Does a Climate Dividend threaten inflation?
Latest inflation figures have revealed that the Consumer Price Index (CPI)—which measures the price of a fixed basket of goods and services representative of typical household consumption—rose 1.8% this quarter (ABS, 2022). Over the past year, this means prices in Australia have risen by 6.1%, well above the RBA’s headline inflation target of 2 to 3% (RBA, 2022). With inflation anticipated to hit a 30-year high of 7.2% at the end of July (NAB, 2022), many Australians are concerned that their wages will not rise quickly enough to keep up with the increasing cost of living. But turning to traditional monetary policy need not be our only approach to controlling inflation. A climate dividend policy could help us too.
Figure 1: Annual CPI inflation trends in Australia (ABS, 2022)
Rising petrol, electricity and gas prices are largely responsible for stoking current inflation. Petrol prices were 35.1% higher over the year to March, while wholesale electricity prices have increased 3 times since early April and wholesale gas prices are now 3-4 times higher than normal levels (Mousina, 2022).
So how does the Australian Climate Dividend Plan (ACDP) offer a solution? Aside from offering arguably the most effective economic solution to mitigating GHG emissions (see Why a Carbon Price?), a carbon tax and dividend policy would offer a significant form of “cost-of-living relief” to Australians. Indeed, under the ADCP, the average Australian household is expected to be $585 p.a. better off. Moreover, by returning a carbon cashback to all Australian citizens equally, lower income households—who are disproportionately affected by inflation—are expected to benefit most, with the lowest 20% of households $1,300 p.a. better off (Holden & Dixon, 2018). These dividends would offer much needed income support to meet rising household costs and would redirect finance towards low carbon living. The carbon tax incentivises a shift towards zero carabon technologies which in turn leads to cheaper energy in the medium to long term (see Why the Dividend in a Carbon Price).
So far we have established that the ACDP would assist Australian households in meeting the cost of rising electricity bills associated with inflation. But what about the relationship between a climate dividend and inflation itself? Will introducing the ACDP contribute to current inflationary pressures? Research analysing the economic effects of carbon pricing schemes remains at a nascent stage. Previous research—which has largely relied on computable general equilibrium (CGE) models—has suggested climate mitigation tools may lead to varying inflation effects. However, as Kondradt and Weder di Mauro (2021) emphasise, these theoretical models rely on several simplifications for tractability, which may limit their application to real-world scenarios. These limitations warrant the need for further economic modelling that instead makes use of the growing body of empirical data.
Using data from carbon tax schemes introduced in Canada and Europe over the last 30 years, Konradt and Weder di Mauro (2021) use two separate empirical approaches to show that carbon taxes do not have to be inflationary and may even have deflationary effects. Moreover, those countries that imposed some form of redistributed scheme—similar to that proposed under the ACDP—experienced no inflation. The potential mechanisms underpinning the lack of inflationary effect can be understood by considering two key channels.
Reduced consumption: The increase in energy prices associated with a carbon tax may have a depressive effect on household income. In turn, this dampens consumption expenditure, thereby reducing inflation. The magnitude of this income channel may depend on the redistribution scheme in place. In Canada, for example, where the redistribution is very progressive in income (i.e., going mostly to low-income households) higher-income households experience a greater tax burden, resulting in this demographic cutting consumption more aggressively.
Offsetting decreases in non-energy prices: While the implementation of a carbon tax does lead to a temporary increase in energy prices, this rise is compensated by a reduction in food and service prices as well as the cost of energy-intensive durable goods such as houses and cars. This relative decline in prices can be understood by two further channels.
Reduced demand: When consumption expenditure is reduced by the first channel detailed above—particularly for higher-income households—there is reduced demand for on-tradable goods such as food and services. This lower demand is associated with a reduction in prices.
Reduced net present value (NPV) of energy-intensive goods: When computing the value of energy-intensive durable goods such as houses and cars, higher future energy prices are factored in. This results in a lower NPV, thus depressing the price at which these goods are traded.
As the authors demonstrate, these findings are robust across different jurisdictions, for different implementation waves, and controls for macroeconomic performance and monetary policy responses.
We now have compelling cross-country evidence that a carbon tax—particularly when combined with a dividend redistribution scheme—has no inflationary effect on the economy. Moreover, even if there are inflationary pressures, these are likely to be short-lived given the subsequent reduction in price of renewables (Ruesterholz, 2022). The introduction of a climate dividend scheme will also tackle energy affordability, with 75% of Australian households expected to be better off financially under the ACDP (Holden & Dixon, 2018). In the current climate of high inflation and rising energy bills, the case for the ACDP now seems clearer than ever.
References
Australian Bureau of Statistics (July 2022) Consumer Price Index, Australia, ABS Website, accessed 27 July 2022.
Holden, R., & Dixon, R. (2018). A climate dividend for Australians. https://doi.org/https://doi.org/APO-204696
Konradt, M., & Weder di Mauro, B. (2021). Carbon taxation and inflation: Evidence from the European and Canadian experience.
Mousina, D. (2022). Econosights: Implications from Australia’s energy “crisis”. AMP Capital. Retrieved July 26 from https://www.ampcapital.com/au/en/insights-hub/articles/2022/june/econosights-implications-from-australias-energy-crisis
NAB. (2022). NAB Monetary Policy Update – 12 July 2022. Retrieved 26 July from https://business.nab.com.au/nab-monetary-policy-update-12-july-2022-54714/
Reserve Bank of Australia. (2022). Australia's Inflation Target. Retrieved July 26 from https://www.rba.gov.au/inflation/inflation-target.html
Ruesterholz, S. (2022). The inflationary impact of the carbon transition. Retrieved July 24 from https://www.moneymanagement.com.au/features/expert-analysis/inflationary-impact-carbon-transition
