Macroeconomic effects of carbon transition policies: An assessment based on the ECB’s New Area-Wide Model with a disaggregated energy sector

We assess the macroeconomic effects of carbon transition policies aimed at mitigating climate change in the euro area. To this end, we augment the ECB’s New Area-Wide Model (NAWM) with a framework of disaggregated energy production and use, which distinguishes between “dirty” and “clean” energy. Our central transition policy is that of a permanent increase in carbon taxes, which are levied as a surcharge on the price of dirty energy, combined with a price-preserving fall in fossil resource supply. Our findings suggest that increasing carbon taxes to an interim target level consistent with the transition to a net-zero economy entails a transitory rise in inflation and a lasting, albeit moderate decline in GDP. We show that the short and medium-term effects depend on the monetary policy reaction, the path of the carbon tax increase and its credibility, while expanding clean energy supply is key for containing the decline in GDP. Undesirable distributional effects can be addressed by appropriately redistributing the fiscal revenues from the carbon tax increase across households.