Hannah Copeland, Lennart Brandt, Natalie Burr and Boromeus Wanengkirtyo

Emissions Trading Schemes (ETS) are an increasingly popular market-based policy to impose a price on carbon emissions (previously costless to the emitter) (World Bank Group (2025), DESNZ (2025)). With carbon prices expected to increase steadily, and sectoral coverage broadening, these schemes have gained the attention of monetary policy makers (Breeden (2025), Mann (2023)). But what are the implications for inflation? By constructing a new tool (a high-frequency identified ‘instrument’) to measure the impact of supply shocks in the UK carbon market, we document that a tighter carbon pricing regime temporarily increases energy prices and inflation, and decreases output. We find that this shock transmits through multiple energy-related commodity prices, including oil and gas, compounding cost-push pressures arising from the energy sector.

The question

In 2022, Europe experienced the most dramatic energy crisis of the past few decades. The UK annual inflation rate rose to a 40-year high of 11.1%, driven in large part by a collapse in natural gas flows from Russia to Europe, which led to a surge in gas and electricity prices (ONS (2022)).

A lesser-documented phenomenon, however, is that carbon prices also rose rapidly over this period (Chart 1). From a central bank perspective, this raises an interesting question: could the carbon market have played an under-acknowledged role in the 2021–23 rise and fall in energy price inflation? And if so, does the nature of an energy price shock matter from the perspective of how monetary policy makers might want to respond? These are pertinent questions, as the UK carbon price is expected to rise (green diamonds), and UK ETS coverage to expand, over the monetary policy horizon.

To add some context, in the summer of 2022, the UK ETS carbon price had doubled relative to the previous year (orange line). Including the Carbon Price Support (CPS), the effective price of carbon paid by UK power generators reached £115/tCo2e: a non-trivial cost to electricity production (aqua line). Ember (2023), (2025) estimate that as electricity prices peaked, in August 2022, carbon accounted for roughly 13% of total UK gas-fired and 45% of total coal-fired generation costs. Before and after the energy crisis period, when fuel prices were lower and more stable, carbon emissions are estimated to have made up an even larger share of overall gas-fired generation costs. In 2024, for example, gas-fired generators are estimated to have spent roughly £1 on carbon for every £2–£3 on fuel. From March to August 2020, carbon costs are estimated to have been higher than their fuel costs.

Chart 1: Carbon emissions allowance prices in the United Kingdom

Notes: The chart depicts the UK-relevant price. The UK ETS was established on 1 January 2021, but UK operators were bound to comply with the European Union (EU) scheme until the end of April 2021, and 19 May 2021 was the first UKA trading day (UK Government (2021), UK ETS Authority (2023)). The UK-relevant carbon price is therefore the EU ETS price (CFI2Zc1) converted to GBP prior to 19 May 2021 (purple line), and the UK ETS price (UKAFMc1) from that point (orange line). The aqua line is the effective carbon price for the UK power sector, ie, the ETS price plus the CPS uplift. CPS rates are taken from HMRC (2025) Table 3. The London Stock Exchange Group (LSEG) UKA forecast (green diamonds) is in nominal terms (adjusted for 2% inflation), and is produced by the LSEG Commodities Research Group. Future carbon values used by the UK Government for modelling purposes similarly see carbon prices rise over the coming years (see DESNZ (2024) Table 1).

Sources: Bank calculations. Data from LSEG and HMRC.

The model

To quantify the impact of a tightening of the carbon pricing regime on the UK macroeconomy, we estimate a vector autoregression model using Bayesian methods (BVAR), partially identified by our new UK-relevant carbon policy surprise series (described below). Building on the methodology developed by Arias et al (2021), the proxy is introduced as an external instrument. The BVAR is estimated in log-levels, using monthly data on the (UK-relevant) carbon price, natural gas and crude oil prices, as well as real GDP, energy price inflation and non-energy price inflation. The sample period is June 2008 to April 2024, chosen to exclude the EU ETS pilot phase (2005–07), where allowances were freely allocated and non-transferable to future phases, resulting in the carbon price dropping close to zero.

