The inflationary impact of the carbon transition
The shift to net-zero carbon emissions is a global phenomenon, with pledges and commitments now covering 90% of GDP and 85% of the world’s population. These range from firm commitments written into national law through to proposals and pledges, but the trajectory is clear. Globally, greenhouse gas emissions are driven by the energy sector. Much of this is driven by electricity and heat generation, followed by transportation, manufacturing and construction.
Achieving net-zero emissions by 2050 will therefore require a sharp focus on reducing emissions in these areas. Under currently-enacted policies, global emissions would plateau in the 2030s and be slightly below current levels in 2050, according to analysis by the International Energy Agency (IEA) – but the global average temperature rise in this scenario passes the 1.5° Celsius mark around 2030 and reaches 2.6 °C in 2100. Compared with this status quo scenario, IEA projections show the required reduction in emissions to achieve net zero is substantial, even if announced net-zero pledges were fully implemented.
INFLATION IMPLICATIONS
The extent of net-zero commitments and their ramifications for globally significant industries mean there could be significant implications for global inflation.
This is particularly clear in the case of energy. Stable energy prices were a critical driver of the muted inflationary dynamic of the past decade.
According to the US Bureau of Labor Statistics, in the 2000s, energy inflation rose faster than overall inflation, and headline US CPI averaged 2.6%. In the 2010s, as energy prices stayed largely flat, headline CPI rose 1.8% on average. The global inflationary impact of moving towards net-zero emissions is likely to be modestly to moderately positive during the transition period, and once the transition is complete, the long-term impact is likely to be deflationary.
ENERGY PRICE EFFECT
For the energy sector, the upfront costs associated with the transition to net zero, and need for investment today to lower future emissions, means the associated price levels would likely rise by at least 15 basis points to 25bps per annum during the transition over the next several years, before falling by 25bps to 35bps per annum after the transition, as renewable energy sources scale up and drive down energy prices.
These estimates reflect our expectation that governments will shoulder a significant portion of the costs of the transition. This would likely reduce the impact on inflation, at least in the short run, but it may instead lead to other costs, such as higher taxes or greater incentives to engage in financial repression to manage large debt loads.
The need for incremental investment and the possibility of higher fossil fuel prices through the transition could both put upward pressure on prices. In combination, these have potential for 40bps to 50bps of annual positive inflationary forces through 2030 associated with the carbon transition.
The countries most sensitive to energy price inflation are Spain, Thailand, Japan, and India, given their reliance on energy imports and relatively low usage of renewable energy sources. Canada and Brazil have the least relative inflation risk from the carbon transition and the EU, and the US are in the middle of the pack. China is harder to know given a lack of transparency around the composition of its CPI basket.
National impact of the carbon transition
While we expect overall energy price levels globally are likely to rise during the transition, and then fall afterwards, the impact on inflation within specific countries will differ. The sensitivity of a country to inflation risk driven by the carbon transition will depend on several factors, including the weight of energy within a country’s overall inflation basket, the extent to which a country already generates clean energy, which will reflect how much it may need to invest in clean energy, and how much energy a country imports.
How countries weight energy within their inflation baskets
Unlike food, energy as a share of the CPI basket does not exhibit much of a correlation to economic development. This would suggest that the developed world’s inflation is no better or worse positioned than emerging markets during an energy shock. When we look at the CPI weights of key countries, South Africa, the UK, and Canada appear to be least vulnerable to energy shocks whereas Mexico and Spain, would exhibit greater vulnerability.
How countries generate their energy
Countries that produce more of their electricity from renewable sources are generally likely to have less future investment requirements and vice versa.Brazil and Canada stand out as best positioned with Germany, Italy, and Turkey also relatively well positioned. Conversely, South Africa, South Korea, India, and the US are relatively low. One point of uncertainty is where nuclear fits into the future as it is not renewable but is also non-carbon emitting.
Whether nuclear remains acceptable after the transition has significant implications for the amount of investment needed in some countries, especially France – where we assume nuclear will be a long-term part of their electricity portfolio.
How much energy countries import or export
As we have seen in recent months, having to import energy can lead to more pronounced price movements relative to countries with excess energy: for example, natural gas prices have risen much more in Europe than the US in late 2021. Countries that are net importers may face more price volatility during the transition than those that are net exporters. On this factor, Europe, China, India, and Japan are vulnerable, while Canada, the US, Australia, and Brazil are better positioned.
HOW GOVERNMENTS COULD MITIGATE INFLATION IMPACT
Government policies remain a major uncertainty. ‘Green protectionism’ could raise prices, while subsidies could reduce the inflationary impact of the transition. Two approaches that could affect global inflation are carbon taxes and subsidies and incentives focused on the transition.
Notably, at the 2021 COP26 summit, nations made a variety of pledges to reduce their carbon footprint ranging from reducing methane to halting deforestation.
Achieving these pledges will require public and private sector action, and governments will likely have to use regulatory powers, subsidies, direct investment, penalties, and potentially even tariffs to reach these goals. There was a greater consensus on ending deforestation and expanding renewable and affordable hydrogen, while ending overseas fossil-fuel financing and raising maritime shipping standards were the most controversial subjects.
It is worth noting that different inflation methodologies could lead to different outcomes from the same government policies. For instance, in the US, CPI only accounts for the price consumers pay whereas PCE considers the entire cost of a good. So, to the extent subsidies reduce the consumer’s purchase price of an electric car, the impact of the transition on CPI would be less than PCE. All else equal, the energy transition could narrow the historic PCE-CPI inflation gap.
Carbon taxes
The EU has proposed the Carbon Border Adjustment Mechanism (CBAM) targeting aluminium, steel, fertilisers, electricity, and cement. From now through 2025, producers would be given free carbon credits based on the carbon intensity of the top decile of producers in their sector. As such, inefficient producers would face increased costs immediately. After 2025, the credit grants would decline 10% per annum to incentivise all producers to improve operations.
The EU wants to avoid ‘carbon leakage’, whereby imports of ‘dirty’ products increase at the expense of domestic production, thereby mitigating the carbon reductions. The EU effectively aims to set up a carbon border tax to equalise the playing field, crediting any importers for carbon taxes they have already paid. It is unclear whether this would influence emissions policies in other countries, or simply result in higher priced imports.
Such policies may deepen the industrial base in the developed world but could lead to higher consumer prices. A European Central Bank working paper deemed the inflationary impact of carbon taxes to be low, though we believe it poses an upside risk to medium-term inflation forecasts. Governments could also use tariff revenue to increase subsidies in green project, thereby reducing prices elsewhere.
Subsidies and incentives
Rather than seeking to raise the costs of ‘dirty’ energy and products, governments may choose to reduce the cost of clean energy and products. For example, the Biden administration has proposed over $300bn in subsidies for the carbon transition and electric vehicles, as well as direct payments to utilities to fund green projects, though the prospects of this plan becoming law are very unclear.
The required spending to achieve net-zero emissions and the reduction in fossil-fuel power generation are likely to be inflationary, before the various ramifications – including the shift to renewable energy – are disinflationary over the long term. But how fast the transition occurs, alongside the unknowns of future government policy and even geopolitical dynamics, mean significant uncertainty remains.
Scott Ruesterholz is portfolio manager for fixed Income at Insight Investment.
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