Climate Inflation

Impact Reflection | September 2, 2022

The impact of climate change surrounds us, as both everyday and extreme weather events pepper the headlines. The recent flooding in Pakistan has put at least one-third of the country under water, caused by record heat waves in the spring that led to more moisture in the air when the monsoon season hit.¹Heat waves began early in the US as well, with temperatures over 100 degrees in many areas. This weekend record-breaking heat is expected across the Bay Area as a result of a heat dome built up over the past week.²

Policymakers are responding. California passed legislation this week approving $54 billion of spending to address climate change, demonstrating growing momentum to limit greenhouse gas emissions and more rapidly develop renewable energy infrastructure. Last week, the California Air Resources Board approved a rule requiring 100% of new car sales in the state be zero-emission by 2035, a target Governor Newson originally proposed via executive order in 2020. At the national level, Congress passed the Inflation Reduction Act. That bill commits $370 billion to incentivize individuals and businesses to shift energy usage to renewable sources. That a bill to reduce inflation funds renewable energy makes a clear connection between recent inflation and the impact of climate events.

Historically we have understood inflation as driven either by an increase in demand or a shortage in supply. This orthodox economic thinking underpins the Fed’s current commitment to pushing interest rates up to bring supply and demand back into balance, reducing inflation. Higher interest rates lead businesses to slow expansion and use their profits to pay down debt rather than invest in growth. Higher rates also increase mortgage costs for the broad swath of Americans who need debt to buy their homes and raise rates on credit card debt. People spend less, and prices drop when rates go higher.

Climate change is upending that orthodoxy in complex and confusing ways. Using petroleum products has allowed faster rates of economic growth. Greater scale in industrial and agriculture production historically kept prices lower than they might have been and supported increased demand. Climate change is emerging as one consequence of that dramatic increase in the use of fossil fuels, leading to extreme weather events and disruption to flora and fauna. For example, weather and its environmental impacts can reduce agricultural yields and push consumer prices up.

In economics, the concept of “externalities” captures a range of costs incurred by society over time that isn’t included in the stated financial cost of a product or service. The costs of environmental impacts haven’t historically been included in corporate financial statements, but we now know they are real – and can be substantial. In the coming years, they will need to be integrated into financial calculations. Many individuals and industries are already considering the impact of externalities. This is driving efforts to incorporate social and environmental factors into investment research, and is the reason even conventional financial companies are finally considering environmental impacts and risks and creating “ESG” products and services for clients.

Agribusiness in California provides a salient example of the shift in attention to environmental impacts. Many decades of irrigation created a lush and productive central valley. Producing a large proportion of the country’s fruits and vegetables drained aquifer resources, and increases in irrigation costs were insufficient to limit consumption enough to create a sustainable pattern of use. A deepening water catastrophe is now with us, and together with higher petroleum prices, is aggravating food inflation.³ In this instance, we cannot expand supply to cool down prices as academic economics might prescribe, and demand for food cannot be reduced through Fed action on interest rates. Food is an “inelastic” good – even if prices are higher, people need to eat. And while higher input costs for agribusiness may lead to more sustainable production practices, the costs to the consumer are higher.

Fossil fuel exploration and expansion via both mining and drilling have supported extraordinary mechanization across our economy for over a century. Increases in productivity created enormous opportunities for financial investment and contributed to a soaring US standard of living in the twentieth century. The environmental costs – the externalities – of our prosperity have become clear, although redirecting our infrastructure away from fossil fuel use is not simple. Fifteen major oil-producing countries are collectively projecting an increase and not a decrease in global oil and gas production over the next two decades,⁴ making the expansion of alternative sources for energy even more urgent.

A huge amount of work lies ahead to support all areas of energy use, including powering our beloved four-wheeled friends. Increasing renewable energy infrastructure to the needed scale will require massive and continuing investment. The renewable energy provisions of the Inflation Reduction Act and California’s recent commitments are a good start. Opportunities for investment will be available under both sets of legislation to individuals (via tax credits) as well as businesses, creating the prospect of linked financial and environmental benefits.

Moving beyond petroleum will take a sustained and multifaceted effort over time to put into practice. It matters for the environment, and it is increasing obvious that it matters for sustaining a reasonable standard of living and keeping prices for basic commodities at affordable levels as well.

Climate inflation is a new concept, and we are only beginning to adapt earlier economic strategies and behaviors to find a productive path forward. Pre-petroleum practices are being rediscovered and integrated with sustainable technologies. Innovation in meat substitutes will help reduce environmental stress from factory farming of meat. Coral reef regeneration technologies are proliferating, and an upcoming UN treaty on marine biodiversity will further expand efforts to maintain sustainable fisheries. Investment and innovation are accelerating in the arenas of solar and wind energy, as well as technical tools to reduce energy use. These efforts and others will eventually remake our economy and make it possible to imagine real sustainability.

Resources

¹ Smriti Mallapaty, “Why are Pakistan’s floods so extreme this year?” nature, September 2, 2022

² Andrew Freedman, “Heat dome roasts the West, with brutal record-breaking temperatures,” Axios, September 1, 2022.

³ Robert Kuttner, “Climate Costs Are Not ‘Inflation,’” The American Prospect, August 31, 2022.

⁴ UN environment programme, “Governments’ fossil fuel productions plans dangerously out of sync with Paris limits,” October 21, 2021.