With the increasing interest in climate change and the drive towards net zero, environmental policy is very much in the public debate.
Further, we also recognise that as well intentioned as carbon pricing strategies such as a carbon tax might be, the approach can lead to wildly inconsistent incentives to reduce emissions if not well designed.
A carbon tax has features of a supply shock in that it raises the cost of production, while the inflationary impacts reduce demand.
Therefore, a carbon tax has a direct impact on the cost of burning fossil fuels, shifting the relative costs of primary fuel sources in proportion to the carbon emitted by each fuel.
The carbon price will raise the average price of primary fuel inputs, even after allowing for the shift in energy mix.
Countries that continue to rely heavily on fossil fuel exports will suffer a significant loss in potential export revenue, stemming from both a decline in the volume of demand for fossil fuels and a decline in the value of each tonne of fossil fuel exported.
Meanwhile, fossil fuel importers benefit from the lower import price, which offsets some of the inflationary impacts of the carbon price itself.
The NiGEM climate model is an expanded version of the standard NiGEM model that introduces climate policy instruments and other channels needed to model energy transition and physical climate shocks.
The rise in global credit constraints stemming from the heightened financial uncertainty raises the costs of borrowing and constrains access to finance, driving a sharp adjustment in investment.
The carbon tax is imposed on each fossil fuel in proportion to the CO2 that is emitted when burning the fuel and scaled by the energy that is produced by each fuel.
In the short term, nominal fossil fuel prices can be expected to rise by about 4 per cent, in response to the rise in global inflation and different speeds of adjustment of supply and demand in energy markets.
This reflects a combination of factors, including a higher energy intensity of production – especially in Russia and India, a higher reliance on coal – especially in India and China, a strong pass-through of input prices to consumer prices and more weakly anchored inflation expectations.
In the short run, GDP would be expected to fall by 1-2 per cent in most countries, with a more significant decline in the energy intensive Russian economy, which will also suffer sharp terms of trade losses.