How does the climate transition affect inflation?

What effects on inflation can be expected?

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How does the climate transition affect inflation?

What effects on inflation can be expected?

Published: 13 April 2022

The impact of the climate transition on inflation in the coming decades is a relatively small and delimited question in relation to the broader discussion of the socio-economic consequences of climate change. But it is nevertheless important for central banks to try to identify the challenges that may have to be faced in the future, when it comes to keeping inflation low and stable.

One can expect the following main effects that may have an impact on inflation:

  • Higher energy prices
  • A negative effect on the economy's aggregate supply when existing carbon-intensive technologies are phased out
  • Increased aggregate demand in connection with investments in new technologies, and
  • A positive effect on aggregate supply when the new technology is put to use.

These effects are discussed in more detail below. The aim is not to quantify the effects, but to describe on a general level the various mechanisms by which economic actors adapt to more expensive emissions, and to discuss the consequences for inflation and monetary policy.

It should be emphasised that the analysis is partial and focuses on the possible effects of the climate transition as such. Other things can of course happen that also affect inflation, including the effects of climate change that has already occurred and that will occur.[3] For a review of global warming in an economic perspective, see, for example, Olovsson (2020). For a description of how the Riksbank works with climate-related risks within the framework of its mandate, see Sveriges Riksbank (2021).

Higher prices for energy and energy-intensive products

Increased carbon taxes or higher prices for emission rights will lead in the short term to higher prices for fossil-free energy, too, and for products in which energy is an important input. The world's energy supply comes largely from the burning of fossil fuels, such as coal. When the cost of this type of energy production increases, so does the price of energy generated without major emissions of greenhouse gases, such as hydroelectric power. This is a consequence of the energy market being largely international and of the price being determined by the relationship between supply and demand. Swedish energy production is largely fossil-free, although electricity is traded to a certain extent on an integrated European market, where the element of fossil fuel is usually larger.

The impact of energy prices on consumer prices depends on price elasticity, that is, how demand responds to changes in the price. If a product has a high price elasticity, this means that even a small price increase will lead to a sharp decrease in demand. It will therefore be difficult for producers to pass on the higher costs to consumers, and they will have to bear them themselves to a greater degree in the form of lower mark-ups and profits.[4] A study in the United States by Ganapati, Shapiro and Walker (2016) finds that an increase in energy prices does not have a full impact on consumer prices. They also argue that consumers bear a smaller share of the burden than standard methods indicate. Correspondingly, a low price elasticity means that it is easier to pass on the price increase to consumers.

Increasing consumer environmental awareness may also lead to changes in preferences and consumption patterns. This, too, would make it more difficult for companies to pass on the increase in costs.

Nevertheless, in the short term, it is reasonable to assume that the prices of energy and energy-intensive products will increase. This means that the consumer price index, CPI, will rise. There is a risk of higher prices for energy and energy-intensive products spreading to other prices. This can lead to a broader increase in consumer prices, higher wage demands and rising inflation expectations.

Phase-out of carbon-intensive technology

When the costs of using technology based on fossil fuels increase, it becomes less profitable and starts to be phased out. The speed at which this happens depends on the rate at which it becomes more expensive for companies to use carbon-intensive technology. It also depends on the extent to which the higher costs can be passed on to consumers – and profitability can thus be maintained – as well as the extent to which alternative technology is available or is being developed.

If the higher costs are largely borne by producers, the profitability of companies and of production processes dependent on fossil fuels will come under pressure, and they may be eliminated more rapidly. This would hasten the structural transformation, but could also lead to shortages during the transition process.

The phasing out of the old technology will lead to a reduction in aggregate supply in the economy, a negative supply effect. This means that economic activity declines and that prices rise at the same time. If the initial increase in energy prices has provided an inflation impulse that has started to take hold, the inflationary pressures may therefore be further reinforced.

Introduction of new technology

New technology will be gradually introduced. Technological change tends to focus on the input where the most savings can be made, in this case fossil energy. However, in the short term, and for a given production technology, the possibilities of replacing fossil energy with other types of energy are limited. In the longer term, when the technology is also changed, the possibilities are significantly greater. Economic research indicates that the oil price shocks of the 1970s spurred rapid technological change to reduce the need of fossil energy.[5] See Hassler, Krusell and Olovsson (2021), who also develop an intellectual framework around technological advances as the economy's response to finite natural resources – so-called endogenous technological development.

Initially, increased investment in new technology will increase demand in the economy, a positive demand effect, which will push prices up. As the new technology is phased in and replaces the old, the aggregate supply will increase, which dampens prices. Assuming players live up to the environmental agreements that have already been made or will be made, the transition to zero net carbon emissions will eventually be implemented. The central question for a central bank is what happens to inflation during the transition period.

One possibility is that the new technology will be phased in more or less parallel with the phasing-out of the old. In this case, the aggregate effect on supply – the negative effect of the phasing-out of the old technology and the positive effect of the introduction of the new – will be relatively small and have limited effects on inflation.[6] Some economists even highlight the possibility that the development of new energy sources can proceed so quickly and be associated with such major technological breakthroughs that the positive supply disruption they imply will assert a downward pressure on inflation; see, for example, Cœuré (2018).

Summing up, one can expect that energy prices will initially increase and that there will be negative effects on the aggregate supply in the economy when CO2-intensive technologies are phased out. Investment in new technologies will then have positive effects on demand, and when the new technologies are put into use, positive effects will arise on the aggregate supply. A possible scenario is that inflationary pressures will increase, particularly in the beginning of the transition process.