Climate change: shifting the economy

While price increases for some products seem likely to continue, when considered in a broader context that fully considers the destabilising effects of climate change, it seems more like a deflationary influence on the global economy than an inflationary one. 

"Much of the policy effort across countries is going into making climate-friendly activities more cost effective, rather than making climate-harming activities less cost effective.”

More than that, we need to increasingly consider what climate-related changes might mean for the economy within the forecast horizon.

Consideration of climate change risks has become an important driver of political attitudes. Capital is increasingly seeking exposure with solid environmental, social and governance (ESG) credentials; more listed companies report their climate-related financial exposure; financial institutions are quantifying the impact of climate change in their activities and adjusting their exposure accordingly; and the concept of climate-related activities is broadening from weather to encompass a range of other aspects including waste, recycling and species destruction.

Raised threats?

Government policy faces increasingly urgent infrastructure pressure. Consider water security in Chennai and Cape Town or sea wall construction or even relocating for the sinking city of Jakarta. Australia needs policy change and investment to protect the electricity grid as the use of solar panels reduces demand and sea levels threaten infrastructure in places like Port Melbourne and Cairns.

Technically, internalising the external costs of climate change into the inputs of the economy will raise some prices. As will supply-induced shortages of some products. But under current economic conditions, where incomes in most economies are constrained, do those price increases really present an inflationary threat?

In income-constrained economies, demand seems to have become more responsive to even modest price increases. In Australia, for instance, retail food prices have risen strongly in 2019, primarily due to drought. The net result has been a further decline in the growth of real retail expenditure.

While a city running out of water might raise the price of water (in Chennai the cost of water more than doubled), it is hard to believe the full effects of such an outcome would be anything other than deflationary as the city’s social fabric comes under stress.

More or less cost effective

Economists can be somewhat evangelical about a carbon tax as the best policy to address climate change. But, as of 2019, only 57 governments at either a country or regional level have enacted some form of carbon price. More to the point, “only 20 per cent of global greenhouse gas emissions are covered by a carbon price and less than 5 per cent of those are currently priced at levels consistent with reaching the temperature goals of the Paris Agreement,” according to the World Bank.

Rather, much of the policy effort across countries is going into making climate-friendly activities more cost effective, rather than making climate-harming activities less cost effective. Electric vehicles, recycling and renewable energy all feature.

Critically, most renewable energy sources now lie within the fossil-fuel cost range. On the expectation ongoing improvements will bring down prices, further shifts to renewable sources of electricity generation are likely.

This is causing important secular shifts, as the dominant forms of energy are being left behind. Consider in 2018 more coal-generated electricity capacity was shut down than was approved, “almost certainly the first time this has happened in a generation, and possibly the first time since the 19th century”. According to the International Energy Agency new investment in coal has fallen around 75 per cent over the last decade.

Acutely vulnerable

Oil prices are also likely to be negatively affected, with peak demand having taken over from peak supply as the most important coming secular shift. Oil prices are a large (often the largest) driver of headline inflation rates.

The view of climate change as inherently inflationary is also being challenged by some of its human impacts. Climate-related migration has become a prominent concern with “the Asia-Pacific region acutely vulnerable”. This is not just due to sea level rises but also the threats to food supply and the societal impacts that unfold.

Even consider the issue more granularly; Global Health Alliance Australia has suggested rates of food poisoning and workplace absenteeism from heat-related illnesses will rise.

As insurers and financial services use better data to reprice climate-related exposure, some may find the cost of insurance is just too high and forgo cover. Economic activity is likely to naturally gravitate away from those areas.

Climate change and economics are inextricably linked. For instance, much of the rise in US emissions before 2007, and then decline to 2009, was driven by the economic cycle. Many parts of the world are only now recognising that longer-lived secular stagnation is not just a European or Japanese problem. And yet we are now closer to the Paris agreement’s 2030 target than to the beginning of the global financial crisis in 2007.

The effects of the crisis still linger and in some areas climate-related activity will reinforce those effects.

Richard Yetsenga is Chief Economist at ANZ