Regime shift: the accelerating response to climate change

Countries are likely to rapidly accelerate the decarbonisation of power generation as emissions need to fall by more than 40% in the next seven years as a vital interim step toward net zero by 2050. The shift to net zero emissions represents a new key structural trend for the global economy as it will require a radical change in the energy system and in other key sectors of the economy. This note will discuss the policy measures that governments are likely to implement to incentivise the move towards net zero and their macroeconomic implications.

The energy transition is likely to lead to higher inflationary pressures over the medium term, while a weaker growth outlook is also expected. Additionally, the note highlights that investment in key technologies is rising, with innovation set to be another important force disrupting the global economy. The changes will support activity across the entire sustainable energy value chain, creating many opportunities for investors as the expansion of green energy technologies keeps gaining traction. More widely, these changes are another aspect of a new regime of supply side shortages and more frequent price increases (see Regime shift: investing into the new era).

Response to climate change set to accelerate as governments face increasing physical risks

In the run-up to the adoption in 2015 of the Paris Agreement on climate change, governments were invited to present their Nationally Determined Contributions (NDCs) and actions to reduce greenhouse gas (GHG) emissions.

The NDCs are required to meet a target of limiting temperature rises to 1.5°C above pre-industrial levels, and give the best chance of preventing devastating climate change. Encouragingly, over the past few years there has been a significant acceleration in the number of countries making pledges to hit net zero GHG emission targets by 2050.

More than 40 countries and the European Union (EU) have now made such promises, accounting for around 70% of global CO2 emissions (chart 1). However, less than a quarter of these countries have made these pledges legally binding and current policies around GHG emissions are insufficient if the world is to avoid the most damaging effects of climate change.

This year’s COP28 in the United Arab Emirates will throw a spotlight on pledges made so far as it will include a “global stocktake”. Climate policies will be under scrutiny as this process will be the first official check-up on the Paris Agreement, evaluating if every party is making sufficient progress towards net zero.

We have started to see more action on climate change. In the past three years the US has re-joined the Paris Agreement and China has committed to a net zero target by 2060. The response to climate change is set to accelerate as governments face up to the rising risks of physical damage from unchecked climate change. It seems that policymakers of major Western economies increasingly agree that stricter regulations – either laws that introduce green subsidies to encourage certain behaviours, or carbon pricing to compel them – are required to force through change.

A shift in climate legislation – recently seen with major new industrial policies in the EU and US mandating investment in green technology – will help convert climate policies into concrete action.

The US has historically avoided carbon taxes due to political reasons and has chosen green subsidies as the preferred approach to incentivise the move towards net zero. In contrast, European countries have encouraged the decarbonisation of their economies through the implementation of carbon pricing since the early 2000s.

So far, the EU has been leading on climate action and regulation. The bloc has one of the highest carbon prices at a global level and is set to implement the world’s first carbon border tax. Concerns around energy security following Russia’s invasion of Ukraine have also recently accelerated the appetite for rapid change, particularly in the EU. However, many political obstacles remain, not least a changing balance of geopolitical power since the war. A new world order is emerging (which we will explore in part 3 of the regime shift series), with major emerging economy emitters on one side, and the US and EU on the other.

Green technology investment driven by the stick or carrot approach?

Decarbonisation represents a major structural shift that is set to accelerate in the coming years. 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, is widely seen as the main policy approach needed to solve the climate problem. By internalising the costs of the negative impact on health, the environment, and future generations, carbon prices provide great incentives to reduce the consumption of fossil fuels and ultimately to transition to net zero emissions.

Carbon pricing can effectively correct the market failure created by the environmental externality, i.e. when a traded good (or service) causes environmental damage that is not included in the price.

Putting a price on pollution encourages producers and consumers to move away from a suboptimal equilibrium, where there is market failure, to an efficient allocation of resources, where the equilibrium price takes that externality into account. A carbon price provides an 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 and represents only a second-best option. This is because government subsidies can drive overcapacity while putting pressure on public finances.

In contrast, carbon pricing schemes can be an important source of revenue, that governments can recycle back into the economy. This can occur either in the form of lump sum payments to households or, indirectly, by using the extra revenue to reduce the public deficit. The latter would allow other taxes in the economy to be cut, or free up funds to invest in economic development.

The energy transition is likely to be expensive, as investment and innovation costs are set to rise with the shift to a green economy. As discussed in more detail below, 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. This means that climate mitigation will negatively impact global GDP growth in all but the most optimistic of outcomes.

