Recycling Carbon Pricing Revenue to Substantiate a Just Transition

This blog was coauthored by Moritz Schaefer.

Carbon pricing has become a key climate policy tool on a global scale. Governments around the world are working to implement and enhance carbon pricing policies to meet more ambitious climate targets. Carbon pricing policies designed to internalize the economic costs of climate change and incentivize emissions abatement covered approximately 21.5% of global greenhouse gas emissions in 2021. Though an important and effective climate policy tool, carbon pricing can have regressive distributional effects for poorer households because of their proportional higher spending on heating, electricity, fuel, and food.

The impacts of regressive distributional effects depend on which sectors and entities are subject to the carbon price at which points in their value chains and how governments decide to use ensuing carbon pricing revenue. A jurisdiction’s approach to spending revenue will impact whether carbon pricing will be an effective, durable policy that contributes to a just transition toward climate neutrality or a policy that increases inequality and puts climate policies at risk.

Governments Are Taking Different Approaches

To address these challenges, governments can leverage revenue recycling or social compensation mechanisms, including:

• Direct monetary transfers to households or a specific vulnerable group through the tax system (e.g., Canada)
  
• Establishing a fund to target specific communities or geographies (e.g., California)
  
• Financing energy efficiency improvements and renewable energy projects (e.g., France)
  
• Financing low carbon transportation options and infrastructure (e.g., Belgium)
  
• Investing in programs that promote job opportunities (e.g., the US Regional Greenhouse Gas Initiative states)
  
• Financing R&D of low carbon technologies (e.g., Switzerland)
  

In the European Union (EU) Emissions Trading System (ETS 1), the European Commission redistributed revenue to member states with a mandate that at least 50% be used for climate- and energy-related purposes. Many member states have also used a portion of revenue to support additional social compensation measures. The EU has also reserved a portion of ETS revenue to support redistribution through the Modernisation Fund, specifically focusing on modernizing energy systems and improving energy efficiency in the 10 lowest income member states.

With the release of the Fit for 55 proposal, the Commission is now suggesting enhancing revenue distribution activities under ETS 1 and the Modernisation Fund as well as implementing a second ETS (ETS 2) in the heating and road transport sectors. As a result, households dependent on fossil fuels for electricity generation, cooling, and heating, or that rely on personal gas-powered vehicles will likely see their costs increase. Lower income households will feel these price increases, and rising energy prices have and will create additional burdens, especially in Eastern, Central, and Southern European countries that exhibit higher rates of energy poverty.

The Social Climate Fund Can Help Ensure Equity

The Commission has proposed that a portion of revenue from ETS 2 be earmarked for a Social Climate Fund to address social impacts from the new system. This system would focus on increasing building energy efficiency, decarbonizing heating and cooling, granting improved access to zero emissions mobility and transport, and implementing measures and investments that principally benefit vulnerable households, microenterprises, or transport users. 

Designing a fair and effective carbon pricing policy requires careful consideration of how costs and benefits are distributed across society. Good practices from carbon tax and ETS jurisdictions around the world have shown that using revenue to simultaneously further decarbonization goals and address distributional outcomes can make carbon pricing policies progressive and long-lasting. Using revenue for social compensation may address immediate cost challenges but does nothing to reduce emissions or incentivize a switch to zero-carbon technologies in the medium to long term.

On the other hand, leveraging revenue for emissions reductions only does not address the regressive impacts that carbon pricing can have on households and individuals. Strategic investments that consider both challenges—affordable access to green energy and revenue recycling for low income households—can provide opportunities for realizing multiple benefits, including additional emissions reductions, diminished energy bills in the long term, and more progressive climate policies. Also, transparent and strategic revenue recycling can build and maintain support for carbon pricing policies.

The European Commission has established several regulatory and monetary instruments to fairly transition the EU to become the world’s first climate-neutral continent. By implementing the Social Climate Fund, member states can leverage auction revenue to further emissions reductions, diminish regressive and environmental impacts for the EU’s most vulnerable, and build additional political support for emissions trading as a key climate policy tool.