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

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.

_{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}

_{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.