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This paper studies how carbon pricing affects emissions, economic aggregates and inequality. Exploiting institutional features of the European carbon market and high-frequency data, I identify a carbon policy shock. I find that a tighter carbon pricing regime leads to a significant increase in energy prices, a persistent fall in emissions and an uptick in green innovation. This comes at the cost of a temporary fall in economic activity, which is not borne equally across society: poorer households lower their consumption significantly while richer households are barely affected. Not only are the poor more exposed because of their higher energy share, they also experience a larger fall in their income. These indirect effects play a crucial role in the transmission, accounting for over 80 percent of the aggregate effect on consumption. My results suggest that targeted fiscal policy can reduce the economic costs of carbon pricing without compromising emission reductions.