It is possible that rapid green technology advancements could offset the worst of these productivity losses, but this is unlikely in the next 10 years. Perhaps the expected productivity gains from renewable energy will mark the next era, but in this new current regime that we focus on, the stagflationary outcome of the transition is likely to put central banks under further pressure to keep monetary policy tighter than it has previously been. This is very much in line with trends highlighted in the first part of the series (see Regime shift: central banks will prioritise inflation over growth).

Leaders and laggards in carbon pricing

Using data from the World Bank on carbon pricing and emissions covered, we have calculated an emissions-weighted average price. This is to take into account that not all jurisdictions have their policy covering the same amount of emissions.

Our analysis on the effective carbon price highlights that countries like Norway, Sweden, Switzerland and the EU as a bloc are leading in terms of climate action, reflecting the strong ambition in the continent to tackle global warming (chart 2). Emerging countries like China, South Africa and Mexico have a much lower carbon price, suggesting that transition risks remain elevated for these markets. These risks are even more significant for some large polluting countries like Australia and India where the internalisation of the cost of emissions in their economies has yet to start.

The inflationary impact of more stringent climate regulation

Decarbonisation and the transition to a more sustainable economy are likely to be a very inflationary trend at least 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 incentivise the shift to net zero and meet the 1.5°C Paris target.

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.

In order 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, which we capture with our Current Policies scenario.

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.

The NGFS use integrated assessment models which derive optimal prices for a given degree of mitigation while maximising the welfare of each economy. The NGFS model suggests that a global carbon price of around $200/tCO2 is needed by 2030 to incentivise a transition towards net zero.

In Delayed Transition, the world ends up with more stringent policies from 2040 as a stronger incentive is needed to limit global warming to below 2°C, highlighting the risks associated with governments failing to act swiftly.

Only our Net Zero with Innovation scenario factors in wider economic benefits associated with greater innovation. Net Zero with Innovation 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 (R&D) bring down the marginal cost of reducing emissions. This means that carbon taxes do not need to rise as high in this scenario to achieve the same degree of preference switching.

As countries decarbonise their energy production and move away from taxed products, inflation will start declining in 2030 in an orderly transition, returning to its baseline level by 2050. Inflation under the Net Zero with Innovation 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. This is why a disorderly transition is set to be more inflationary than a gradual move to net zero.

It is also important to note that our analysis suggests that the impact on price growth will not be homogeneous across countries, as shown in chart 3. Russia and South Africa are likely to witness the largest price pressures, while the rise in inflation will be more modest in Europe and the UK.

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. 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 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. This implies that for the same amount of tax, coal prices will rise more than the other fossil fuels. 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. 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.

Shortage of key minerals will add to inflationary pressures

Clean energy technologies, including wind turbines, solar panels and electric vehicles, are highly mineral intensive. For example, an offshore wind plant requires around 13 times more mineral resources than a gas plant and an electric vehicle requires six times more mineral resources than a conventional car. This means that demand for key minerals and metals is set to boom over the next couple of decades and supply will not be able to match the demand.

The IMF has compared projected demand and supply for metals over the next 30 years assuming net zero GHG emissions (based on the International Energy Agency’s net zero scenario analysis) is achieved. It found a supply shortage of more than 50% for graphite, cobalt, nickel and lithium (chart 4).

This supply-demand imbalance will lead to higher prices for these key metals and highlights vulnerabilities in accessing them. It is, in part, these vulnerabilities which are driving Western governments to intervene directly to increase green technology manufacturing capabilities.

A new carbon pricing initiative

Large disparities in carbon pricing across countries is raising interest in carbon border taxes on the back of concerns on “carbon leakage”. Carbon leakage occurs when domestic emissions controls incentivise the move of carbon-intensive production to less regulated countries.

The EU is leading here with a new initiative called the Carbon Border Adjustment Mechanism (CBAM).

At the end of last year, members of the European Parliament reached an agreement with EU governments to reduce the risk of carbon leakage. The CBAM is the first tax in the world that targets the carbon content of imported products and is set to become a key pillar of the European climate policy. It is specifically designed to ensure that EU efforts to reduce emissions are not offset by higher emissions outside its borders through relocation of production to countries where carbon prices are lower than those in the EU.

