Income policy instruments are the solution

Inequality is no reason for weakening CO2 pricing

Blog
March 16, 2023

CO₂ pricing leads to asymmetry in purchasing power among Dutch citizens. Research by PwC shows that the introduction of the price incentive to reduce emissions will widen the income differences between higher and lower incomes. Should CO₂ pricing therefore be off the table? No, say PwC experts Jan Willem Velthuijsen / Gulbahar Tezel. Pricing is an essential step toward sustainability. Income policy instruments are the solution.

Price incentive works

The purpose of CO₂ pricing is simple: to steer sustainable behavior to reduce pollution. In that context, there is good news. The price incentive works, as the European pricing system proves. Emissions from the sectors within this system - the European Union Emissions Trading System, (EU ETS) - fell by as much as 35 per cent between 2005 and 2019 .

And this is just the beginning. Brussels announced in December that the system will also apply to road transport and buildings. Shipping will also be covered by EU ETS. Higher prices for CO₂-intensive products will align the choices of producers and consumers with the social interest of reducing overall CO₂ emissions.

CO2 pricing leads to worsening income distribution

Not everyone is enthusiastic about the European pricing system. For example, a number of EU member states that are heavily dependent on fossil fuels are critical of EU ETS because it could lead to relatively high costs and thus, energy poverty. In addition, the system worsens income distribution between countries and between income groups.

Our analysis shows that lower income groups are indeed hit harder by CO₂ pricing than higher incomes. This is the case at the moment - when the costs of the damage from CO₂ emissions are fully passed on while spending patterns remain unchanged.

Main conclusions of our analyses

Our calculation and analysis show the following:

The lowest income groups in the Netherlands spend about twenty percent of their income on CO₂-intensive products, such as electricity, gas, transportation and meat. Among the group with the highest incomes this is about 6.5 per cent.
The average CO₂ cost in euros for the lowest income group averages nearly 370 euros (3.8 per cent of disposable income). The highest income group faces average CO₂ costs of 640 euros (1.1 per cent of disposable income). Thus, the lowest income group is hit almost four times harder.
The higher income groups generally have more opportunities to invest in sustainability measures to avoid the higher CO₂ costs, for example by buying solar panels or an electric car. This may increase the asymmetry of the purchasing power effect.

This was calculated based on:

Spending pattern and disposable income by 20% income groups (CBS, 2015)
(Household spending patterns are published every five years. The last year is 2020, but this is not representative because of the coronacrisis)
CO₂ content of the products studied from MilieuCentraal's database (Energy: natural and town gas, electricity. Transportation: gasoline, diesel, international flights, Meat: beef and veal)
CO₂ costs based on a CO₂ price of 80 euros per tonne CO₂-eq. (average ETS price of the past year)

We made the following assumptions:

That producers pass on one hundred percent of the additional costs of emitting CO₂ to consumers.
That these consumers do not adjust their behavior in response to higher prices.

Softening climate policy bad idea

A price incentive on CO₂ thus hits low-income earners disproportionately hard. In addition, the historically high energy prices at the moment are reviving the (international) discussion on softening CO₂ pricing.

Despite the fact that it is more than undesirable in social terms to hit low incomes four times harder, we still support this price incentive.

Government does not have to choose: climate policy and income policy can be pursued simultaneously

The government does not have to choose between combating climate change and limiting the burden on lower incomes. With income policy, for example through income tax, the side effect of income inequality can be addressed. By doing this in addition to carbon pricing, consumers can make choices when spending their income that are more in line with societal interests because prices reflect the true costs to society.

The EU itself is also taking a step in this direction. The expansion of ETS is accompanied by an 86 billion euro social climate fund to compensate vulnerable households for the costs of energy transition. This fund addresses the inequality that climate policy causes, but keeps incentives intact.

One policy, one goal

This is also in line with the theory of famed economist Jan Tinbergen. The winner of the Nobel Prize in Economics says that whoever wants to implement (economic) policy needs as many policy instruments as goals. In other words, a policy measure can only serve one purpose.

Those who follow Tinbergen see that designing CO₂ pricing in a way that spares the lowest incomes is impossible. You cannot both pursue an effective climate policy and at the same time use that same instrument to prevent further income inequality. After all, climate policy is not an income policy.

CO₂ pricing: what is it?

To meet climate goals, price incentives are being implemented at both the national and European levels to reduce emissions. CO₂ pricing is a good example of this and, in short, puts a price on societal damage.

A price on CO₂ emissions ensures that more sustainable products become relatively more attractive. This is because it ensures that in CO₂-intensive production processes, the actual costs of the social damage caused are internalized. This makes these products relatively more expensive than products that cause no or less damage. Companies and citizens are thus incentivized to produce and consume lesser emissions.