglitz and Stern 2017, 39). While this could be achieved through cash transfers, it could also be done through, for example, through retrofit policies whereby energy firms are required to install energy-efficient systems in lower-income homes. In Sweden, where a CPF has been in place since 1991, the government has recycled revenues through public investments in updating infrastructure, insulating houses and making electric cars cheaper (Government Offices of Sweden, n.d.). Given that the EU has no pre-existing system of cash transfers directly to households, channelling revenues through national governments while earmarking them for low-carbon transition may be a palatable solution. Moreover, while cash-transfers may be better for equity in the short-term, a key goal of the CPF would be to encourage people reduce their carbon emissions and receiving payments that come ultimately from carbon usage may eliminate the incentive to switch. While the direct impacts on inequality and how to tackle them seem clear, many cost-benefit analyses fail to consider the co-benefits that a reduction in CO2 emissions – which, it has been agreed, CPFs achieve – would bring (Budolfson et al. 2017, 493). In the long-run, the CPF alongside the ETS would make low-carbon and renewable energy more competitive and affordable. It is argued that the “merit order effect” causes the price of energy to be depressed as more is generated by renewables because the operating costs are low in comparison to fossil fuels (for evidence of the merit order effect, see, for example, Sensfuß et al. 2007). What is more, investment in renewable energy alongside the retreat of fossil fuels has been found to have a net positive impact on job creation (Quirion and Demailly in Chancel 2018, 52). If played out alongside proactive policies, the increased use of renewable energy stemming from the CPF could improve equality and welfare in the EU. Similarly, more co-benefits will emerge indirectly from the reduction of CO2 emissions. In their literature review on the distributional impacts of carbon pricing, Wang et al. describe previous studies’ tendency to overlook environmental co-benefits as a “loophole” (2016, 1129). Climate change mitigation will, in the long run, have an impact on the poor, who tend to be the most vulnerable to the disasters and damage that climate change causes (Chappell 2018). Moreover, a reduction in CO2 emissions will have positive impacts on air and water quality and therefore health and wellbeing. Indeed, it is almost impossible to quantify these co-benefits in line with economic distributional impacts, and this may be an area for further research among climate economists. Nevertheless, we have seen that while a CPF has the capacity to increase inequality through the regressive nature of the tax, there are ways to counteract this negative impact through recycling revenues and improving the environment. This is certainly a positive outlook for the EU, however, cleverly-designed policy and high-level cooperation are required in order positively and constructively impact both the environment and equality. Conclusion In order to reach the goals of the Paris Agreement and its environmental objectives, there is an urgent need to reduce carbon emissions beyond the current rate in the EU. The measures included in the ETS do this insufficiently, largely because they fail to maintain a high carbon price. Even with the newly-implemented Market Stability Reserve, the ETS falls short of sending a clear price signal that would stimulate investment in low-carbon technology and realistically incentivise an emissions reduction. A CPF could address this shortcoming by guaranteeing a minimum price on carbon. However, this measure is controversial due to the flat-rate tax’ potential impacts on inequality. Using the most recent data available from Eurostat, our findings support that if the CPF is introduced in sectors that will increase household expenditure on electricity, gas, and other fuels, it will have a regressive effect by hitting the lowest income quintiles hardest due to their relatively higher proportional spending in this area. Although there are studies claiming that the CPF could be progressive in itself, the vast majority of researchers in the field agree that the direct effects of an EU CPF, at least in the short-term and especially without being co-introduced with corrective policies, will place a heavier burden on the poor compared to the rich. Our findings support this. What is more, we also find that a CPF may not only increase inequality between income groups, but between, for example, the richer and poorer countries of the EU. However, this known effect does not remove the need for a higher price on carbon in the EU in order to adequately and appropriately address climate change and reach set goals. A CPF is a solid candidate to drive that process, and the fact that there is wide agreement on the effects on inequality should be seen as an advantage in the negotiation process in order to develop a policy package that takes it into account. Specifically, ex-post measures that utilise newfound tax revenue from the CPF may be of particular good use. Here, the Swedish government’s investments in greener infrastructure, housing insulation, and transportation alternatives should be used as a best-practice model, especially as in the long run, decreasing carbon emissions will have positive effects on lower-income groups’ health and wellbeing. Recycling the CPF revenue directly towards households requires significant structural reform of the EU tax system, as there is currently no distributional mechanism directed at households. This could, however, be an avenue for future research, and potentially be linked to the broader goal of an enhanced cooperative effort between social and environmental policy in the EU. For now, this article has shown that implementing an EU-wide CPF would be an effective tool in increasing carbon prices and thus would address the current lack of progress in decreasing carbon-heavy industry in the region. It would also have a damaging effect on inequality by hitting lower-income quintiles the hardest. This should therefore be accounted for in a broader policy package that corrects the inequality effect ex-post in a timely manner, making up for the short-term direct impacts. In the long-term, if these ex-post measures targeted at inequality are included in the implementation, an EU-wide CPF will likely have an overall positive effect both on the climate and on inequality in the region.

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