Market-based climate policy with fluctuating fossil energy prices

Abstract

Since market-based climate policies such as carbon pricing affect the cost of using fossil resources, rule-based climate policy adjustments in response to fossil energy price shocks may promote macroeconomic stabilization. This raises the question of whether climate policy should adapt to short-term fluctuations in fossil energy prices. We examine this question by employing a dynamic stochastic general equilibrium (DSGE) model calibrated for the German economy. Our results indicate that the macroeconomic and welfare impacts of rule-based carbon pricing adjustments depend on the share of recycled revenue. If revenue is fully absorbed, lowering emissions prices can stabilize the economy in response to rising energy prices. Conversely, if revenue is at least partially recycled, maintaining a stable carbon price will improve overall welfare. With a stable carbon price, revenue recycling acts as insurance against fluctuating energy prices. This result remains robust across several robustness checks.