What net zero means for inflation

Reducing carbon emissions is essential to curb global warming, one of the biggest long-term risks for the world economy. All countries across the globe will have to introduce ambitious mitigation policies over the next few years if the physical costs associated with a changing climate are to be limited.

Consensus among economists on carbon taxes as an effective policy lever to tackle climate change is rapidly growing.

By internalising the costs of the negative impact on health, the environment, and future generations, carbon taxes provide great incentives to transition to “net zero” emissions. They not only curb demand for fossil fuels, but also encourage business investment in renewable energy and low-carbon technologies, stimulating innovation.

In addition, they represent a source of government revenue. This can be used to finance tax reforms, lowering taxes on workers and businesses while supporting economic growth, or redirected to fund investment in climate technology.

Carbon taxes are fundamental to discourage the use of high-carbon energy sources and key to drive the behavioural change needed for the move towards net zero. They are, however, likely to have a large impact on energy and electricity prices, given the current widespread use of fossil fuels for energy production.

What our three scenarios tell us

To analyse and better understand the impact of carbon taxes on inflation, we use the Oxford Economics Global Economic Model (GEM) to consider three different scenarios: Net Zero, Net Zero Transformation (NZT) and Delayed Transition.

Given the high degree of uncertainty around policy intervention to tackle global warming, scenario analysis is a key framework to assess the implications of climate-related risks.

In the Net Zero and NZT scenarios, global warming is limited to around 1.5°C by 2050 as carbon taxes start from 2022.

The Delayed Transition scenario, meanwhile, sees temperatures increase by 1.7°C as it assumes annual emissions do not decrease until 2030.

The key difference in assumptions between the first two scenarios is that only the NZT scenario assumes that there are wider economic benefits associated with innovation. NZT also factors in a greater amount of green investment from the private sector. Carbon prices are lower than those in the Net Zero scenario as it is assumed that benefits from research and development bring down the marginal cost of reducing emissions.

The assumptions on carbon taxes for the different scenarios are shown in chart 1. These trajectories are consistent with the analysis done by the Network for Greening the Financial System (NGFS) that derives the carbon tax for a given degree of mitigation while maximising welfare. The Delayed Transition scenario highlights the risks associated with governments failing to act swiftly. The world ends up with more stringent policies from 2040 as a stronger price signal is needed to limit global warming. The chart also shows the economic benefits associated with greater innovation, reflected in much lower carbon taxes for the NZT scenario.

Carbon prices rise to $200 per tonne of carbon dioxide (tCO2) by 2030 and steadily increase to more than $700/tCO2 in 2050 in the Net Zero scenario. Prices don’t exceed  $400 /tCO2 under NZT.

In the Delayed Transition, carbon prices increase rapidly after 2030 to reach $800/tCO2 in 2050.

Oxford Economics assumes that the government recycles 50% of the carbon tax revenues  back to consumers in the Net Zero and in the Delayed Transition scenarios. The other 50% remains on government balance sheets and is partly used to fund investment.

In NZT, they assume that the government fully recycles revenues in the form of lump-sum transfers to households. Therefore, the clean energy transition is financed by increased government borrowing that takes the global economy on a higher equilibrium level of economic growth.

What will drive inflation?

The impact on inflation will come via changes in energy prices. The Oxford Economics model assumes that fossil fuel supply is slow to adjust to the change in prices. In contrast, demand is more elastic, adapting more rapidly to a change in price. These are realistic assumptions.

Therefore, spot prices fall below baseline on the back of weaker demand for fossil fuels. However, the move in the spot price is not large enough to keep the after-tax price at the pre-shock level. Given the large magnitude of the tax increase, after-tax prices are significantly higher than their baseline level.

Charts 2 and 3 provide a graphical illustration of what happens to the oil price in the US in the three scenarios we analyse. It is evident that oil prices will rise more rapidly in the Delayed Transition scenario starting from 2030 given the disorderly impact of the late policy implementation. Meanwhile, oil price increases are more modest in NZT thanks to the lower tax profile associated with greater innovation and green investment that boosts productivity.

Higher inflationary pressures on the horizon

The recent developments in the gas and oil markets are already showing us how important energy prices are for headline inflation. Accelerating energy prices have been a key factor behind the recent surge in global inflation. Therefore, it should not come as a surprise that with the adoption of carbon taxes, inflationary pressures will increase globally. In addition, the move to net zero will also dramatically boost demand for key industrial metals used to generate and store renewable energy. Given the supply challenges, this is likely to add further pressure on inflation, via higher prices for aluminium, copper, cobalt and lithium.

