By Michael Fredericks, Head of Investing for Multi-Asset Strategies & Solutions at BlackRock
If inflation is the noise from the economic engine, it was previously caused by the engine revving too fast. In future, it is more likely to be due to the engine misfiring. Inflation will arise even if economies are not running hot.
We believe the post-pandemic economic restart and Ukraine war provide a glimpse of what is to come. The resolution of this double supply shock will not end the era of supply constraints, in our view. The transition to net zero will be like a restart drawn out over decades, bringing new supply constraints that push inflation up.
The transition is fundamentally about including the costs of climate damages in economic decisions. These costs can be reflected in different ways: carbon taxes, regulations or consumers choosing to pay more to avoid harming the climate. Regardless of how the cost is internalised, we see a broad-based impact on inflation: energy costs are likely to rise, driving up producer and consumer prices.
Estimates of the cost of eliminating each tonne of carbon emissions vary widely. At the upper end, the Network for Greening the Financial System puts the cost at US$160 per tonne by 2030. The US emits about 240 tonnes of carbon per US$1 million of expenditure. So consumer prices could rise by as much as 4% by the early 2030s if all the cost is passed to consumers. How that translates into inflation depends heavily on the timeframe over which that 4% price rise occurs.
A smooth, even transition would add 0.4 percentage points to inflation each year. If the shift is faster, the impact would be more significant.
How much has the war in Ukraine changed things? We see it spurring the West to wean itself of Russian energy. This should entail a shift in fossil fuel demand to non-Russia parts of the industry, which may receive higher cashflows in the short-term. In the medium-term, we expect the conflict to accelerate Europe’s energy transition.
For end users, the energy shock is equivalent to a carbon tax and Europe is facing its highest energy cost as a share of GDP since 1981. See the chart. This, plus the drive for energy security, as well as societal preferences for green energy, will reinforce the push towards renewables and electrification.
In addition, the crisis has eroded the relative price for greener forms of energy. The impact in other parts of the world, such as the U.S. and China, will be less pronounced. But overall we believe the urgent search for substitutes for Russian energy will ultimately accelerate the transition at a global level, rather than derail it.
The most effective way to contain inflation is to ensure the transition is gradual and orderly, so that supply can keep pace with shifting demand across sectors and higher energy costs can be absorbed over time. A transition left too late may keep inflation down in the short term but risks a much greater impact later on.
2021 gave a glimpse of what happens when the transition is not smooth. As China sought to reduce emissions by cutting coal use, surging demand for natural gas drove prices up sharply, pushing up inflation.
Would no transition at all be better for containing inflation? Not in our view: while even an orderly transition is likely to bring higher inflation, we believe it will still deliver a better outcome than a failure to act. No climate action would mean rising temperatures, more frequent severe weather and greater economic damage: we estimate that no climate action would result in a cumulative loss in economic output of nearly 25% over the next 20 years.
Title: Energy burden as a share of GDP
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