Greenflation and the transition to carbon neutrality

Significant consequences for growth and price levels?

The delay in climate action in recent years risks making the ecological transition abrupt and potentially disorderly. The necessary acceleration in the transformation of the global economy into a carbon-neutral one could have significant economic consequences on growth levels and price stability.

Rising carbon prices or regulations aimed at decarbonising production could influence energy prices. Raising the price of carbon-intensive goods and services relative to the price of other goods and services could send a dissuasive signal to consumers and encourage substitution of these products by low-carbon, low-greenhouse-gas-emitting alternatives. However, it could also lead to more inflation.

This phenomenon, known as ‘green inflation’ or ‘greenflation’, reflects the difficulty of redirecting resources towards sustainable activities in the short and medium term, but also the persistent effect on inflation expectations of successive energy price shocks. While climate transition-related factors currently play a limited role in inflationary pressures, in the future, transition policies could be a source of significant macroeconomic shocks.

Consumer prices are affected directly via energy prices and indirectly via the rising cost of carbon-intensive goods. The final effect will depend on the degree to which carbon prices are passed on to electricity prices. Similarly, regulations on carbon emissions can increase the prices of products affected by new standards.

Tensions could also arise in the markets for key transition minerals. The International Energy Agency estimates that transition-related demand for industrial minerals would increase sixfold by 2040 in a scenario with net-zero emissions. Given the inelasticity of supply for these minerals in the short term, imbalances between supply and demand could become an additional source of macroeconomic instability, increasing price volatility.

In addition to the direct effects of higher energy prices, the transition process may have an impact on inflation through frictions in the relative price adjustments of different markets (labour, capital, goods and services), or through major economic disruption linked to the restructuring and adaptation made necessary by climate change.

Positive and negative shocks

The combined effects – direct and indirect – of climate transition policies require an understanding of the transmission mechanisms to the economy as a whole. From a macroeconomic point of view, the transition can be analysed as shocks simultaneously affecting supply and demand, which can be both positive and negative.

A positive demand shock – the kind usually presented in orderly or optimistic scenarios – could have a positive effect on economic activity, but also have inflationary implications. On the other hand, negative demand shocks – triggered by uncertainty or turbulence in financial markets – could be disinflationary and recessionary.

On the supply side, positive shocks could stimulate economic growth and reduce inflation if they boost innovation and productivity. On the contrary, if they are negative, triggered for example by higher costs due to carbon taxation or stranded assets, stagflationary episodes could result. The total impact on inflation of these combined shocks may be significant, but whether they are inflationary or disinflationary depends on the transition trajectory.

It is therefore possible that the climate transition could result in a stagflationary shock or in a positive, disinflationary supply shock. It is more likely, however, that it will combine certain inflationary aspects with contractionary or expansionary reactions of supply and demand, some spontaneous, others triggered by new public incentives and regulations.

If not properly anticipated, the transition to carbon neutrality could also lead to a rapid succession of shocks, increasing price volatility. This could disrupt the decisions of economic agents, weaken inflation expectations and create difficulties in conducting monetary policy that would be adapted to the challenges of transition.

To what extent should central banks ‘look through’ the volatility of inflation generated by climate mitigation policies without compromising the anchoring of inflation expectations to their target? This is a difficult question. Trade-offs will need to be made as price stability – and therefore monetary policy – is likely to have a positive impact on the transition by encouraging green investment. As inflation tends to distort investment decisions, price stability remains essential to ensure the proper allocation of investments in key sectors of the transition to a low-carbon economy.

Stephane Dees is Head of Climate Economics at Banque de France.

This article was published in the Q2 2024 edition of OMFIF’s Bulletin.

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