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Everlution: Pay some now or pay lots more later?

Updated: Nov 17, 2022

The world must cut greenhouse gas emissions by at least a quarter before the end of this decade to achieve carbon neutrality by 2050. Progress needed toward such a major shift will inevitably impose short-term economic costs, though these are dwarfed by the innumerable long-term benefits of slowing climate change. At a time when global inflation is on the rise, this subject would seem less palatable, but necessary.

In the latest World Economic Outlook (WEO), the estimated near-term impact of different climate mitigation policies on output and inflation were assessed. It was found that if the right measures are implemented immediately and phased in over the next eight years, the costs will be small. However, if the transition to renewables is delayed, the costs will be far greater.

To assess the short-term impact of transitioning to renewables, WEO developed a model that splits countries into four regions—China, the euro area, the United States, and a block representing the rest of the world. It assumes that each region introduces budget-neutral policies that include greenhouse gas taxes, which are increased gradually to achieve a 25 percent reduction in emissions by 2030, combined with transfers to households, subsidies to low-emitting technologies, and labour tax cuts.

The results show that such a policy package could slow global economic growth by 0.15 percentage point to 0.25 percentage point annually from now until 2030, depending on how quickly regions can wean off fossil fuels for electricity generation. The more difficult the transition to clean electricity, the greater the greenhouse gas tax increase or equivalent regulations needed to incentivize change—and the larger the macroeconomic costs in terms of lost output and higher inflation.

For Europe, the United States, and China, the costs will likely be lower, ranging between 0.05 percentage point and 0.20 percentage point on average over eight years. Not surprisingly, the costs will be highest for fossil-fuel exporters and energy-intensive emerging market economies, which on balance drive the results for the rest of the world. That means countries must cooperate more on finance and technology needed to reduce costs—and share more of the required know-how—especially when it comes to low-income countries.

In all cases, however, policymakers should consider potential long-term output losses from unchecked climate change, which could be orders of magnitude larger according to a host of different sources.

In most regions, inflation increases moderately, from 0.1 percentage point to 0.4 percentage point. To curb the costs, climate policies must be gradual. But to be most effective, they also need to be credible. If climate policies are only partially credible, firms and households will not consider future tax increases when planning investment decisions.

This will slow the transition (less investment in thermal insulation and heating, low-emitting technologies, etc.), requiring more stringent policies to reach the same decarbonization goal. Inflation would be higher and gross domestic product growth lower by the end of the decade as a result. The WEO estimates that only partially credible policies could almost double the cost of transitioning to renewables by 2030.

Inflation and monetary policy

A pressing concern among policymakers is whether climate policy could complicate the job of central banks, and potentially stoke wage-price spirals in the current high-inflation environment. WEO’s analysis shows this is not the case.

Gradual and credibly implemented climate mitigation policies give households and firms the motive and time to transition toward a low-emission economy. Monetary policy will need to adjust to ensure inflation expectations remain anchored, but for the kind of policies simulated, the costs are small and much easier for central banks to handle than typical supply shocks that cause a sudden surge in energy prices.

Using the United States as an example, WEO show that climate policies impact inflation and growth under a range of scenarios. When policies are gradual and credible, the output-inflation trade-off is small. Central banks can choose to either stabilize a price index that includes greenhouse gas taxes or let the tax fully pass through prices. The former would only cost an additional 0.1 percentage point of growth annually.

If the transition is more difficult—reflecting a slower transition to clean electricity generation—the trade-off increases but remains manageable. The costs would be much higher if monetary policy were to lose credibility, a concern in today’s high-inflation environment. If inflation expectations become de-anchored, introducing climate policies could lead to second-round effects and a larger output-inflation trade-off, as illustrated by the less-credible monetary policy scenario.

WEO’s analytical chapter shows how to design climate policies to avoid such a situation, curbing the impact of the greenhouse gas tax on inflation with subsidies, feebates or labour tax cuts. Is it reasonable to wait—as some have proposed—until inflation is down before implementing climate mitigation policies?

WEO ran a scenario delaying implementation until 2027 that still achieves the same reduction in cumulative emissions in the long term. The delayed package is phased in more rapidly and requires a higher greenhouse gas tax, since a steeper decline in emissions is necessary to offset the accumulation of emissions from 2023 to 2026.

The results are striking. Even in the most favourable circumstances when monetary policy is credible and the transition to decarbonized electricity is rapid, the output-inflation trade-off would rise significantly; GDP would have to drop by 1.5 percent below baseline over four years to drive inflation back to target. Delay beyond 2027 would require an even more rushed transition in which inflation can be contained only at significant cost to real GDP. The longer we wait, the worse the trade-off.

Extreme weather worsened by climate change is a hidden cause of inflation, threatening to push up already high prices of everything from food and clothing to electronics. Heavy rainfall, flooding, heat waves and droughts erode agriculture, infrastructure and workers' ability to stay on the job — all of which lead to supply-chain breakdowns and worker shortages.

Recently, chip and solar panel factories in one of China's key manufacturing regions just shut down as the country tried to ration power during a 60-year record heat wave. Of even worse consequence is the drought in China curbing hydro-electric generation and threatening drinking water availability.

Dairy and meat prices in Europe are rising even higher as droughts zap lands meant for grazing and growing grain for feed. In the U.S wheat fields in Kansas, Oklahoma, Nebraska and cotton harvests in Texas have also been withering due to drought. In California, production of processed tomato product are suffering due to a lack of rain while workers are starting to walk off the job at an Amazon delivery hub partially in protest of heat exhaustion.

Destruction from historic rains and floods in the Northeast, North Carolina, Europe and South Korea demonstrates how ill-equipped our infrastructure is to withstand climate change impacts — and how difficult it is for communities to rebuild, let alone get back to work.

Extreme weather is affecting both the supply and demand sides of the economy, Tamma Carleton, a professor of environmental economics at UC Santa Barbara says:

  • Research hasn't yet quantified the exact impact extreme weather has on inflation. Some changes, such as the price of agriculture, are easier to pin down, while others — such as worker productivity — are harder to detect.

  • When people take longer breaks to recover from heat exhaustion, or leave 15 minutes early, for example, it adds up day after day, Carleton said.

As the pandemic has shown, disruption to supply chains and workers' productivity drives up the cost of doing business. And one way or another, companies pass those costs onto consumers.

  • Workers facing more strenuous conditions tend to command a higher wage, Solomon Hsiang, a professor of public policy at UC Berkley, says.

  • And if companies have to pay more to protect them or install new equipment like air conditioning in warehouses, "someone's got to pay and at the end of the day that someone is usually the consumer."

The conclusion, long-lasting heat waves land other natural disasters will become more commonplace — just as global inflation is leading to a slowdown in economic growth.

Meanwhile, the International Energy Agency (IEA) is forecasting that global low-carbon energy investment is likely to surpass $2trn annually by 2030, up from $1.3trn last year, with nations set to continue investing in renewables and nuclear beyond the energy price crisis.

The IEA notes that “much faster and more pronounced” reductions in fossil fuels will be needed to align the world with the Paris Agreement’s temperature trajectories. Like a key report from the UN earlier this week, the Agency is forecasting a 2.5C temperature increase between pre-industrial times and 2100.

It believes that, under the stated policies scenario, the share of fossil fuels in the energy mix in 2050 will be 60%, down from 80% in 2021.

Bringing the proportion down in line with net-zero by 2050 would require annual global clean energy investment to ramp up significantly this decade, reaching $4trn by 2030. This is double what the IEA is expecting, as already noted above.


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