The instrument

We extend the high-frequency identified carbon policy surprise series developed by Känzig (2025) from the EU to the UK carbon market, reflecting the fact that on 1 January 2021 the UK left the EU ETS and established its own (DESNZ (2025)).

In practical terms, we collect a comprehensive list of (UK-relevant) regulatory update events about the supply of carbon allowances, covering the period 2020–24. We then isolate the subset of those announcements that are not ‘confounded’ by other news, and measure the change in the (UK-relevant) carbon futures price in a tight (one day) window around the event. The key idea is that exogenous shifts in supply drive these price fluctuations, meaning that they can be used as an instrument to estimate the dynamic causal effects of carbon price movements. This technique has a long-standing application in the monetary policy literature (eg, Kuttner (2001), Gertler and Karadi (2015), Nakamura and Steinsson (2018)), and has more recently been applied to energy markets (eg, Känzig (2021), Känzig (2025), Alessandri and Gazzani (2025)).

Chart 2 shows the resulting UK-relevant carbon policy surprise series, aggregated to monthly frequency. To the best of our knowledge, this is the only instrument able to study the macroeconomic impacts of supply shocks in the UK carbon market. It is therefore also the only instrument appropriate for estimating the impact of carbon pricing in the UK during the period of most interest to monetary policy makers: the recent energy crisis and carbon price surge.

Chart 2: UK-relevant carbon policy surprise series

Notes: The UK-relevant carbon policy surprise series, constructed as the percentage change in the UK-relevant carbon futures price around regulatory policy events concerning the supply of UK-relevant carbon emissions, aggregated to monthly frequency. ‘UK-relevant’ refers to EU ETS futures price and events until 30 April 2021 (end of UK operators’ compliance with the EU ETS), and UK ETS futures prices and events after 19 May 2021 (the first UK ETS auction and trading day) (UK Government (2021), UK ETS Authority (2023)). The 2005–19 portion of the series (aqua line) is Känzig’s EU ETS carbon policy surprise series (2023 series, variable: surprise, pct). Note that our results hold on the alternative version of the instrument, too (constructed as the change in the carbon futures price relative to the wholesale electricity price).

Source: Authors’ calculations.

The results

We find that contractions in the supply of carbon allowances that increase the carbon price can have a significant impact on the UK macroeconomy. They operate much like other supply-side shocks: increasing inflation, and decreasing output, within the three-year monetary policy horizon. Chart 3 shows the impulse responses of UK macroeconomic variables to a restrictive carbon policy shock, scaled to increase energy price inflation by 1 percentage point (pp) at peak. To give a sense of scale, this is a large shock which increases carbon prices by roughly 7% at peak. It leads to a prolonged increase in energy price inflation, which peaks after around one year, followed by a smaller but more persistent rise in non-energy price inflation (0.12pp at peak, a further four months later), and a lagged and temporary fall in GDP (-0.06% at peak, around two years after the initial shock).

Chart 3: Impulse response functions of UK macroeconomic variables to a restrictive carbon policy shock

Notes: Impulse responses to the identified UK-relevant carbon policy shock, normalised to increase energy CPI inflation by 1pp at peak. Estimation sample: June 2008 to April 2024. The solid line represents the median draw. The shaded areas are the 80% credible intervals.

Source: Authors’ calculations.

The dynamics imply a clear transmission channel, with the energy sector playing a key role: passing on rising shock-induced costs to energy prices, thereby propagating cost-push pressures to energy-intensive sectors across the economy. But what drives these rising costs in the energy sector?

