The economic case for carbon pricing is among the most robust in the environmental economics literature. A price on carbon internalises a previously unpriced externality — the social cost of greenhouse gas emissions — and creates a continuous incentive for emission reduction across the entire economy without requiring regulators to identify specific abatement opportunities. In theory, a carbon price set equal to the social cost of carbon (SCC) at the margin optimises aggregate welfare.
The 2006
Stern Review set the SCC at around $85 per tonne of CO₂ in 2006 dollars; updated estimates from the US Environmental Protection Agency (2023) place it at $190 per tonne of CO₂ at a 2.5% discount rate. The current global weighted average effective carbon price, as estimated by the
IMF, is approximately $6 per tonne — roughly 3% of the estimated SCC. The distributional structure of carbon pricing — who bears the cost, who captures the benefit, and the resulting political economy determine what is implementable.
A carbon price that is uniform across fuel types and consumption patterns is regressive in its initial incidence — meaning that lower-income households bear a higher burden as a proportion of income. This arises because lower-income households spend a larger share of income on energy (for heating, transport, and food) than higher-income households, and because they have less financial flexibility to respond to price signals by switching to lower-carbon alternatives (e.g., they cannot afford to replace a petrol vehicle with an electric one in response to higher fuel prices). This distributional effect is politically toxic and has derailed or weakened carbon pricing in multiple jurisdictions.
The economic literature is clear that the regressivity of a carbon price is not a necessary feature — it is a consequence of how revenue is used. Revenue recycling through equal per-capita dividends (the 'carbon dividend' approach) can make a carbon price progressive in net terms where all households face the same price on carbon, but lower-income households receive a larger dividend relative to their carbon bill, resulting in a net transfer from high-carbon, high-income consumption patterns to lower-carbon, lower-income households. The British Columbia carbon tax, which historically recycled revenue through per-household rebates, demonstrated this effect empirically. The Canada Carbon Rebate, despite political pressure to eliminate it, has also maintained this structure.
The choice of revenue recycling mechanism is critical design decision in carbon pricing implementation. Options include:
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Per-capita dividends. This is progressive, politically popular with net recipients, but increases income available for consumption.
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Income tax reductions. Benefits higher earners who pay more income tax, does not fully address regressivity.
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Corporate tax reductions or industry compensation. This maintains industrial competitiveness but removes progressivity.
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Green investment funds . This earmarks revenue for low-carbon investment, popular with environmental constituencies, does not address household distributional concerns; and combinations of the above.
The political economy of revenue recycling is itself a collective action problem. Revenue recycling to households builds political constituencies for the carbon price — recipients become defenders of the policy. Recycling to industry builds industry support but undermines public legitimacy. Earmarking to green investment satisfies environmental advocates but creates fiscal rigidity. Most jurisdictions combine approaches, which distributes political support while simultaneously diluting each mechanism's effectiveness. France's
Gilets Jaunes protests (2018–2019) illustrated what happens when carbon price increases are not accompanied by credible revenue recycling to affected households. The distributional grievances become a political crisis that can reverses the policy.
The most durable political argument against unilateral carbon pricing is the competitiveness objection. If a jurisdiction imposes a carbon cost on domestic producers that foreign producers do not face, carbon-intensive production shifts to the unregulated jurisdiction (carbon leakage), generating no global emissions reduction while destroying domestic industrial employment. This argument has empirical support in sectors with high carbon intensity and high trade exposure such as steel, cement, aluminium, and chemicals.
The Carbon Border Adjustment Mechanism (
CBAM) — now in force in the EU from January 2026 — is the most comprehensive attempt to address the competitiveness objection to date. By imposing a carbon cost on imports equivalent to the EU ETS price, CBAM eliminates the relative cost advantage of unregulated foreign producers in EU markets. This is not without limitations. For instance, it applies only to directly embedded emissions in covered sectors, does not cover all downstream products, and creates complex diplomatic tensions with trading partners. But the mechanism represents a genuine policy innovation that the theoretical literature had proposed for decades without political traction, and its practical operation will generate empirical evidence on leakage reduction and trade effects that will inform the next generation of carbon pricing design.
When integrating carbon pricing assumptions in your analysis or strategy, remember that the political economy of carbon pricing is a direct risk variable. Carbon prices have been weakened, exempted, frozen, and reversed in multiple jurisdictions in response to political pressure — the European ETS required significant redesign after initial price collapse from over-allocation, and several national carbon taxes have been reduced or repealed under electoral pressure.
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(a) revenue recycling that creates net beneficiary households;
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(b) Exemption structures that are explicit and time-limited rather than open-ended and sector-specific;
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(c) linkage to broader energy system investment that creates constituencies for the policy; and
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(d) regulatory certainty embedded in legislation rather than administrative decisions subject to executive revision.
Carbon price trajectories published as political commitments — rather than enacted in durable legislation — carry substantially higher political risk than regulatory instruments that would require legislative action to reverse. Practitioners pricing carbon in long-horizon investment models should discount political commitments and weight legislation with bipartisan support more heavily than executive announcements.
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By
Julius Atulinde, Senior Associate
