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The Climate Change Impact on Inflation

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The Climate Change Impact on Inflation

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Agora #89
Pages 17-19

Currently, at 8.1% (compared to May 2021), inflation has resurged in Europe to levels not seen since the 1980s.

Regressive effects and policy options

Currently, at 8.1% (compared to May 2021), inflation has resurged in Europe to levels not seen since the 1980s. As recent ECB data suggest, it is currently driven primarily by higher energy prices (where inflation was 39.2% compared to May 2021) but also by unprocessed food prices (9.1%), both direct impacts of the war in Ukraine and the economic sanctions that western and other democracies have been imposing on Russia.

Inflation in general and the currently observed one, in particular, tend to affect more those households with lower incomes, exacerbating income inequality for two reasons. Inflation erodes the purchasing power of money incomes (such as wages and social benefits), and lower-income households tend to rely more on such incomes as they do not own (or own fewer) other types of assets to fall back on. Moreover, in the current circumstances, energy and food, as basic commodities, constitute a relatively larger part of the budget of low-income households than of the budget of higher-income households; therefore, high prices put relatively more pressure on these lower-income households.

Varieties of climate change inflation

Some recent research by ECB researchers looked more specifically on the effects of extremely high temperatures on inflation. It found that ‘climateflation’ has a non-negligible impact on inflation even in the medium-term, which is the time horizon (usually 1-5 years) over which central banks consider developments in inflation when deciding whether and how to adjust their monetary policy, especially in emerging (poorer) economies but not as much in advanced ones. A possible reason for this difference between emerging and advanced economies is that food is a relatively more important commodity in the ‘basket of goods’ used to calculate inflation in the emerging economies and because their resilience to natural hazards is relatively lower. We, therefore, see that extremely high temperatures have an unequal impact on ‘climateflation’ (with all that it brings) between emerging and advanced economies. However, the researchers warned that the increased frequency of extremely high-temperature episodes may create ‘climateflation’ even in advanced economies.

The war in Ukraine has provided some impetus for accelerating the green transition in Europe by reducing our reliance on natural gas and oil imported by Russia. Even if the geopolitical context were to shift to produce a (sustainable) peace agreement dramatically and a lifting of sanctions though, however, we are likely to face further inflation surges related to climate change and actions to mitigate it with at least partly similar effects to the ones we currently see. As Isabel Schnabel, member of the governing council of the ECB, recently stated, however, such inflation surges have distinct sources.

First, extreme weather events (for example, heavy rainfalls or heatwaves) and the natural disasters they can be linked to (for example, floods, droughts or wildfires) may destroy harvests or agricultural land. This would result in a lower supply for some foodstuff which, given demand, would result in higher inflation for these commodities, what can also be called ‘climateflation’. Studies investigating how exactly such weather events affect inflation are rather scarce.

Secondly, the price of fossil fuels has been rising (what can be called ‘fossilflation’) due to different reasons. Despite grand declarations, fossil fuels and natural gas still accounted for 85% of total energy use in the euro area in 2019. Therefore, ‘fossilflation’ has a high impact on the general (headline) inflation. There have been different reasons for ‘fossilflation’, from carbon pricing policies, aiming at reducing their consumption to mitigate climate change, to the rolling back of investing in fossil fuels, reducing their supply even though demand remains high. Finally, the fact that there can only be a few suppliers of fossil fuels, resulting in a so-called ‘oligopolistic’ market, has been allowing these companies to increase prices of fossil fuels by controlling (that is, reducing) supply and creating shortages.

Thirdly, the development of new green technologies (for example, wind-generated power) and products (for example, electric cars) that would help curb carbon emissions and reliance on fossil fuels rely on materials, such as minerals and metals, whose supply (through mining) is unlikely to grow in line with the increase in demand for them in the next decade or so, as countries around the world strive to meet their commitments to carbon emission curbs. This will lead to ‘greenflation’.

