Greenflation

Is the fight against climate change driving up prices?

  • The transition to a more climate-friendly world will contribute to rising inflation over the coming years
  • But ‘greenflation’ is just one factor behind rising prices – the impact is currently greater from ‘climateflation’ and, in particular, ‘fossilflation’
  • Greenflation has several causes, most of which are reflected only indirectly in the inflation rate

Of price drivers, brown and green

Prices are rising across the board, with inflation at its highest level for decades. And in the eurozone at least, there could be further pain to come. Energy is one of the main reasons for this. As things stand, European natural gas costs more than twice as much as it did at the beginning of the year, with prices soaring in the wake of growing uncertainty about the supply situation. However, inflation in Europe is likely to plateau as we head towards autumn, after which rates should gradually begin to fall again. The burning question for the capital markets right now is not so much whether inflation will decline, but by how much. Because if inflation rates do not move back to within range of the central banks’ targets, the banks may feel they have no other choice but to further tighten their monetary policy line.

And then it won’t be long before another potential price driver moves back into view – one that has somewhat fallen out of the spotlight following the outbreak of the war in Ukraine – namely, greenflation. It raises the question as to whether we are now stuck in a hamster wheel of energy inflation. Currently powered by expensive ‘brown’ energy but soon to be seamlessly replaced by green energy and climate policy in general.

Isabel Schnabel, member of the Executive Board of the European Central Bank (ECB), had announced in January that the ECB would be closely monitoring the costs of fighting climate change and the impact of this on inflation. Although we ourselves do not consider it likely that greenflation will significantly drive up prices, it is important to precisely determine the extent to which individual factors are contributing to inflation as a whole. It’s all too easy to lump everything together and over- or underestimate the true effect.

At its most basic level, greenflation can be understood as the component of inflation caused specifically by the transition to a more climate-friendly world. It has two close cousins, climateflation and fossilflation. Isabel Schnabel called these three dimensions “three distinct but interrelated shocks that can be expected to lead to a prolonged period of upside pressure on inflation.”1

Climateflation describes the phenomenon by which price increases are triggered by climate change that is already taking place, i.e. the direct costs of climate change. Examples include rising prices when crops fail due to heatwaves or if production is interrupted because of storms. Logistics problems also belong in this category. Think back to the temporary suspension of shipping on the Rhine as a result of the low water levels in 2018.

Fossilflation refers to price increases that can be attributed to higher prices of fossil fuels, but with the price components driven by regulatory measures – such as emission allowances and other such taxes and duties – stripped out.

The breakdown of the inflation rates shown in the chart clearly shows that fossilflation is currently the main factor driving inflation. Since April 2021, higher fossil-fuel energy prices have consistently accounted for more than half of all inflation in the eurozone.

Energy price increases have recently been accounting for more than half of the inflation rate

Contribution to eurozone inflation rate in percentage points*

Energy price increases have recently been accounting for more than half of the inflation rate
Sources: Union Investment, Eurostat; as at 17 June 2022. *Rate of inflation (total, %), above the bars

Whereas the effect of climateflation is most obvious in the food and services sectors in the chart, quantifying greenflation is trickier because its impact can rarely be directly ascertained. Greenflation is more about price increases that result from additional, externally imposed costs and from firms adjusting their spending plans. We distinguish between four factors driving greenflation, some of which overlap:

  • Regulation: The number of non-market-based regulatory rules and requirements has been on the rise for a number of years now, particularly in the environmental sector. Compliance with these, in order to limit harmful emissions, for example, burdens businesses with higher costs. Capital investment becomes less profitable than it would be in a world without such external constraints. This might mean, for argument’s sake, that it becomes too expensive to mine new raw materials. The result, initially, is a decrease in supply at macro level, and thus a scarcer commodity fetching a higher price. But, as recent developments have shown, the wheel of regulation can also be turned back. One impact of the war in Ukraine and the broader goal of energy security is that technologies that were consigned to the past – in Germany, at least – are suddenly back in vogue. Chief among them are coal-fired power plants.
  • Internalisation of external costs: Until a few years ago, CO₂ had no real price to speak of. Carbon taxes seemed a distant dream and emissions trading was still a niche activity. You could essentially emit the greenhouse gas at no cost whatsoever. In economic terms, it was an externality borne by everyone, including the corporate sector. Now, of course, businesses in many industries must either pay a carbon tax or buy emissions permits if they want to emit CO₂. These costs are internalised and, where possible, passed on to customers in the price of the product.
  • Greater investment in the technologies of the future: External constraints such as stricter carbon emission targets require businesses to invest in new processes and structures. This is money they would otherwise not have to spend. Excluding the effect of any productivity gains, there is no increase in supply at first. But costs rise nonetheless. If these costs are passed on to customers, inflation increases too.
  • Imbalances in supply and demand: The supply of commodities in particular cannot simply be dialled up when there is greater appetite in the market. The very lengthy process of increasing output, together with factors such as general availability, limited access to markets and geopolitical and geological issues, mean that supply cannot be increased at the speed and in the volumes necessary to meet a surge in demand. As the economy shifts to a greener footing, metals such as copper, nickel and lithium will be particularly sought-after. Indeed, their prices have already began to rise sharply. Meanwhile, the prospect of more supply bottlenecks further down the line, exacerbated by the effects of the Ukraine war, could add to the inflationary effects of greenflation and push prices even higher.

Looking ahead: Where is the price pressure coming from?

