Economic Commentary

How might climate change affect inflation?

A new word has been added to economists’ lexicon over the last year or so: ‘greenflation’. Although greenflation is yet to be given a formal definition by the mainstream dictionaries, the term encapsulates the idea that climate change and the fallout from the transition to a ‘greener’, more ‘sustainable’ world is putting upward pressure on costs and inflation. In this month’s commentary we look at the topic of climate change and inflation, and some of the potential issues this might raise going forward.   

When discussing the impact of climate change on the economy it is useful to divide the effect between the physical impact (for example from global warming and the increased incidence of extreme weather events) and that related to the fallout from the transition to a greener economy.

Extreme weather impact

Perhaps the most obvious physical impact from climate change on prices is in agriculture. Scientists have warned for years that global warming will hit food production as more regular incidents of extreme weather (heat, droughts and floods) result in crop failure 1.

Today’s high food prices – the Food and Agriculture Organization's food price index rose 28% to a 10-year high in 2021 2 - have multiple causes, including disruption from the pandemic and the increased cost of fertilizer and energy (itself in part related to the green transition – see below). However, extreme weather events – be they droughts in Canada, floods in continental Europe or severe frosts in Brazil – have played a key role in driving up prices for a range of foodstuffs including wheat, potatoes and coffee over the last year 3.

While technological developments (such as drought resistant crops etc.) hold out the possibility of mitigating the impact of climate change, the broad body of opinion suggests that food prices are likely to head higher, a trend that could be exacerbated if shortages prompt food exporting countries to adopt protectionist measures 4.

The notion of climate change negatively impacting yields in agriculture might have an echo in the broader economy if higher temperatures reduce labour productivity, for example by making it more difficult to work outside in areas such as construction. One study suggests that productivity falls by approximately 1.7% for each one degree centigrade increase in daily average temperature above 15°C 5. As a result, there are strong grounds to expect rising temperatures to push up unit costs, and ultimately prices, going forward.

Of course, more extreme weather events carry the potential to dramatically disrupt supply chains and result in price increases. In 2011, severe flooding in central Thailand hit the production of semiconductors, resulting in supply bottlenecks in a range of industries. At the other extreme, a drought in Taiwan and subsequent water rationing last year threatened the production of semiconductors at a plant operated by Taiwan Semiconductor Manufacturing Company (the world's largest semiconductor maker) which reportedly uses 37 million gallons of water a day 6.

The increased incidence of extreme weather events is also likely to further push up insurance costs. According to the Swiss Re Institute, climate risks are expected to add as much as US$183 billion to annual premiums for property insurance by 2040, accounting for just over a fifth of the overall rise in property premiums expected over the next two decades 7. Some homeowners in areas at high risk from flooding or wildfires are finding that they are unable to secure home insurance at any cost. 

Green energy transition

The sector which has arguably dominated the ‘greenflation’ debate is that of energy. Indeed, it is an area where the direct impact of extreme weather as well as policies relating to the transition to greener sources of energy and the attitudes of increasingly environmentally-conscious investors have combined to put upward pressure on prices.

The rise in gas and oil prices over the last year or so is in part due to a normalisation of demand as economies have reopened after the pandemic, as well as geopolitical factors (e.g., tensions with Russia).  However, weather-related events (reduced output of hydro power in Asia and Latin America due to droughts, and a lack of wind halting wind turbines in Europe) have also been instrumental in pushing up prices, as disrupted output from renewables has led to higher demand for gas, coal and oil.

The recent volatility in energy prices highlights the problems that can arise when the capacity to supply fossil fuels is wound down before alternative sources can make up the shortfall. Capital expenditure in conventional energy production has fallen as the focus has turned to net-zero carbon emissions targets, and institutional investors have shunned fossil fuel companies. This is not surprising given predictions that half of global fossil fuel assets will be worthless in 15 years or so under a net zero transition 8. Lack of spare capacity and limited investment in the oil and gas sector are often cited by analysts as reasons to expect further price increases in fossil fuels going forward 9.

These dynamics risk exacerbating cost pressures resulting from carbon pricing schemes, i.e., initiatives such as carbon taxes or so-called cap-and-trade systems, which create financial incentives for companies to reduce greenhouse gas emissions. Carbon pricing raises costs for carbon-intensive industries, which in turn may ultimately result in higher prices for consumers.

These pressures are only likely to increase as measures to reduce carbon emissions are broadened and regulations tightened. According to figures recently cited in a speech by ECB Executive Board Member Isabel Schnabel, only 21.5% of global emissions are covered by carbon pricing instruments, and only 4% are covered by a price of more than US$40.00 per tonne 10. However, most climate economists think the price of carbon should be above US$75.00 per tonne if the aim of reaching net zero emissions by 2050 is to be achieved 11. The price of carbon permits under the European Union’s Emissions Trading System (ETS) has risen sharply in recent months 12, in part reflecting the expectation that commitments to reducing carbon emissions are getting more serious.

Moreover, there are also signs that the era of falling prices for renewable energy might be coming to an end. Advances in technology, along with economies of scale, have resulted in a sharp drop in the price of solar and wind power over the last decade 13. However, rising prices for raw materials, along with ongoing global supply chain disruptions, are now putting upward pressure on the prices of solar panels, wind turbines and batteries 14. For example, the prices for lithium (a key input for batteries) and copper (used in electric cabling) have traded near record highs in recent weeks, as the drive towards electrification has increased demand for both metals 15,16. This has prompted talk of a new ‘commodity supercycle’ (i.e., a sustained period of strong demand and rising prices) for raw materials required for the green transition.

Policy response

Taking all of these developments together suggests that climate change and the policies to mitigate it will continue to put upward pressure on costs. Whether such cost increases represent changes in relative prices or a broader, sustained inflationary impulse remains to be seen and will depend on a host of factors including offsetting technological improvements, the degree to which any cost increases can be passed on to consumers, how inflation expectations are impacted, and how central banks respond.

There is some survey evidence to suggest that the public are prepared to pay up for more sustainable, ‘greener’ goods and services 17, implying that companies will be able to pass on higher costs to the consumer. However, the issue of how income-constrained households actually respond is open to debate. Indeed, if, for example, energy prices do continue to rise for the reasons outlined above, households might spend less on everything else, which could put downward pressure on prices for non-energy goods and services. We might also see a political backlash against ‘green’ policy initiatives that are perceived as increasing the cost of living.

Much will depend on how policymakers react. In the past, central bankers, who seek to secure price stability over the medium term, have tended to look through temporary spikes in energy prices. However, if higher energy prices lead to a rise in household inflation expectations which heightened the risk of a wage-price spiral, central bankers are more likely to respond by tightening monetary policy.

Another consideration is whether the impact of climate change will prompt a rethink regarding inflation targets. If central banks seek to maintain headline inflation around their current targets (normally 2% in developed economies) against the backdrop of steeper rises in energy prices, this would imply the need to curb price increases for non-energy components of the CPI basket.

All of this suggests that the issues surrounding climate change, sustainability and inflation are more complex and multi-faceted than a simple portmanteau might imply. At a time when policymakers are trying to fathom the extent to which current elevated levels of inflation are transitory or have longer-lasting causes, the issue of climate change adds another dimension to the traditional macroeconomic debate.

10th February 2022