Regime shift: are taxes the solution to the climate crisis?
Schemes which attempt to put a price on pollution are likely to be highly disruptive, bringing both challenges and opportunities.
If net zero is to be achieved by 2050, emissions need to fall by more than 40% in the next seven years. As a result, countries around the world are likely to rapidly accelerate the “decarbonisation” of power generation as fossil fuel based heating and transport systems are electrified in the coming decade (see What “rewiring” an economy looks like, and what it means for investors).
Not only will this shift require a radical change in the energy system, the so-called energy transition, but also drive major change in other key sectors of the global economy.
At the economy-wide level the energy transition is likely to lead to higher inflationary pressures over the medium term, while a weaker growth outlook is also expected. That is why we expect the accelerating climate response (see chart 1) to be a “stagflationary” force in the global economy, which describes a situation where growth is low or slowing at the same time as inflation remaining high or rising.
Simultaneous to these changes, however, investment in key technologies will be rising, with the resulting innovation set to be another important disruptive force. The changes will support activity across the entire sustainable energy industry and value chain, creating many opportunities for investors as the expansion of green energy technologies keeps gaining traction.
Green technology investment driven by the stick or carrot approach?
Achieving net zero emissions requires a radical change of the energy mix.
Carbon pricing, either in the shape of a cap-and-trade framework, such as the EU Emissions Trading System (EU ETS), or a carbon tax, are widely seen as the main policy approach needed to solve the climate problem. This includes the world's first carbon border tax, or CBAM – the Carbon Border Adjustment Mechanism – from the European Union.
Putting a price on pollution in these ways sends economic signal to emitters, and allows them to decide to either transform their activities and lower their emissions, or continue emitting and paying for their emissions. By making them more expensive than clean sources, carbon pricing not only curbs demand for fossil fuel energy sources, but also encourages business investment in renewable energy and low-carbon technologies, while improving energy efficiency.
This price-induced innovation represents the “stick” approach to climate mitigation. The alternative, the “carrot”, involves inducing innovation through green subsidies. This is, for example, what we are seeing in countries like the US, which are focusing on increasing the supply of renewables through government funding. However, this is not considered cost-effective by many economists because government subsidies could lead to overcapacity (producing more than required) while simultaneously putting pressure on public finances.
In contrast, carbon pricing schemes can be an important source of revenue, which governments can recycle back into the economy.
The energy transition is likely to be expensive, as investment and innovation costs are set to rise with the shift to a green economy. Stricter carbon pricing will be inflationary for at least the next decade, due to the heavy reliance on fossil fuels. This is what central banks call “fossilflation”.
There will also be another element of inflation - “greenflation” - due to shortages of key minerals and metals. Combined with high carbon pricing, these shortages are likely to raise the cost of production, increasing prices, and lowering demand, which will inevitably result in lower overall economic output.
Leaders and laggards in carbon pricing
Using data from the World Bank, we have calculated an emissions-weighted average carbon price. This is to take into account that not all jurisdictions’ policies cover the same amount of emissions.
Our analysis on the effective carbon price highlights that countries such as Norway, Sweden, Switzerland and the EU are leading in terms of climate action, reflecting the strong ambition in continental Europe to tackle global warming (see chart 2). Emerging markets such as China, South Africa and Mexico have a much lower carbon price, suggesting that transition risks remain higher for these markets.
Lower carbon prices in developing markets may lead companies to make investments in technologies, such as power plants that use high-carbon technologies, that are ultimately wasted. These will later either need to be scrapped, losing the investment, or will lock countries into a pathway of higher emissions over the medium term. A higher carbon price provides a strong signal that should help to avoid this.
The inflationary impact of more stringent climate regulation
Decarbonisation and the transition to a more sustainable economy are likely to be very inflationary over the next decade. This is because the current cost of emissions is too low, with the global average carbon price being around $6 per tonne of carbon dioxide (tCO2), much lower than the $200/tCO2 level needed by 2030 to meet the 1.5°C target laid out by the Paris Agreement of 2015.
Given the current widespread use of fossil fuels for energy production, higher carbon pricing is likely to have a large impact on energy and electricity prices, especially in the early stages of the energy transition.
To understand the implications on inflation from more aggressive carbon pricing, we have considered three different scenarios: Net Zero, Net Zero with Innovation, and Delayed Transition. Our analysis highlights that with a stronger adoption of carbon taxes, inflationary pressures will increase globally across all our scenarios versus existing measures.
The carbon prices used in our analysis closely match those from the corresponding scenarios of the Network for Greening the Financial System (NGFS), a group of 116 central banks and supervisors, working together to enhance the role of the financial system to manage risks and to mobilise capital for green and low-carbon investments.
As countries decarbonise their energy production and move away from taxed products, inflation will start declining in 2030 and return to its baseline level by 2050. Inflation under the Net Zero with Innovation scenario will return more quickly to its baseline due to higher productivity and less severe carbon pricing.
Meanwhile, in the Delayed Transition scenario, inflation will start rising from 2030 and remain above the baseline in the longer term due to continued increases in taxation policy. Therefore, a disorderly transition is set to be more inflationary than a gradual move to net zero.
The impact of carbon pricing across the globe will depend on various country-specific factors.
Firstly, the level of carbon taxes is a key determinant in the change in energy prices. Carbon prices will be much higher in developed markets than in emerging markets. 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 upward pressure on prices.
Separating out the industry from the economy-wide implications
As we’ve already explained, decarbonisation will not just curb productivity/economic output and raise inflation, but also spur innovation. Schemes which put a price on pollution as well as green subsidies will encourage business investment in renewable energy and low-carbon technologies.
Resulting new green investment and innovation will have implications for sectors such as carbon capture and storage, new transport infrastructures, smart grids, and sustainable hydrogen, which are all required for the energy transition.
The electrification of energy will also entail developing and expanding new technologies that allow a more efficient of use of energy, such as heat pumps instead of gas boilers to heat our buildings.
At a broader level, clean energy technologies are highly mineral intensive. As a result, demand for key minerals and metals is set to boom over the next couple of decades will supply unlikely to match the demand, which could be positive for certain extractive industries. So, while the accelerating response to climate change will come will challenges, it is also likely to create plenty of opportunities.
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