The lumpy, unpredictable nature of climate change and the transition towards zero carbon is likely to mean that inflation will be higher, and more volatile in the future.
Much of this inflationary pressure relates to the impact that climate shocks have on the supply of essential commodities, especially agricultural and energy. However, the transition to a zero carbon economy (and the costs that implies) is likely to become an increasingly important contributor to high and volatile inflation.
Up until relatively recently, carbon prices were low and the impact on carbon abatement behaviour was limited. Over the longer term though, higher carbon prices provide the incentive to decarbonise power generation and industrial assets. However, these assets take time to come to fruition, which means that in the short-term capital is diverted away from high carbon sectors such as fossil fuels.
Higher carbon prices also represent a cost that business must either pass onto their consumers, or alternatively absorb it and see their margins cut. Uncertainty over short and long term carbon prices will become more and more important in determining inflationary expectations.
Volatile inflation is particularly pernicious due to the significant cost it imposes on economic activity resulting from the the uncertainty it introduces into decision making (see 'Greenflation' fears are a twin threat to the EUs monetary and climate credibility.
Central bankers should play a pivotal role in communicating the economic trade-offs involved in decarbonisation. They have the power to provide a stable foundation for the investment and behaviour change required. Without that foundation then carbon prices are likely to be higher, and for much longer.
The degree to which inflation will result from carbon pricing ultimately depends on where we are today.
Compliance carbon markets covered ~17% of global emissions in 2021 and posted a carbon market-weighted average price of ~$28 per tonne (~€26.50). The low average price reflects the large share of emissions covered by China’s nascent carbon market and it’s relatively low carbon price; launched in July 2021 the scheme closed the year below $10 per tonne. Taking account of other countries where carbon taxes exist and carbon pricing of some sort (either taxes or carbon markets) covers around 22% of global emissions. The other 78% are starting from zero.
On a global basis this means the price of carbon is low, really low.
~$2.50 per tonne.
We are so very early. Global carbon prices need to be well north of $75 per tonne if the world is to decarbonise in the timescales its leaders have committed to. The inflationary implications of higher carbon prices has barely begun.
Impact of higher cost of carbon on energy prices
Credit Suisse estimates that every $10 per tonne increase in the carbon price (equivalent to €9.50), will add ~$4 per barrel (bbl) to the oil price. At an oil price of $100 per bbl, this would imply a 21% and 42% increase in prices if carbon rose to $50 per tonne and $100 per tonne respectively.
When it comes to natural gas the bank estimates that every $10 per tonne increase in the carbon price would add ~$0.5 per MMBtu. At $8 per MMBtu, a $50 per tonne carbon price would raise natural gas prices by 34%, and 68% at a carbon price of $100 per tonne.
Crucially, the estimates here only account for Scope 3 emissions, i.e. those involved with the combustion of the fossil fuels. If Scope 1 and Scope 2 emissions are included then the impact on energy prices for every $10 increase in the carbon price could be some 25% higher.
Remember that higher carbon prices could be introduced through the compliance markets (e.g. via steeper floor price or expanding the coverage, etc.), or through direct carbon taxes, or some combination of the two (e.g. several countries in Europe have a separate carbon tax and are also part of the EU ETS).
Impact on inflation across economies
The impact of higher carbon prices on inflation will vary significantly across different economies. There are 3 main factors that are likely to influence this path.
The starting point matters - If an economy has a long history of relatively high carbon prices, covering a broad section of activity then additional hikes in the carbon price are unlikely to have the same inflationary impact as those countries that start from a low carbon price base.
The share of energy production from renewable sources - Economies with a high share of renewable power generation have a lower exposure to carbon intensive fossil fuels and are more able to respond to higher carbon prices, a process that will accelerate as renewable generation costs come down. They are also able to lever this to accelerate decarbonisation in other, more difficult to decarbonise sectors, e.g. the use of hydrogen in steel making and other industry’s.
The carbon intensity of GDP - High carbon prices are likely to be more inflationary in jurisdictions where a large share of economic activity comprises fossil fuel extraction and carbon intensive heavy industry. Higher carbon prices represent a larger shock to costs than in less carbon intensive economies.
Analysis conducted by Credit Suisse using this framework suggests that Europe, the US and Japan are likely to experience relatively low inflationary impacts. They estimate that a $10 per tonne increase in carbon prices across all emissions would result in a 0.3-0.4 percentage point increase in inflation in these economies.
In contrast, China, Russia and India are likely to experience much higher levels of inflation. A later starting point, the lower share of renewables and high carbon intensity means that a $10 per tonne hike in carbon prices could lead to a 0.8-1.0 percentage point rise in inflation.