But how will price pressure from greenflation, in particular, but also climateflation and fossilflation change over time? And what will be the implications for fiscal and monetary policy? From an economic perspective, the crucial factor is where the inflation is coming from. There are two classic inflationary scenarios: price pressure on the supply side, often due to shocks such as the coronavirus pandemic (broken supply chains) and the war in Ukraine (energy shortages), and price pressure on the demand side, with supply unable to keep up with demand in the short term – not necessarily for all goods and services, but with a certain broad effect nonetheless.

Climateflation and fossilflation are clear cases of supply-side pressure. If harvests fail due to heatwaves or if production in certain sectors is forced to shut down because of flooding, supply is reduced. If demand stays the same, prices will rise. It is a situation that played out during what is surely the most famous example of fossilflation – the oil price shock of the 1970s. OPEC throttled back supply while demand remained unchanged. Prices skyrocketed as a result.

Greenflation is more difficult to assign to one side or the other because of the different ways in which it manifests itself. Looking at it through the prism of the aforementioned four factors reveals the following:

  • Regulation: When regulation and red tape prevent capacities from being expanded while demand remains constant or increases, prices will rise. German wind power is a case in point. If, in the past, there had been fewer constraints on this sector and it had been allowed to expand at an accelerated rate, the supply of wind power would be higher today, which would have had a dampening effect on prices.
  • Internalisation of external costs: If it becomes more expensive for companies to emit carbon, and they curb output because of the higher cost of production, the pressure clearly comes from the supply side, as it does when the prices of end products are directly impacted – which is the case with the German CO₂ tax, for example. However, a flat-rate initial surcharge can also have a dampening effect on demand. The new equilibrium price will then depend not only on the pricing power of the companies but also the elasticity of consumer demand. Depending on the product, demand will respond to higher prices either directly or with more of a lag.
  • Greater investment in the technologies of the future: Increased spending on research and development and, ultimately, the realignment of production boosts demand for a whole range of intermediate goods. But, of course, these new, more sustainable processes, brought about by external pressure, need to be funded somehow. And provided companies have the requisite pricing power, it is consumers who will end up paying more. In the longer term, however, new processes can also bring prices down – for example, when they lead to efficiency gains and economies of scale. The true inflationary effect from the supply side is therefore uncertain.
  • Imbalances between supply and demand: The transition to a green economy will greatly increase demand for certain commodities, not least industrial metals. The International Energy Agency (IEA) and the International Monetary Fund (IMF) expect demand from the renewable energy sector to increase fourfold for copper, 30-fold for lithium and an incredible 60 times over for nickel by 20502. But mining operations take many years to plan and execute, and the extraction of certain minerals and materials can be hugely complex. This will drive up the prices of individual commodities significantly – a transition that may well last several years given how long it takes to develop new deposits.

Is greenflation becoming structural?

The question remains as to whether and for how long greenflation could become a major driver of inflation. Will the fight against climate change mean that inflation will be structurally higher in the future?

Our baseline assumption is that greenflation will persist for several years, if not decades. Particularly when it comes to those commodities needed for the shift to a green economy, the market will probably continue to underestimate the rising demand – and thus also the rising price pressure.

Input prices are also likely to increase for other reasons. For example, in order to reduce their carbon footprint, companies will need to invest in new manufacturing processes. Stricter regulation, meanwhile, will make other input factors more expensive. Carbon taxes and the planned expansion of emissions trading are some of the ways this might happen. Companies will try to pass on as much of this production-cost increase as possible to their customers, thereby pushing up prices – and thus inflation – further into the medium term.

The outlook for the inflation contribution of the fossil fuels oil, gas and coal is more complicated, and their prices can be expected to continue rising. Not only because their external costs – i.e. the harmful effects on the climate – will be further internalised, but also because increasing environmental regulations will probably lead to a shortfall of investment in the sector.

However, fossil fuels unquestionably face a tipping point in the medium term. As soon as renewable energy is available in sufficient volume, demand for fossil fuels will fall sharply, as will the price. In the case of electricity, it appears likely that it will soon be cheaper to generate electricity from green sources than from fossil fuels. But because of the continued need for significant investment and an even greater increase in demand, it will be some time before these changes are reflected in the prices that consumers pay.

Greenflation will therefore probably be less visible overall than the inevitable future fluctuations in oil and gas prices, which will remain a dominant influence on the inflation rate. Whereas we are constantly reminded of fossilflation when filling up the car, buying heating oil or reading our household gas bill, greenflation mainly affects intermediate goods, with manufacturing companies’ costs affected the most. The breakdown in the chart above shows that greenflation would most likely be reflected in the price of manufactured goods and services.

On the one hand, this could make people less actively aware of greenflation, but on the other it could be used to place the blame on greenflation when in fact other factors – such as climateflation and fossilflation – are behind higher prices. Because of what the transition to a green economy entails, we are expecting structurally higher inflation in certain intermediate goods and in certain sub-sectors of the economy for many years to come. But by no means all price drivers are ‘green’ when it comes to overall inflation – the more important ones are probably still ‘brown’.

  1. 1 “A new age of energy inflation: climateflation, fossilflation and greenflation“, speech by Isabel Schnabel as part of a panel discussion on monetary policy and climate change at the ECB and its Watchers XXII conference, Frankfurt am Main, 17 March 2022(https://www.ecb.europa.eu/press/key/date/2022/html/ecb.sp220317_2~dbb3582f0a.en.html)
  2. 2 See our study paper ‘Rohstoffmärkte werden grün – Energiewende sorgt für Favoritenwechsel’ (‘Commodities go green – The energy transition is paving the way for new favourites’), published in November 2021.(https://institutional.union-investment.de/startseite-de/Kompetenzen/Nachhaltige-Investments/Studien/Themen_Rohstoffmaerkte_werden_gruen)

Authors:

Volkmar Baur, Janis Blaum

 

As at 12 June 2022.

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