The lumpy, unpredictable nature of climate change and the transition towards zero carbon is likely to mean that inflation will be higher, and more volatile in the future.
Much of this inflationary pressure relates to the impact that climate shocks have on the supply of essential commodities, especially agricultural and energy. However, the transition to a zero carbon economy (and the costs that implies) is likely to become an increasingly important contributor to high and volatile inflation.
Up until relatively recently, carbon prices were low and the impact on carbon abatement behaviour was limited. Over the longer term though, higher carbon prices provide the incentive to decarbonise power generation and industrial assets. However, these assets take time to come to fruition, which means that in the short-term capital is diverted away from high carbon sectors such as fossil fuels.
Higher carbon prices also represent a cost that business must either pass onto their consumers, or alternatively absorb it and see their margins cut. Uncertainty over short and long term carbon prices will become more and more important in determining inflationary expectations.
Volatile inflation is particularly pernicious due to the significant cost it imposes on economic activity resulting from the the uncertainty it introduces into decision making.
Central bankers should play a pivotal role in communicating the economic trade-offs involved in decarbonisation. They have the power to provide a stable foundation for the investment and behaviour change required. Without that foundation then carbon prices are likely to be higher, and for much longer.
The degree to which inflation will result from carbon pricing ultimately depends on where we are today.
Compliance carbon markets covered ~17% of global emissions in 2021 and posted a carbon market-weighted average price of ~$28 per tonne (~€26.50). The low average price reflects the large share of emissions covered by China’s nascent carbon market and it’s relatively low carbon price; launched in July 2021 the scheme closed the year below $10 per tonne. Taking account of other countries where carbon taxes exist and carbon pricing of some…