The CBAM will initially apply only to carbon intensive industries, including iron and steel, fertilisers, aluminium, electricity production and cement. It will begin to operate from 1 October 2023 but with a transition period where the obligations of the importer are only limited to reporting. Starting from 2026 importers will need to buy CBAM certificates based on the emissions content of the volume of goods they bring in.

Our analysis shows that the impacts of the CBAM will be concentrated around a small number of the EU’s trading partners. In particular, chart 5 shows that Russia and China are likely going to be heavily hit by the introduction of the CBAM due to their large exports of iron, steel and aluminium.

India and China have opposed the EU’s CBAM, denting hopes it will force policymakers there to talk about establishing a carbon price in these countries. They are depicting the mechanism as veiled protectionism. Concrete multi-lateral efforts to take a lead in decarbonising the global economy, such as CBAMs, are certainly likely be tested in a new world order.

CBAMs will have important implications for international trade with the potential to encourage trading partners to decarbonise their production processes. It is likely to force policymakers to talk about establishing a carbon price in countries where currently there is no pricing mechanism for domestic emissions, like in the US. It could also incentivise other countries to introduce their own carbon border taxes. Canada and the UK for example have started to consider them.

The green technology transition will spur investment in innovation

While these policy changes are expected to put upward pressure on inflation and drag on economic growth, there is another force at play that could alleviate this stagflationary outcome. 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. This is because technological innovations are essential to achieve the emissions reductions needed to fight global warming.

Investment in green technologies is already on an accelerating trend. Investment across the sustainable value chain has doubled since the Paris Agreement was signed in 2015, rising from $650 billion to $1.3 trillion in 2022. Investment in electrified transport grew the most over this period, rising at an average pace of 60% annually, but renewable energy keeps leading the way, attracting the largest amount of capital every year.

Higher investment in clean energy is on the way, and this is likely to further boost activity across the entire value chain, creating large opportunities for investors. Companies in these particular segments will capture this capital and convert it into new earnings and cash flow growth.

Companies investing in technology such as carbon capture and storage, new transport infrastructures, smart grids, and sustainable hydrogen are all likely to be targeted by investors. The shift to net zero is not just about moving away from fossil fuels, but it is also about the electrification of energy and 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.

Supply-side incentives in the form of R&D subsidies and tax credits will be needed to reduce innovation costs and are critical to facilitate the creation of these new technologies.

As mentioned earlier, greater innovation will help boost productivity, partially offsetting the inflationary impact of rising carbon prices. However, it is important to highlight that we will start to see these price mitigation benefits from the surge in investment only after 2030.

In summary, technological change will stimulate economic growth, while lowering inflation over the long-term. This is because the successful deployment of new technologies means that carbon taxes do not need to rise as much as they would have otherwise. For instance, if more emissions can be captured at the point of release and then stored, perhaps by piping them back into disused oil and gas fields, the necessary change in behaviours might not need to be as extreme. Essentially, technology will bring down the marginal cost of reducing emissions, while creating significant investment opportunities.

Summary and conclusions

• Response to climate change has accelerated in recent years, but we think there is more to come as economies continue to face larger physical damages on the back of higher temperatures.
• In particular, we expect carbon prices to start rising across many economies in order to internalise the costs of carbon emissions. Other policy measures such as CBAMs will also become a key feature of a new world order.
• In all but the most optimistic of scenarios – where rapid green technology advancements offset the worst of the productivity losses as high carbon taxes discourage production and lower overall economic output – climate mitigation will negatively impact global growth.
• Higher carbon taxes are going to drive up energy prices and result in higher inflation in all major economies. Fossilflation, stronger price growth on the back of higher carbon pricing, will be most acute in the early stages of the energy transition, as economies are still heavily reliant on fossil fuels as sources of energy. Inflationary pressures will also come from a shortage of key minerals and metals.
• Both the EU and US are set to foster more localised supply chains for green technology to achieve their energy transitions. They seem likely to co-operate on greening their economies and accepting the stagflationary risks of the changes required for meeting net zero.
• Innovation will be another key force disrupting the global economy. Technological advance is needed in order to achieve deep emissions reductions and governments are likely to provide more support for R&D spending.
• Investment across the sustainable energy value chain has already increased sharply since the Paris Agreement and prospects for larger capital inflows in these key sectors are good. Energy transition companies that will best deploy this capital are likely to generate significant equity growth, creating large opportunities for investors.

For more on the market and economic implications of regime shift visit: www.schroders.com/regimeshift.