Is a Sustainable World an Inflationary World? Part 1 of 3: The Net Zero Question

Insights 08

Is a Sustainable World an Inflationary World? Part 1 of 3: The Net Zero Question

Insights Firm-wide
10 mins read time 18 Jan 22
Generation Investment Management
Generation Investment Management
Generation Investment Management

Generation Investment Management

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In brief

  • More researchers and investors are exploring the links between the net zero transition and inflation
  • Some argue that cutting back on fossil-fuel energy will make the world more vulnerable to inflationary shocks
  • But there are reasons to believe that the net zero transition could in fact be deflationary


Two seemingly unrelated conversations are grabbing the headlines. The first relates to the sharp rise in inflation across advanced economies (see chart 1)1. While a small rise in inflation is no bad thing, the concern among economists is that expectations for high inflation will become entrenched, reducing living standards.

Chart 1: OECD inflation rate

Source: OECD

The second relates to sustainability. The world has a lot to do to move to a net zero future. Fossil fuels satisfy 83% of global primary-energy demand2 but this needs to fall towards zero.

In fact, though, the net zero transition and inflation have more in common than you may think. More people are asking themselves an intriguing question. Could net zero and control of inflation be in conflict? The relationship between net zero and macroeconomic outcomes is becoming a hot topic. Institutions including the Bank of England3 and the European Central Bank4 have recently explored the economic and financial consequences of net zero.

To identify the potential trade-offs involved in the net zero transition does not mean arguing that it is not necessary: it unquestionably is. Rather, it helps people arguing for a sustainability transition (such as Generation) to anticipate, understand and counter the arguments of those who wish to block such a transition.

For reasons that we at Generation do not understand, inflation is an extremely partisan topic. Some people will always insist that hyperinflation is just around the corner; others put their heads in the sand about the possibility of inflationary shocks. Partly for that reason we do not offer final answers or forecasts in these pieces. We merely pose the questions and explore the possibilities.

Hypothesis: Efforts to shift away from fossil-fuel production, and towards renewable energy, will raise companies’ costs and thus create inflationary pressures.

Arguments in favour

Argument 1: Reduced supply of fossil fuels

Energy companies are, rightly, winding down new investment in oil-and-gas sources. In America, for instance, private investment in new sources of oil and gas has been trending down for some time (see chart 2)5. Global investment in oil and gas seems relatively weak by historical standards.6

Chart 2: Private investment in mining exploration, shafts and wells, US ($bn)

Source: Federal Reserve Bank of St Louis

Lower investment in new supply of oil and gas has important consequences. In the jargon, supply of fossil fuels is less “elastic” than it used to be. Chart 2 shows exceptionally high global investment in 2014, a time when oil prices were high. Firms were responding to the price signal and quickly spending more on new supply (they then cut capex when oil prices collapsed).

But the economics of the industry have changed. Many firms will no longer respond this way (they are less “elastic”), in part because announcing oil-and-gas exploration will be heavily criticised by shareholders, activists and journalists. Simple economic theory says, therefore, that any surge in demand for this form of energy will largely result not in higher supply but in higher prices. This is, ultimately, the root cause of the recent surge in oil and gas prices. If demand for fossil fuels continues to grow, overall energy costs could keep rising fast, contributing to overall inflation.

Argument 2: Carbon prices adding to companies’ costs

Taxes can be inflationary. For instance, when Britain increased the rate of value-added tax in 2011 from 17.5% to 20%, inflation rose from 2.5% to 3.8%7. (Other factors were at play too, but in our opinion the rise in VAT almost certainly contributed.)

Carbon prices -- a form of taxation -- are an important tool to get the world on a net zero path. The IMF estimates that the effective average global carbon price is around $3 a tonne.8 Their estimates suggest this needs to rise to approximately $75 a tonne by 20309 in order to be consistent with limiting global temperature increases to 1.5-2 degrees (and the Paris Agreement has more ambitious goals, meaning an even higher carbon price may be necessary). The share of global carbon emissions which are priced needs to rise substantially (see chart 3).

Chart 3: Share of global emissions under a carbon price, 1990-2021

Source: World Bank

A carbon price this high would probably provoke large increases in the consumer prices of fossil fuels such as oil -- by design10. The Bank of England envisages that, in a scenario where governments and people take early action to limit damage from climate change, the user price of a barrel of oil will rise from under $100 today to over $400 within 30 years,11 while the price of gas would triple.12 Modelling studies on the effect of carbon taxation point to potentially large inflationary effects, based on the assumption that higher energy prices are passed on to households in the form of higher prices.13

The speed of any sustainability transition matters greatly. Research suggests that any increase in inflation will be modest in the event of an orderly transition to net zero, because any price rises can be spread out over time.14 Inflation could be much higher in a disorderly transition because governments would need to implement radical policies quickly.

Argument 3: Price increases in commodities needed for the renewable transition

As the world relies less on fossil fuels, it will rely more on other sorts of natural resources. A new research paper by the IMF15 identifies four commodities in particular that are essential for a green transition: copper, nickel, cobalt and lithium. Electric vehicles require 3-5 times more copper than conventional combustion engine vehicles. Lithium has many uses, including in batteries for mobile phones, laptops and electric vehicles.

The International Energy Agency projects large increases in the consumption of these materials in order to achieve a net zero transition (see chart 4).16 Rising metals prices would increase companies’ costs, and they might pass on these added costs to consumers in the form of higher prices.

