Some sectors have greater potential to unleash such a “shockflation” than others. This extends to „carbonflation“. Borrowing from the idea of some banks being too important or too connected to fail in the context of financial stability, this study refers to these sectors as systemically significant.
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Carbon Prices and Inflation in a World of Shocks
Climate change and geopolitical tensions render supply shocks more likely which can trigger inflation. One might call this „shockflation“. The recent shockflation bout has been unleashed by the emergencies of pandemic and the war in Ukraine. But the climate emergency, too, can trigger shockflation. Extreme weather events can interfere with production processes and overall economic productivity, affect agricultural yields, interrupt transportation and undermine the productivity of renewable energy generation– just to name some examples of climate induced supply shocks. While climate change presents a major risk for price stability, CO2 price policies, which are the key climate mitigation tool in the European Union, can create additional inflationary pressures. One might call this “carbonflation”.
Daniel
Posch
Project Manager
Content
Our toolboxes are no longer fit for purpose
Climate change mitigation policies face challenges in an inflationary environment. If the policy response to shockflation is for central banks to hike interest rates and for governments to move to fiscal austerity as has been the case in the Eurozone, this bears the danger that decarbonization investments are slowed down or even halted due to high upfront capital costs in critical areas like renewable energy . The economic insecurity associated with an austerity response to inflation also bears a political risk. It could strengthen far-right parties and hence undermine the political support for climate change mitigation policies.
Fighting inflation by pushing down the whole economy, even though it is unleashed by sectoral price increaes does neither appear to be an accurate nor a feasible strategy. At least not in the long run. Therefore, a new policy toolbox is needed to respond to inflation in a world of shocks and under the imperative of climate change mitigation in a more targeted manner. This new approach to fighting inflation might be focused on preventing and containing price spikes in sectors that matter for system wide price stability. It should combine stabilization with transformation efforts for systemically significant sectors.
Identifying Germany´s „systemically signficant prices“ to contain inflation
However, preventing both „shockflation“ and „carbonflation“ requires the knowledge of the sectors that have the greatest potential to unleash these shocks. That is why this study uses input-output simulations to assess which sectors are systemically significant for shockflation and carbonflation in Germany.
Germany is a case of particular interest for shockflation in light of the 2022 energy crisis. The energy price shock was the most important inflation driver in Germany. The EU´s largest economy is also relevant for carbonflation since in addition to national carbon pricing policies it is part of the first European Emissions Trading System (ETS1) and will be part of ETS2 for the majority of sectors in the Effort Sharing Regulation (ESR) starting in 2027. The ETS2 will replace the national carbon price. Experts warn that the prices that will emerge on the new ETS2 are highly uncertain and that there could be a carbon price shock . Some go as far as to argue that the magnitude of the CO2 price shock in 2027 could be similar to the fossil fuel price shock of 2022-2023 in the wake of the Russian war in Ukraine.
What to do?
In addition to studying systemically significant prices, their relevance for CO2 price policies and inflation by using the case of Germany, this study also comes up with sectoral policy conclusions to prevent carbonflation and reduce the risk for shockflation.
