Emission impossible: Balancing Environmental Concerns and Energy Prices

Abstract

We develop a theoretical framework to examine how carbon pricing policies affect domestic energy producer prices and to quantify the policy-driven price impacts of achieving net-zero emissions. Energy-producing firms comply with emission caps by adjusting production, undertaking abatement, or purchasing permits, and these strategies determine both emissions reductions and outcomes in the energy producer price index. We first model an emissions-regulated energy sector and solve for the market equilibrium under a dynamic allocation of allowances set by the regulator. We then extend the framework to a regulator that balances emission reduction and energy price stability objectives, identifying the optimal allocation when both environmental and domestic energy price concerns are considered. The analysis shows how varying the penalties assigned to deviations from targets allows regulators to calibrate policy priorities. Under reasonable parameterisations, even when substantial weight is placed on limiting energy price increases or when emissions reduction targets are downplayed, the costs of missing emissions goals outweigh any benefits from marginally lower energy producer prices. Our results underscore that emission reduction objectives must remain the primary focus for policymakers.