The presentation of the above types of inflation and their sources suggests two insights. The fact that we have not yet weaned ourselves off our dependence on fossil fuels will cost us higher ‘climateflation’ and ‘fossilflation’. Speeding up that process of decarbonization, on the other hand, by means of advancing innovative green technologies is likely to fuel ‘greenflation’. While it would curb ‘fossilflation’, we are nevertheless bound to live with extreme weather phenomena and the ‘climateflation’ they cause for decades to come. ‘Fossilflation’ and ‘greenflation’ suggest that unless policy interventions are in place, households with lower incomes are likely to be stuck with energy supplied by fossil fuels, which will become ever more expensive. At the same time, more sustainable forms thereof may also remain unaffordable for them. This would perpetuate inequalities and energy poverty.

Policy options

High inflation breeds public discontent, as households feel the squeeze in their budgets. In Europe, the task of maintaining inflation low and stable is primarily assigned to central banks, including the ECB. What do these climate change-related types of inflation mean for its policies?

‘Climateflation’ and ‘fossilflation’, similarly to the inflation surge we currently experience, are trickier to tackle as, in their case, price increases come hand-in-hand with risks of economic activity slow down or even recession: higher prices, especially of commodities such as fuel and food are likely to reduce production and consumption, as production costs increase and the budgets of households are spent increasingly on these commodities but not on others. Therefore, the conventional monetary policy reaction of raising interest rates to reduce inflation runs the risk of making these negative impacts of inflation on-demand and job creation worse and of increasing inequality as, during recessions, those at the margins of the labour market tend to suffer more in terms of unemployment or precarity of employment. Moreover, rising interest rates for the entire economy would harm investment, including on investment in renewable energies and new green technologies, perpetuating the causes of all three types of inflation related to climate change.

Tackling ‘greenflation’ does not pose these risks if a central bank increases interest rates to stem it. The challenge of ‘Greenflation’ is how we can step up investment to the degree which would allow the supply of materials used for new green technologies and products to increase faster and in line with their demand. The ECB can impact the financing conditions and, therefore, the steering of investment towards these activities in two ways. First, in the context of its Assets Purchasing Programmes, by taking a more active approach in steering its asset purchases towards activities and companies which promote investment in new green technologies and products and away from those which do not contribute to the EU’s climate objectives. Secondly, in the context of its collateral framework whereby banks deposit financial assets of high quality as security for receiving liquidity from the ECB, by shifting the rules determining which financial assets are admissible collateral in favour of those financing genuinely green activities and limiting the admissibility of financial assets which contribute to climate change.

The ECB concluded a monetary policy strategy review last July. Its new strategy (to be reviewed again by 2025) includes an action plan to support the EU’s fight against climate change. The first step in that direction is to understand better how exactly climate change, whether through extreme weather events, policies to step up decarbonization and those to develop new green technologies, affect output growth and prices but also how they would affect the financial system through which the policies of the ECB have an impact on the real economy. The ECB’s climate change action contains points on adapting the assumptions and models the Bank uses to forecast macroeconomic developments, based on which its policy decisions are made, to better account for the effects of climate change and related policies (e.g. carbon pricing) on its forecasts.

Moreover, in its new strategy, the ECB committed to taking more actively into account the environmental sustainability of activities financed by assets serving as collateral for its credit operations and/or purchased in the context of the ECB’s corporate asset purchasing schemes, as it has been facing criticisms that these operations have been inadvertently financing economic activities that enhance rather than mitigate activities detrimental for climate change. While moving in the right direction, these commitments had been criticized even before the war in Ukraine broke out, for being way too modest, given the urgency of the EU’s climate objectives.

The impact of climate change on inflation is still a topic we need to know more about. However, it is also one of the channels through which climate change accentuates inequalities. The current surge of inflation, mostly driven by geopolitical developments which, however, play out on Europe’s dependence on fossil fuels, has prompted the ECB to announce a reversal of its ultra-accommodating policies of recent years. This is bound to reduce some degrees of policy freedom for tackling climate change. However, it could also serve as an opportunity to focus political minds and will on moving forward with other policy frameworks, from the EU fiscal rules and the terms of coordination between fiscal and monetary policies in the EU to the EU taxonomy for sustainable activities to accelerate just green transition.

Sotiria Theodoropoulou

About the author

Sotiria Theodoropoulou joined the ETUI as a Senior Researcher in November 2010 and in 2018 she became Head of Unit II, European economic, employment and social policies. She has been regurlarly acting as an external expert for the European Economic and Social Committee (EESC). She is a member of the Advisory Committee of the Social policies unit of the Eurofound in Dublin.

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