Carbon tax could help monetary policy – ECB paper

A carbon tax should be used to “cool down” economies during boom periods, and stimulate them during recessions, according to a new paper from the European Central Bank.

In Green Asset Pricing, Ghassane Benmir, Ivan Jaccard and Gauthier Vermande argue that an optimal carbon tax would be linked to the price of CO_². In order to gauge its price, the authors create a model using “higher-order perturbation methods”.

They find that an optimal carbon price is pro-cyclical and can be used during both boom and bust cycles. As an example, the authors state it would have been “optimal” to increase the tax in the run-up to the financial crisis and then “reduce it sharply” when the financial shock hit.

“A tax cut generates an increase in consumption that exceeds the increase in the stock of emissions,” the authors explain. “The optimal policy therefore allows the planner to mitigate the surge in risk aversion that occurs in recessions.”

The implementation of a carbon tax could have a significant impact of monetary policy in terms of preventing central banks from hitting the zero lower bound, the authors say.

In the authors’ model, households become more risk averse when businesses and financial firms do not account for the damage caused by their emissions.

“Risk aversion in turn raises risk premia and lowers the natural rate of interest by increasing precautionary saving,” the authors say. “A low natural rate increases the likelihood of hitting the effective lower bound.”

Implementing a carbon tax would eliminate the “fluctuations in the risk aversion that are inefficient”, the authors say.

However, the authors note the success of a carbon tax “critically” depends on whether there are viable alternatives to carbon. “The welfare gains from the optimal tax are of a much lower magnitude if the abatement technology is not efficient,” the authors say.

If the technology has not been developed, the authors believe the decline in risk premiums would be minimal.  As a result, the authors advise prioritising existing “emission abatement technology” before implementing a tax.