What are the impacts of decarbonisation on inflation?

With the rise in fuel and food prices, a cost-of-living crisis and geopolitical unrest, will decarbonisation ease the pressure on inflation or make it worse? Economic Modeller Zsófi Kőműves shares top modelling insights.

Over recent months, the Russian invasion of Ukraine has brought on extreme price hikes and supply chain disruptions.  Fuel and food prices have increased rapidly, pushing up the overall price levels, accelerating inflation and raising cost of living.

Facing a changing climate and more frequent and severe natural disasters, climate scientists and economists have called for stronger climate action. Implementing and strengthening commitments for a decarbonised future announced at COP26 could turn us back from the brink of a disaster.

With the rise in fuel and food prices, a cost-of-living crisis and geopolitical unrest, what are the impacts of decarbonisation policies in the short and long term?

Will they ease the pressure on inflation, or make it worse? And what does this mean for managing the medium to long term risk of climate change?

I put these questions to the test with our global macroeconomic model E3ME, using inflation projections from a Global Net Zero by 2050 scenario originally developed for our strategic partnership with Ortec Finance.

Decarbonisation is inflationary, but also leads to faster growth of the real economy

Overall, decarbonisation is inflationary for most countries worldwide in the short and long run, with some slow-down in the 2030s. However, our modelling also showed that decarbonisation leads to faster growth of the real economy and ultimately reduces the impact of climate change.

The graph below shows the stylised (smoothed) inflation impact based on our modelling results for the EU27, illustrating the net effect of 3 key drivers:

  1. Green investment stimulus
  2. Cheaper electricity, lower production costs
  3. Expensive ways to reduce emissions, increasing production costs

Source: Cambridge Econometrics, E3ME modelling (Climate MAPS, Global Net Zero 2050 scenario), EU27 inflation impact compared to baseline (smoothed)

3 ways decarbonisation impacts inflation

1 Green investment stimulus

Large amount of investment is required to kick-start decarbonisation, which increases inflation in the short-term, but investor payback pushes prices higher in the long run.

Investment promoting renewables in the power sector, electric vehicles, and low-carbon heating acts as a direct economic stimulus.

These investments fuel economic growth and decarbonisation increases demand for labour, materials, and products across the supply chain. Rising employment and household income increase consumption demand, which accelerates price growth and creates demand-pull inflation in the short run.

Funding the low-carbon investments may also raise inflation in the longer run. Our modelling assumes that firms build the costs of private investment into product prices, while public investments are covered from taxes. If emission taxes cannot fund the total investment needs the government may increase taxes to cover the remaining amount, which again raises price levels and accelerates inflation.

Although decarbonising the economy is inflationary in our modelling, it also brings higher growth of the real economy through the productivity enhancing effect of investments.

2 Cheaper electricity, lower production costs

High share of cheap renewables in power generation can decrease electricity prices and slow inflation down.

Solar and wind costs have been falling by 50-85% in the 2010s. The International Energy Agency (IEA) finds that solar generation was the cheapest way of increasing power generation capacity in 2021 in face of increasing fossil prices and emission taxes for most countries.

Naturally, country-specific costs vary substantially, but for economies relying on fossil fuel imports, increasing the share of renewables can reduce electricity prices. As electricity prices build into production costs and ultimately product prices, this can slow down inflation (cost-push channel).

3 Expensive ways to reduce emissions, increasing production costs

The use of negative emission technologies for offsetting emissions of hard to decarbonise sectors are expected to increase costs, prices and inflation in the long run.

Many countries, including the EU, have announced net zero emission targets and aim to reach carbon neutrality between 2050 and 2070.

There are production processes, especially in materials and chemicals, which are hard to decarbonise.

It may be cheaper to allow those sectors to have some emissions, which are offset by negative emissions in other parts of the economy. In our modelling bio-based carbon capture and storage (BECCS) technologies are assumed to be introduced in the long-run for this purpose. While necessary for carbon neutrality, these technologies are still quite expensive. Their use increases average electricity prices, pushes up production costs and could accelerate inflation (cost-push channel).

The costs and benefits of climate action

Overall, decarbonisation leads to higher inflation for most countries in the short and long run, with some slow-down in the 2030s.

But our modelling also shows that decarbonisation brings higher real economic growth, creating jobs and increasing household incomes.

Beyond the economic impacts, climate action helps to avoiding a global climate disaster for which higher inflation is ultimately the price to pay.

Ideally, climate action can lock-in climate change related physical risks which would otherwise bring devastating impacts on economy and human society. Gradually increasing temperatures bring more unpredictable weather, stronger and more frequent extreme weather events.

Droughts, heat waves and storms destroy the infrastructure, damage agricultural production, hurt economic supply chains and reduce labour productivity. The UN has already expressed concerns over raising food prices due to Ukraine dropping out of global agricultural supply chains. Climate change’s potential impact on prices and product supplies would be much stronger than that.

Decarbonising the economy is a challenge and especially with facing severe price pressures and geopolitical unrest. But the window is closing, these next years are critical in reducing emissions to limit warming and secure a liveable future.

Click here for more information on our Sustainable Investment service and stay tuned for the model update with our strategic partner Ortec Finance, due to be released later this year.

Zsófi Kőműves Economist [email protected]

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