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The 3D Reset: decarbonisation

Decarbonisation is one of the “3Ds” we see as shaping a new economic regime characterised by higher inflation. We explain how.

01/07/2023
EN

Authors

Simon Keane
Investment specialist

Action on climate change is accelerating. We can see this in particular with the decarbonisation of power generation and the move away from fossil fuel based heating and transport systems to ones powered on electricity generated from renewable sources.

This energy transition is a necessary condition of meeting ambitious targets to reduce greenhouse gas emissions (GHGs) such as carbon dioxide (CO2) to net zero by 2050 in order to avoid unchecked global warming.

Reconfiguring economies around renewable energy, and away from oil, natural gas and coal, is, however, likely to come at a cost. Even in the most optimistic of scenarios the changes are expected to add to inflationary pressures over next decade.

They are likely to take a toll on productivity as higher carbon pricing discourages production and lowers overall economic output. That is why accelerating climate action is expected to be a stagflationary force, stagflation being a combination of slowing growth and accelerating inflation.

Stick versus carrot approach to decarbonisation

Carbon pricing is widely seen as the main policy approach required to solve the climate problem as it sends a clear economic signal to companies emitting CO2. As a price is put on pollution, companies can either transform their activities and lower emissions, or continue emitting and incur the extra cost.

Europe has taken the lead with carbon pricing through schemes such as the EU Emissions Trading Scheme and Carbon Border Adjustment Mechanism. Carbon pricing is expected to curb demand for fossil fuel energy sources and encourage 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” approach, involves inducing innovation through green subsidies. This is the approach being taken in the US, which is focusing on increasing the supply of renewables through government funding, and legislation such as the Inflation Reduction Act.

Irene Lauro, environmental economist, says:

“Investment in technology and innovation is a key building block in meeting the net zero target. The move to net zero is not only about carbon pricing and more severe climate regulation, but it will also drive greater investment in green technology over the next decade.”

Fossilflation in the early transition stages

The history of technological change offers plenty of hope, and green technology is likely to enjoy many breakthroughs. As the benefits of new investment come through in time, greater innovation will help boost productivity, partially offsetting the inflationary impact of rising carbon prices.

However, stricter carbon pricing will be inflationary for at least the next decade, due to an ongoing heavy reliance on fossil fuels. So-called fossilflation will be hard to escape in the early stages of the energy transition as stricter carbon pricing impacts on energy and electricity prices in particular.

One of the other main elements of inflation related to decarbonisation – greenflation  – describes the impact of shortages of key minerals and metals required for the energy transition.

While the stagflationary consequences of decarbonsation for the global economy will be hard to escape, greater innovation is the likely longer-term reward as the challenges are met with a wave of new investment and innovation.

For a description on highlighted words see: The 3D Reset: the economic terms you’ll need to know

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Authors

Simon Keane
Investment specialist

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