Climate change creates new risks that affect both prices and production. This affects the Riksbank’s ability to fulfil its mandate and the Riksbank therefore needs to acquire knowledge about how these risks affect the economy. These include physical risks in the form of extreme weather conditions such as hurricanes, heavy rainfall and rising sea levels. The second is the transition to a less fossil-based economy, which entails various transition risks, such as when taxes on carbon emissions and the price of emission allowances are increased or when consumption patterns change.
Another type of risk is tipping points in different ecosystems, i.e. critical points that, when crossed, accelerate further climate change. Once a tipping point has been passed, the changes in ecosystems can become irreversible. The Amazon rainforest, the Arctic polar ice and the Siberian permafrost are examples of ecosystems where tipping points may be passed. If this happens, the consequences will include physical and transition risks, which become more difficult to manage.
How climate change might affect inflation more specifically, but also the economy more generally, was discussed in an Economic Commentary during 2022. See M. Apel How does the climate transition affect inflation? Economic Commentary, no. 13, Sveriges Riksbank. See also, M. Angeli, et al. (2022) Climate change: possible macroeconomic implications, Bank of England Quarterly Bulletin quarter 4, 2022. In the transition to new and sustainable energy, there may be negative supply-side effects as carbon-intensive technologies are phased out. Energy prices may therefore initially rise. Increased investment in new technologies will gradually have a positive impact on demand and, as new technologies come on stream, this will also have a positive impact on supply.
The extent to which inflation is affected depends, among other things, on how monetary policy reacts. One challenge may be to maintain confidence in the inflation target without lowering output and employment. Inflation resulting from high energy prices may be transitory. But the longer inflation remains high, the greater the risk that it will affect expectations in the long run, and the more difficult it will be to bring inflation down without large costs in terms of output and employment. Monetary policy may therefore face difficult trade-offs.
In two ongoing projects, the Riksbank is studying how weather changes can affect variations in prices and output in Sweden, and how monetary policy should respond to sharply rising energy prices. In the first project, historical weather data are used to study the relationship between temperature, prices and output. The second project analyses how different monetary policy strategies can affect inflation and economic development in an environment of sharply rising energy prices, which may be due to, for example, transition risks.
Rising energy prices, inflation and monetary policy
Russia’s invasion of Ukraine, disruptions to the global economy that occurred during the pandemic and new pandemic-related restrictions in China contributed to higher prices for energy as well as various inputs and food in 2022. Much of these cost increases were passed on by companies to consumers, contributing to a rapid rise in consumer prices during the year. The spillover effects to other prices were also larger than expected. However, ever since the rise in energy prices became evident at the end of 2021, the Riksbank has stressed that it will be difficult to predict how lasting the rise in inflation will be.
The high gas and oil prices in Europe this year cannot be explained by the green transition, but are primarily due to the effects of Russia's invasion of Ukraine. However, the transition to a fossil-free economy is likely to play a greater role in energy prices in the future, although the effects are highly uncertain. See F. Panetta (2022) Greener and cheaper: could the transition away from fossil fuels generate a divine coincidence? speech, Italian Banking Association, Rome 16 November 2022. For example, the transition will have an impact on both demand and supply of fossil fuels, with uncertain effects on prices. In addition, the cost and availability of renewable energy is uncertain, affecting the potential for fossil fuel substitution. However, the transition does not necessarily mean sustained higher inflation. Much will depend on the policies implemented to switch from fossil fuels to green energy. See also I. Heemskerk, C. Nerlich and M. Parker (2022) Turning down the heat: how the green transition supports price stability, ECB blog, 9 November 2022.
The impact of the green transition on inflation also depends on the shaping of monetary policy, which affects, among other things, inflation expectations of businesses and households. If high inflation as a result of the transition were to become established in price setting and wage formation, the period of high inflation would be longer and monetary policy may need to be tightened further. The Riksbank monitors price and wage developments on an ongoing basis and adjusts monetary policy so that inflation is close to the target. Bringing inflation down quickly is important because high and volatile inflation makes it difficult for households and businesses to plan their economic decisions and can dampen investment and growth.