Emission Impossible: Balancing Environmental Concerns and Inflation

Abstract

We provide a theoretical framework to examine how carbon pricing policies influenceinflation and to estimate the policy-driven impact on goods prices from achieving net-zeroemissions. Firms control emissions by adjusting production, abating, or purchasing permits,and these strategies determine emissions reductions that affect the consumer priceindex. We first examine an emissions-regulated economy, solving the market equilibriumunder any dynamic allocation of allowances set by the regulator. Next, we analyze aregulator balancing emission reduction and inflation targets, identifying the optimal allocationwhen accounting for both environmental and inflationary concerns. By adjustingpenalties for deviations from these targets, we demonstrate how regulatory priorities shapeequilibrium outcomes. Under reasonable model parameterisation, even when considerableemphasis is placed on maintaining inflation at acceptable levels or grant lower priorityto emissions reduction targets, the costs associated with emission deviations still exceedany savings from marginally lower inflation. Emission reduction goals should remain theprimary focus for policymakers.

Keywords: Allowance dynamic allocation, Cap-and-trade, Carbon pricing, Inflation, Stochastic dynamic Optimization, Market equilibrium