Chart 4: Global consumption of nickel under various scenarios

Source: Generation adaptation of International Monetary Fund/International Energy Agency analysis17

Arguments in opposition

So that’s the case for higher inflation in a net zero world. But it is also important to consider the counterarguments. What are they?

Counterargument 1: Fossil fuels are inherently inflationary, whereas renewable energy is inherently deflationary

The argument here is subtle. All else equal, the cost of producing fossil fuels is likely to grow over time. This is because production generally moves from the cheapest, easiest-to-extract sources first, to the more expensive ones later (as the first sources are depleted).

By contrast, once installed, renewable energy never runs out (assuming the wind continues to blow and the sun continues to shine), meaning that producers do not have to keep looking for new and more expensive sources.

As such, renewable energy costs may fall over time, rather than rise. Indeed the cost of production in renewable energy has been in steep decline in recent years, largely due to technological improvements (see chart 5). This is also disinflationary, as is the widespread adoption of digital goods, which often have zero price.18

Chart 5: Levelised cost of electricity (2020 USD/kWh), 2010 and 2020

Source: IRENA

Similar trends may be at play for other net zero technologies, such as electric vehicles. Battery pack prices for EVs fell by about 90% from 2010 to 201919 and the evidence suggests that this trend is likely to continue.

Counterargument 2: Inflation dynamics are complicated

It is important to distinguish between “higher prices” and “inflation”. A world of permanently (or semi-permanently) higher energy prices (if that happens at all) does not necessarily mean higher inflation. Inflation refers to a change in the price level. Fossil-fuel energy may be permanently more expensive -- and that is a good thing in terms of dissuading consumption -- but that does not imply that energy prices will continue to rise year on year.

It is also important to distinguish between relative prices and overall prices. Imagine that energy does become more expensive over time (again, not a certainty). That does not necessarily translate into permanently higher inflation. Other goods and services could become cheaper, keeping overall inflation steady. This is indeed what a new study20 finds. Inflation may in fact fall after the introduction of a carbon price, because higher energy prices reduce the prices of goods and services which require a lot of energy consumption. Imagine if gas (petrol) prices double. Lots of people might think twice about buying another car -- it's become a lot more expensive to run, after all. Therefore, demand for cars would decline, reducing the price of cars.

Counterargument 3: A generalised decline in demand

Consumers’ choices will, in part, affect whether or not the world hits net zero. In a growing number of Western countries flying is increasingly shameful, while second-hand clothes and electronic goods are becoming cool. Perhaps the world is entering a new phase of lower consumer spending, as people recognise that overconsumption is environmentally destructive. All else equal, that should reduce inflation, because the economy’s supply side will be plentiful relative to demand.

To be clear, this also comes with a trade-off. Permanent weakness in demand for all sorts of goods and services will reduce inflation, but it is also akin to the “secular stagnation” seen in many advanced economies shortly before the pandemic, with weak GDP growth and high unemployment rates. You might therefore think of this as the “wrong sort” of low inflation, since it comes with other high costs.

Further reading

In the next two instalments of this series, to be published in future weeks, we will focus on two other ways in which sustainability goals and control of inflation could be in conflict: improved health outcomes and more financial inclusion.

  1. Generation analysis of OECD data
  2. The Economist, October 16th 2021
  3. For instance,
  4. For instance,
  5. Generation analysis of Bureau of Economic Analysis, National Income and Product Accounts
  6. International Energy Agency, “World Energy Investment 2021”, p.7.
  7. Generation analysis of Office for National Statistics, consumer-price inflation data
  10. Fossil-fuel subsidies are a related issue. At present global governments subsidise fossil fuels to the tune of about $500bn a year (around 0.5% of global GDP). These reduce user costs. Removing them would be excellent news from an environmental perspective. But they would raise prices for consumers, and thus provoke inflation. One point to bear in mind, though, is that most fossil-fuel subsidies occur in low- and medium-income countries, not rich countries. Thus they are unlikely to make a big difference to rich-world inflation rates, the focus of this piece.
  11. Chart 4.2
  12. Chart 4.2
  16. Quoted in International Monetary Fund, “Energy transition metals”, October 2021.
  17. Quoted in International Monetary Fund, “Energy transition metals”, October 2021.
  18. We would add that the net zero transition may also be deflationary for fossil-fuel production costs, because as demand is destroyed, the favoured production will be the lowest cost production, such as Saudi oil.

Important Information

The ‘Insights 08: Is a sustainable world an inflationary world? Part 1 of 3: The net zero question' is a report prepared by Generation Investment Management LLP (“Generation”) for discussion purposes only. It reflects the views of Generation as at January 2022. It is not to be reproduced or copied or made available to others without the consent of Generation. The information presented herein is intended to reflect Generation’s present thoughts on sustainable investment and related topics and should not be construed as investment research, advice or the making of any recommendation in respect of any particular company. It is not marketing material or a financial promotion. Certain companies may be referenced as illustrative of a particular field of economic endeavour and will not have been subject to Generation’s investment process. References to any companies must not be construed as a recommendation to buy or sell securities of such companies. To the extent such companies are investments undertaken by Generation, they will form part of a broader portfolio of companies and are discussed solely to be illustrative of Generation’s broader investment thesis. There is no warranty investment in these companies have been profitable or will be profitable. While the data is from sources Generation believes to be reliable, Generation makes no representation as to the completeness or accuracy of the data. We shall not be responsible for amending, correcting, or updating any information or opinions contained herein, and we accept no liability for loss arising from the use of the material.