On a global basis Credit Suisse estimate that inflation would rise by 0.5 percentage points.
However, this analysis is too simplistic. What’s really important is how politicians, monetary authorities, and individuals respond to higher carbon prices. The pace of decarbonisation and the degree to which governments seek to protect their economy from the adverse impacts is key.
The speed of implementation - A gradual escalation in carbon prices (as well as a clear view as to future prices) gives an economy sufficient time to adjust, investing sufficient resources to decarbonise. However, a disorderly transition, one in which are forced to stamp on the brakes, is likely to be significantly more inflationary (see What happens if policymakers are forced to "stamp on the brakes" and force carbon prices higher?).
Redistributive policies - The degree to which governments choose (or are able) to respond to higher carbon prices and protect consumers, particularly those on low incomes, from the full brunt of the inflationary impact. Lower income households typically spend a greater proportion of their income on energy and commodities and so poorly designed redistributive policies (i.e. those where the incentive for conservation are destroyed), could make the inflationary impact of carbon prices worse.
The CBAM accelerates the rollout of carbon pricing - and its inflationary impact
In an earlier article I highlighted how the introduction of the EU’s carbon border adjustment mechanism (CBAM) is also likely to be inflationary. The CBAM is one mechanism by which global pricing for carbon can be extended to cover more countries and more industries, and at a faster pace than individual governments acting alone could introduce their own carbon pricing mechanisms.
The CBAM is a way for the bloc to protect EU producers subject to EU carbon pricing from rivals in countries with less ambitious emissions requirements. Importers to the EU will have to pay taxes unless they are already pay a price for carbon similar to that charged in the EU, through emissions trading or other systems in their own countries (see Hedging the CBAM: What the EU's carbon border tax might means for carbon investors.
Currently set to be introduced at the start of 2026, the CBAM would cover highly energy intensive imports (e.g. cement, electricity, fertiliser, etc.), before being rolled out to other EU producers subject to carbon pricing. By introducing a CBAM, carbon costs will be passed through to end users for both European and imported goods, therein stimulating consumer price inflation.
On a knife edge
In the past, the typical central bankers playbook was to ‘look through’ price shocks emanating from energy and other commodity prices. If they didn’t and they responded in force to higher energy prices there was a risk that they would severely damage economic activity, all for the sake of a transitory shock.
As I outline in this article, the inflationary impact of carbon prices is likely to be more persistent, rolling out across the economy, and not simply affecting the most carbon intensive goods. It will mean inflation is higher, and more volatile.
The risk central bankers now face is that they can’t simply ‘look through’ the carbon shock. When, for example will the net-zero carbon shock be over? By 2030, 2040…or 2050? By not responding, central bankers risk sitting by as inflationary expectations gradually build and become ingrained.
Of course, central banks do not have the tools to speed up the decarbonisation. Raising or lowering interest rates does nothing to speed up innovation and the pace at which technology is adopted. Quantitative easing cannot help us find more lithium, copper, tin or any of the other commodities thought essential to decarbonisation.
The ECB and other central banks face a delicate balancing act, one that is going to become even more finely balanced in the years to come.
Higher inflation in the future means that central banks should respond by hiking interest rates, both short and long-term rates. However, by doing so the capital cost of decarbonisation will rise. On the flipside, failing to address the inflationary impacts - by keeping interest rates too low, for example - means the resource cost of decarbonisation including materials, labour, etc. could spiral out of control.
Stray too far from the edge and central banks risk delaying decarbonisation, prolonging the need for high carbon prices.
Many economic commentators, most notably former US secretary of the treasury, Larry Summers have criticised central bankers who stray too far from their day jobs and opine on issues including climate change.
This is a mistake, one that I believe carbon market investors should avoid. In fact, I believe that paying attention to what central bankers say on the subject, and what they don’t say is a vital piece of information.
Central banks face the most challenging economic environment they have ever encountered. The economies most likely to navigate decarbonisation successfully will be those whose monetary authorities can effectively communicate the inherent trade-offs required by decarbonisation.
Those that fail to do so are likely to see much higher carbon prices and higher, and more volatile inflation.
These combustion emission factor estimates assume that each barrel of oil generates ~0.42 ton of CO2 , while each MMBtu of natural gas produces 0.07 ton of CO2. However, these estimates are likely to be an underestimate given that they don’t account for the Scope 1 and Scope 2 emissions. As CS explain, these estimates are ~20% below the IEA’s lifecycle emission intensity estimates for global oil & gas production, which include emissions generated during the production, process, and transport of hydrocarbons.