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Could rising energy costs mean net zero is an inflationary pressure?

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Polarised politics and energy security pressure caused by the Ukraine war has raised the question of whether politicians are willing or able to build commitment to net zero. Given rapid increases in energy costs and materials and the knock-on economic effect, it’s important to understand the extent to which net-zero targets can or should be considered inflationary.

Interest rates have increased recently as inflation soars. The UK is currently facing its highest inflation rate in over a decade, and the Bank of England has warned further expansion could stall the economy by the end of 2022.

The real challenge is how policy makers respond to the pressures of war, and the knock-on effect this could have on climate change action.

In the last couple of decades energy price shocks in particular have been managed through central bank action but with energy estimated to be responsible for half of the EU’s recent inflation increase – with inflation standing at 7.5% – combined with European reliance on Russia for fossil fuel supplies, structural changes in the market seem likely.

Net zero made problematic by potential consistent higher interest rates

European Central Bank (ECB) executive board member Isabel Schnabel warned in early May that a new macroeconomic climate is being created where higher interest rates are going to be the norm, suggesting a further interest rate hike could be in play as early as June.

Meanwhile, the Bank for International Settlements warned that central banks are going to need to take action on inflation expectations, warning that ‘whether inflation enters a persistently higher regime will depend on labour market developments, and on whether a wage-price spiral emerges.’ This has led to renewed calls that the commitment to net zero may prove too expensive a commitment.

Market shifts, such as those currently in play in the fossil fuel markets, are only likely to be exacerbated by the transition towards net zero.

The major concern about net zero is further pressure on energy costs, as policy makers impose new regulations to cut emissions – and a great deal will be dependent on the pace of transition. While there is existing pressure on fossil fuel supplies, growing demand for the materials required for the net-zero transition is likely to also prove inflationary.

Carbon taxes could be instrumental in switch to clean energy

There are a range of different scenarios published by think-tanks and researchers which explore the speed at which a shift away from fossil fuels will play out.

Multinational asset management group Schroders recently released an analysis using the Oxford Economics Global Economic Model (GEM) to look at the impact of three different scenarios: Net Zero, Net Zero Transformation and Delayed Transition.

According to Schroders economist Irene Lauro, “consensus among economists on carbon taxes as an effective policy level to tackle climate change is rapidly growing” and an increase in carbon taxes is likely to prove inflationary.

One of the key factors in the Schroders work is the assumption that the transition away from fossil fuels will be driven by carbon taxes, of one kind or another. These can either be directly inflationary or, if those taxes are repurposed to other government spending in the right way, they can help drive economic growth in other ways.

The decreasing cost of technology can drive clean energy transition

There are other issues at play within energy transition scenarios aside from the implementation of carbon taxes, though, and the Schroders analysis brings this out – a lot is dependent on the extent to which innovation to address energy transition can bring wider economic benefits. High carbon costs could drive investment, which could have a significant impact on economic growth.

While renewable energy still provides a relatively low proportion of global energy, over the last decade the costs of the technology has fallen by up to 90% in some areas – meaning it is cheaper than fossil fuels and its operational costs are predictable over the longer term.

It’s also important to consider the potential costs associated with delayed action on transition – failure to act fast could mean more dramatic interventions further down the line.

Inflation will have an impact on net zero targets

There is no simple answer to the question of whether net zero is inflationary. It has the potential to be so but the extent to which energy contributes to inflation is going to be, in large part, dependent on how governments, corporations and even consumers respond to it.

Patrick Thomas, investment director and head of ESG investing at Canaccord Genuity Wealth Management, rote recently: “Whether inflation continues to spiral remains to be seen, but we don’t necessarily think the move towards net zero will add to any long-term inflationary pressure. In fact, it might influence it in the right direction.”

What matters as a business is preparing for the potential challenge. In the ESG world the current debate is mainly focused on whether companies should be focused on materiality (meaning financial materiality, using ESG as a means of better understanding the financial implications of a changing world) or double materiality (where companies consider both financial materiality and impact on the environment and society).

Rising energy prices

Another term is becoming more widely used and that’s dynamic materiality – that’s where the consideration is how these different issues interact and change over time. What’s clear is that no business can afford to ignore the implications of rising energy, and potentially carbon, prices.

While critics continue to argue that ESG is too generic, or simply a trend, there is little question that an ESG framework can help business understand where its risks and opportunities lie.

ESG reports can help identify those companies at risk from higher energy and carbon prices and those that are already addressing the problem – cutting energy use, implementing new processes and technologies.

There are two areas where companies and investors need to pay attention – the extent to which inflation is going to become an economy-wide challenge (globally or domestically) and the extent to which different companies in different sectors respond to the challenge.  And neither issue can be ignored.

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