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Will acting on climate change push up inflation – or would not acting be worse?

Author: ICAEW

Published: 28 Sep 2021

Sunday Times Economics Editor David Smith writes an exclusive column for ICAEW’s Financial Services faculty every month. This month he covers how climate change could affect inflation.

Long before the pandemic, the number one risk to the planet was identified by scientists and governments as climate change. And long after the worst phase of the coronavirus has begun to fade in the memory, the climate change risk will remain. As Britain prepares to host Cop26 in Glasgow (disappointingly it only stands for conference of the parties) it is not just politicians who are concerned about its effects. It is high on the agenda of central bankers. Will climate change hamper their efforts to keep inflation under control?

This not unknown territory for central bankers. When Mark Carney was Bank of England governor, he emphasised the importance of climate change so much that, when he stepped down last year, he became not only a United Nations’ special envoy on climate change and finance but also the prime minister’s special adviser.

Climate change raises many issues but the debate on its economic impact, and in particular its potential inflationary effect, is a straightforward one. Will the shift towards net zero be inevitably inflationary, and add to the potential inflation dangers ahead? Or would we risk a bigger inflationary shock if we failed to respond to climate change?

The argument that net zero will be inflationary is easily put. Households face higher costs for, for example, installing heat pumps instead of gas boilers. Businesses will find, across a range of inputs, that the environmentally friendly alternative costs more. Green does not mean cheap, at least not yet.

“If our solution is entirely just to get a green world, we’re going to have much higher inflation, because we do not have the technology to do all this yet,” said Larry Fink, the chief executive of Blackrock recently. “That’s going to be a big policy issue going forward.”

Roger Bootle, founder of Capital Economics, and known for declaring the death of inflation in a book of that name in the 1990s, agreed. “If I had to put my money on a single factor that was going to push up costs in the years to come, I would say it was the environmental emphasis and in particular the drive towards net zero,” he told Bloomberg recently. “I think this is going to lead to a whole series of costs and price increases across the economy.”

That the costs of achieving net zero over the next three decades will be considerable is not in doubt. The Office for Budget Responsibility (OBR), in its Fiscal Risks report, published in July, estimated the investment cost of the transition to net zero to be £1.4 trillion in 2019 prices. Though the government has yet to say what proportion of that cost will be borne by the public sector, the OBR suggested an addition to government debt equivalent to 21% of gross domestic product. Carbon taxes will be a source of new revenues, while the transition to net zero, under its “early action” scenario would add to the debt interest bill. 

It is this, early action, which holds the key to how central banks are viewing the climate change issue. “A disorderly transition, where more severe policies are introduced later in the horizon to compensate, could result in both lower growth and higher inflation from rising energy and materials costs in the economy,” Andrew Bailey, the Bank governor, told a Reuters event recently.

He was reflecting the views set out by three Bank economists in a paper, ‘Climate change: Macroeconomic impact and implications for monetary policy’. They said: “Climate change can affect the macroeconomy both through gradual warming and the associated climate changes and through increased frequency, severity and correlation of extreme weather events (physical risks). Inflationary pressures might arise from a decline in the national and international supply of commodities or from productivity shocks caused by weather-related events such as droughts, floods, storms and sea level rises. These events can potentially result in large financial losses, lower wealth and lower GDP.”

If that is the danger from not acting, with potentially severe growth and inflationary consequences, the impact of acting to head off these risks is not without its adverse effects.

A recent report issued by an umbrella body representing central banks, conceded that, while early action was needed to prevent much worse long-term economic outcomes, it would push up inflation. The Network for Greening the Financial System said that an orderly transition to net zero by 2050 “could lead to some increase in global GDP, and lower unemployment relative to prior trends."

An integral part of the plan it set out, however, was an increase in price of carbon to $160 a tonne – at today’s prices – by the middle of the century, some three times current levels. This is where the inflation effect could come in. As it said: “Long term interest rates tend to increase in the transition scenarios, reflecting the inflationary pressure created by carbon prices, as well as the increased investment demand that the transition spurs on."

It looks like policymakers are caught between a rock and a hard place. Climate change is likely to periodically push up inflation and add to economic instability. This effect, in fact, may already be beginning to show through. 

Acting on climate change, for which there is no alternative, also comes with a big bill attached, however. It is a bill that governments have been unwilling to inflict on voters so far. When they do so, it will look and feel like we have moved into an era of permanently higher inflation. It is one of several reason to wonder whether the low inflation of the past three decades can last.