Chart 4 shows the impact on US inflation under the three scenarios we consider. Carbon prices are estimated to boost US headline CPI, adding 300 basis points (bps) to our baseline forecast in the years following the implementation of the carbon tax. However, higher inflation will be temporary as pressures on prices will be mostly concentrated in the early stages of the transition.

As countries decarbonise their energy production and move away from taxed products, inflation will start declining in the second half of 2020s, returning to its baseline level by 2050. Inflation under the NZT will return more quickly to its baseline due to higher productivity and less severe carbon pricing. Meanwhile, in Delayed Transition, inflation will start rising from 2030 and remain above the baseline in the longer term due to continued increases in taxation policy.

It is important to note that the impact on price growth will not be homogeneous across countries, as shown in chart 5. Over the next 30 years Brazil and France will see the smallest inflation increases, while Russia and South Africa are likely to experience the largest rises. The UK and Germany will also be affected, with the Net Zero transition expected to add more than 50bps to headline inflation over the next 30 years. The analysis also highlights the greater risks to price pressures associated with the delayed transition on the back of more severe increases in carbon prices.

The impact of carbon pricing across the globe will depend on various country-specific factors. First of all, the magnitude of carbon taxes is a key determinant in the change in energy prices. As shown in chart 6, most developed markets will see carbon prices well above the global average. Europe will experience the highest price, almost $900/tCO2 in 2050 in the Net Zero scenario, closely followed by the US and Japan. European prices are higher than other developed countries due to the region’s relatively smaller endowment for CO2 removal, via carbon capture storage technology, for example. Carbon prices for emerging markets will be much lower than their developed counterparts, increasing to $600/tCO2 by 2050.

Another key factor behind the cross-country differences of the inflationary impact is the energy mix. Countries that are currently more reliant on fossil fuels for their energy generation will be more exposed to carbon taxes, as a higher share of fossil fuels strengthens the pass-through to prices.

The degree to which energy prices rise also strictly depends on the carbon content of the fossil fuels used. This is because coal is much more carbon intensive than oil and especially gas, implying that for the same amount of tax, coal prices will rise more than the other fossil fuels (Chart 7).

It is therefore important not only to look at the amount of fossil fuels used in the energy production, but also at the carbon content of each source. Chart 8 highlights that emerging markets heavily rely on dirtier sources of energy. South Africa leads the way, as coal accounts for more than 60% of its energy demand, followed by China and India. Countries highly dependent on oil like Brazil, Japan, Russia and the US will also see significant increases in fuel prices.

Electricity prices will also be impacted by carbon taxes. The higher the share of renewables and nuclear used for electricity generation, the weaker the pass-through to electricity prices. Chart 9 highlights that countries like France, Brazil, and Canada, whose electricity is already being produced with more than 80% of clean energy, will see a more modest rise in inflation.

Achieving net zero emissions requires a radical decarbonisation of the energy mix. By 2050, all coal mining will need to end, stranding these assets. Moreover, the majority of oil reserves will also be unburned. This means that developed countries will need to be less dependent on these dirty sources of energy, and consume low-carbon sources, like natural gas, and rely more on nuclear and renewables. By 2050, oil is assumed to account for less than 10% of total energy consumed for most developed economies (Chart 10).

What are the implications for central banks?

Carbon taxes represent an efficient policy tool to tackle environmental problems, but it is clear that they will lead to inflationary pressures. These will be felt across the globe, but will be more pronounced for economies that still largely rely on energy from fossil fuels. It is interesting that the impact on inflation in European countries will be more limited despite them likely to see the most severe carbon taxes and highest carbon prices. This is thanks to their greater use of clean energy, especially in France.

Our analysis also shows that inflationary pressures are mostly concentrated in the near term. The transitory nature of inflationary impact could imply that central banks look through the carbon pricing shock. The current prevailing consensus is that monetary policy should look through energy shocks as these tend to be short-lived and only result in a temporary deviation from the inflation target, provided that expectations remain anchored. And this is in line with what the Oxford Economics model assumes. But the energy transition will require a radical transformation in the energy sector, with the potential to generate large demand and supply imbalances, posing profound challenges to policymakers.

Finally, carbon prices are likely to act as a trigger for large investment stimulus, boosting employment and aggregate demand. Higher energy prices, if associated with a smaller output gap and stronger underlying price pressure, could force central banks to abandon any “look-through policy” and act to preserve price stability.