Energy transition and inflation: a false dilemma

According to a Carmignac study, containing global warming below 1.5°C could add 1.6% to annual inflation over the next decade.

Climate change is inherently inflationary. Rising average temperatures and their seasonal range, induced natural disasters and long-term environmental changes will have negative effects on the supply of goods and labour and positive effects on local demand. According to European Central Bank estimates, uncontrolled climate change would add between 1 and 3 percentage points to annual global inflation over the next decade. It can also be assumed that this impact would extend beyond the decade and would carry a risk of chaotic price surges once its interactions with political and social stability are taken into account. In contrast, the inflationary effect of the energy transition would be limited in time and more predictable; its social consequences would therefore be more easily managed by public authorities.

The cost of transition

To limit the temperature increase to 1.5°C above pre-industrial levels, the goal of the Paris Agreement, an inflationary tetralogy – namely “greenflation”, “fossilflation”, “demandflation” and “strandflation” – can be expected to add 1.6 percentage points of annual inflation over the next ten years, according to our estimates.

The transition to a green energy system will generate pressures on the demand for some critical resources (metals, minerals, skilled labor), needed to manufacture new energy capital goods (wind turbines, solar panels, electric vehicle batteries, grid infrastructure, etc.). “Greenflation” is already here: the cost of wind turbines has increased by 40% due to rising input costs. The likely doubling of the real price of green metals (e.g. nickel, zinc, and copper) over the next decade could, according to our forecasts, increase global annual inflation by 0.1%.

The transition will also incentivize fossil fuel producers to reduce or completely stop the maintenance and investment required to search for and exploit hydrocarbons. Given the rapid and natural decline of existing deposits, this will lead to a decline in global hydrocarbon production, and therefore an increase in their price, a phenomenon we call “fossilflation.” We estimate that to balance demand with oil production, prices would need to increase by about 20% each year, or 0.8% additional global inflation per year.

Demandflation results from the necessary reallocation of resources to other uses in the economy. For every 1% increase in GDP in sustainable investments, a similar proportion of consumption will have to be “crowded out” or postponed in time, at the cost of higher real interest rates and inflation. In addition, the reallocation of production factors (capital and jobs) towards green sectors will create inefficiencies (unemployment, need for training, business bankruptcies, etc.) that will weigh on the overall productivity of the economy.

Today, green technologies are only widely adopted when they are competitive or considered superior. For example, renewable electricity generation is competitive with fossil fuels or nuclear, even when taking into account grid modernization and other costs. However, for many sectors such as cement, steel, district heating, aviation or shipping, we estimate that there are 25% to 300% additional costs for their greening in the absence of economies of scale, innovation or regulatory advances. If there is a forced or natural creation of redundant or unused assets – for example, due to government intervention – a negative supply shock on productivity, and hence the fourth inflationary effect of the transition emerges: “strandflation”.

We estimate that demandflation and strandflation could contribute to an additional 0.7% increase in global annual inflation.

A headache for central banks

Overall, we estimate that the energy transition could add about 1.6 percentage points of inflation per year over a ten-year period, before starting to fade as “fossilflation” turns into deflation and the transition investment cycle moves away from its peak. This is by far the lesser of two evils, with the alternative being a period of quasi-permanent, unpredictable, and uncontrollable inflation. This transition period will nevertheless pose considerable challenges for central banks, the guardians of price stability.

They will have to decide whether this transitory inflation should be “ignored”, at the risk of a de-anchoring of long-term inflation expectations, or on the contrary combated, by causing compensatory deflation in other sectors of the economy.

Ideally, global monetary policy cooperation on this issue would avoid undesirable distortions on import prices, exchange rates, and global interest rates. However, this seems unlikely in the short term. The US Federal Reserve, the linchpin of the global system, is currently playing it safe: anxious to preserve its independence, it believes that it is better to let its supervisory body, Congress, decide, rather than to take up this highly politicized issue itself across the Atlantic.

At a minimum, central banks could isolate some climate costs in their assessment of inflation, and give themselves more flexibility on the time horizon over which their price stability objective should be interpreted. What is clear, however, is that inflation linked to the energy transition will accelerate. Governments and central bankers must find the best way to manage its effects, and do so as soon as possible.

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