Importantly, we find that a tightening in the carbon pricing regime causes not only carbon prices to rise, but oil and gas prices, too. Chart 4 shows the impulse responses of different energy-related commodity prices to the restrictive carbon policy shock. We observe a strong, immediate increase in carbon prices (7% on impact), followed by a smaller and more gradual, but non-trivial, rise in oil and gas prices (around 1.5% and 4% at peak, respectively). The rise in the crude oil price is similarly found by other papers (Känzig (2025), Ortubai et al (2025)), and can be rationalised by the fact that European and UK oil producers and refineries are covered by ETSs. Specifically, activities associated with exploration and drilling, production and processing, transportation, and refining of oil are within scope. The response of the natural gas price reflects fuel-switching due to changes in the relative short-run marginal cost of different types of electricity generation, as substitution away from (more carbon-intensive) coal into gas-fired generation exerts upwards pressure on gas prices (Ember (2023)).

Chart 4: Impulse response functions of energy-related commodity prices to a restrictive carbon policy shock

Notes: Impulse responses to the identified UK-relevant carbon policy shock, normalised to increase energy CPI inflation by 1pp at peak. Estimation sample: June 2008 to April 2024. The solid line represents the median draw. The shaded areas are the 80% credible intervals. The oil and gas prices are the Brent crude oil and UK National Balancing Point (NBP) natural gas front month futures prices.

Source: Authors’ calculations.

In a model extension, we compare the effects carbon allowance, gas, and oil supply shocks on the respective commodity price. For the same sized impact on energy inflation, we find differing effects on headline inflation by type of shock. Chart 5 compares the impulse responses of UK headline CPI inflation to a carbon allowance, gas, and oil supply shock. We see that the type of shock matters: if a 1pp at peak energy price jump originated as a supply shock in the carbon market, the headline inflation impact is roughly 25% bigger relative to an equivalent shock arising in the gas market, and several months more persistent than if it originated in the oil market.

Chart 5: Impulse response functions of UK headline inflation to shocks to carbon allowances, gas, and oil supply scaled to increase energy inflation by 1pp at peak

Notes: Impulse responses to the identified UK-relevant carbon policy shock, and the natural gas and oil supply shocks identified by Alessandri and Gazzani (2025), Känzig (2021). For comparability across shocks, responses are standardised to increase energy price inflation by 1pp at peak. Estimation sample: June 2008 to April 2024 for the carbon and oil shocks, and to December 2023 for gas shock (owing to the shock series length). Note, however, that our UK-specific reconstruction of Alessandri and Gazzani’s gas shocks (which takes the UK NBP natural gas price change around event days) enables estimation over the full sample, and yields similar results. The solid line represents the median draw. The shaded areas are the 80% credible intervals.

Source: Authors’ calculations.

Conclusion

In this post, we have estimated the causal effects that changes in carbon prices have on aggregate UK prices in the short run. Note first that, in doing so, we have only really considered the cost side of climate policy. It is well-documented that climate policies can imply short-term trade-offs for economies which are more likely to show in the monetary policy horizon we focus on. Our model does not consider the macroeconomic impacts of a successful transition to net-zero (which is beyond the monetary policy horizon). These could result in avoided economic losses and direct macroeconomic gains that far outweigh the negative short-term macroeconomic impacts of climate policies.

Second, carbon prices are set to rise further, and we expect carbon policy to become more stringent and increase in coverage over time. Therefore, it is worth highlighting that the results presented here only estimate average dynamics over the baseline sample period (June 2008 to April 2024). Given the substantial developments in the UK energy sector already over the past decade – including, but not limited to, the phase-out of UK coal-fired electricity generation – these relationships could be time-varying: a dimension that we want to explore further.

In any case, our results underscore the importance of not treating fluctuations in energy prices as homogenous. While they are all ‘supply-like’, how central banks respond to energy price inflation might differ depending on the type of shock, even if the peak jump in energy prices is the same. We find that for an equivalent jump in energy prices, the most challenging implications for headline inflation (and thus monetary policy) arise if the source was a supply shock in the carbon market. A shock of this nature transmits diffusely, increasing not only carbon but also oil and gas prices, in a way that compounds cost-push pressures arising from the energy sector.

Hannah Copeland and Boromeus Wanengkirtyo work in the Bank’s Structural Economics Division, Lennart Brandt and Natalie Burr work in the Bank’s External MPC Unit.

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