The carbon price is an inflation hedge

As the price of carbon rises it will increasingly imbed itself in the economy, becoming an important driver of costs for business, and ultimately prices for consumers.

The economy (including all the products and services we consume) currently holds a massive uncovered short position on carbon. Nearly every material good fails to account for the environmental externalities that their production and consumption induce.

As businesses attempt to take account of the carbon abatement cost, production costs are likely to rise significantly. Firms either pass this cost onto consumers, or if not take a hit to their margins.

Although the impact is likely to vary by sector (e.g., size of their short carbon position, degree of competition, etc.), the global nature of the cost (every firm is affected), and the need to ‘bring consumers along on the sustainability journey’ will ultimately mean that higher prices are the more likely outcome.

One school of thought is that we first need to see higher carbon prices as a growing cause of inflation before carbon as an asset market can be seen as a suitable inflation hedge.

To wait for evidence would be mistake bordering on complacency. Investors are forward looking, and if their governments are telling them that they are committed to achieving net zero targets, and the cost to society is likely to be X number of trillion euros then that’s all they need to know.

It’s worth thinking about the various ways that higher carbon prices will leak into consumer prices.

Carbon prices have been a relatively small contributor to the overall increase in power prices seen in Europe during 2021. The rise in natural gas prices has been by far the more important price driver. However, as carbon increases in price, its role in power price formation is likely to grow in the future, even if indirectly.

For example, in the short term natural gas producers may decide to offset the carbon cost of their current production (perhaps by purchasing carbon offsets in the voluntary carbon market), passing the costs to the end user. Longer term they may decide that the expectation of higher carbon costs in the future means they should cut gas exploration today. Higher carbon prices will signal a move towards alternative zero carbon energy systems (renewable generation and in smarter power grids being prime examples), reducing demand for natural gas in the future. The risk of course is that there is insufficient future supply to meet future natural gas demand, resulting in sharply higher natural gas prices.

The move by the EU to introduce the carbon border adjustment mechanism (CBAM) is also important factor. 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.

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.

When will this inflation arrive? Sooner than many people think if net zero targets are to be achieved.

Carbon markets provide exposure to the net zero energy transition in a way that is technology agnostic - it’s irrelevant to the policy objective how it is achieved, simply that it is. Higher carbon prices lets the market decide how best to achieve that objective, whether through some combination of demand and supply side measures.

There are countless numbers of studies pontificating on the ultimate cost of the net zero energy transition, and what this means for carbon pricing by 2030, 2040 or 2050. Different technologies + different economic assumptions = vastly different price targets.

Importantly, its not enough for carbon prices to simply reach a certain level by a an arbitrary year. In order to really incentivise action carbon prices will need to front load their impact. That means prices will need to rise much higher, and much sooner and stay there for a prolonged period to provide the incentive to make necessary investments in low carbon technologies.

That ultimately means that the inflationary impact from carbon prices is just around the corner.

Hedge accordingly.