Inflation and the new green economy

Alquity's Keith Gyles discusses how the green transition is inflationary - but there are deflationary forces at play too

Over the course of the pandemic, inflation has made a dramatic return, rising far above target in economies around the world and prompting a major shift in policy at many of the world’s central banks.

This rebound has caught consumers, investors and policymakers alike by surprise and raised concerns that we may be entering a new era of permanently high inflation, after almost three decades of largely benign price pressures. Indeed, while there are reasons to think that inflation will moderate in the near-term, aided by the global monetary policy response, the longer-term outlook is less clear. In particular, the renewed environmental focus and drive towards net zero could well drive costs and prices in the economy higher over the coming years.

That is not to say that environmental policies are behind the current rebound of inflation. An analysis of the data suggests that this has been driven more by separate factors, mostly related to the pandemic.

Firstly, the dramatic rebound in energy prices have accounted for more than half of the rise in headline inflation in major economies through the last year. While this was partly due to the rapid recovery in activity as Covid restrictions were eased around the world, it was also driven by a slow production response in oil markets and by geopolitical factors in Europe, which drove up gas prices.

However, it is not all about energy, as core inflation has also risen notably over this period. This looks to have largely been due to a jump in core goods price inflation, resulting from the surge in consumer demand for goods during the pandemic, while also reflecting the impact of the significant disruption to supply chains. Finally, the huge policy action through the pandemic, especially the massive fiscal transfers, have supported incomes, encouraging a sharp rise in spending, particularly in the US. This translated not only to much higher spending on goods, but also to increased expenditure on services, where prices have risen as well, albeit more moderately.

Looking ahead, base effects mean that even if global energy prices stay elevated, their impact on inflation will fade over time, bringing headline inflation rates gradually lower. Indeed, in some emerging markets, headline inflation rates already seem to have topped out early in 2022. Core goods inflation may prove to be stickier, particularly in economies where the recovery is well entrenched and spare capacity reduced, such as the US. However, barring another surge in demand, price pressures here too should ease in time, especially as the impact of higher interest rate feed through. But this is in the nearer-term, and it is in the longer-run that the impact of the drive to net zero will likely be felt.

When considering the costs of shifting away from fossil fuels towards a more sustainable energy supply, one of the key questions is whether that switch will inevitably be inflationary, and whether those costs will exceed the benefits, or whether the costs of doing nothing would be worse. Considering the latter, besides the obvious environmental costs of doing nothing, it is reasonable to assume that delaying the green transition would have significant inflationary consequences of its own. For example, the increased frequency and severity of extreme weather events, such as drought and flooding, would probably have a major impact on the production and supply of important commodities, especially foodstuffs, pushing up prices. On the other hand, making the transition to a renewable energy supply too quickly would have its consequences as well, if the technology to manage that transition is not yet in place. This relates to the idea of an orderly vs. disorderly transition. An orderly transition, giving consumers and businesses time to adjust, would be less costly than a disorderly one that causes major disruption. The impact from the disorderly disruption of supply chains in 2020-21 is a case in point.

So, why then could a green transition be inflationary? Firstly, the cost of carbon will have to rise significantly in order to reflect its true environmental cost. A recent IMF estimate has suggested that in order to meet Paris Agreement targets, the price of carbon would need to rise to $75 per tonne by 2030, far above the current average global price of around $3-4. Another recent study suggested that to reach net zero by the middle of this century, the price of carbon would need to reach $160 per tonne by the end of this decade. Governments can achieve this through the use of carbon taxation as well as introducing carbon price floors, although any changes would have to be gradual to minimise the disruption. While producers will absorb some of the increase in costs, it is likely that some will also be passed on to consumers, putting upward pressure on CPI inflation.

Secondly, there is the impact that reduced supply of fossil fuels will have on prices. To encourage the green transition, governments will have to reduce fossil fuel subsidies and introduce policies that decrease the incentive for companies to add new production. On top of that, social pressure is likely to further discourage fossil fuel producers. As these firms cut back on investment in exploration and extraction, it is likely that new supply of oil and gas will decline more quickly than demand, putting upward pressure on prices, at least in the near-term. Indeed, there is already some evidence of this happening, as major oil and gas companies begin to shift their focus towards renewables.

Thirdly, it is likely that higher demand for other commodities that are needed for the green transition will push up prices of these supplies too. For example, the increasing need for electric vehicles will add significantly to demand for metals such as lithium and nickel, which are essential for battery production, as well as for copper needed for the wiring in these vehicles. The IEA estimates that demand for lithium alone could rise 40 times over the next two decades as battery use increases.

Meanwhile, investment in wind power will also increase demand for zinc and rare earth minerals, which are required for corrosion protection and in magnets, respectively. Large quantities of rare earths are also needed for construction of photo-voltaic panels, along with silicon and silver. While rare earths are commonplace in the earth’s crust, they are rarely found in sufficient concentrations to be economically viable for extraction, and mining tends to be focused in a few countries, with China dominating production. This suggests that the prices of rare earths and other commodities listed above will rise, perhaps significantly. Again, as producers face higher costs, the risk is that some of this is passed on to consumers.

Of course, not all aspects of the green transition will be inflationary. There are likely to be some deflationary forces at play too. In particular, renewable energy costs have fallen sharply in recent years, as production has increased and as the underlying technology has improved. Solar photovoltaic costs have fallen by around 90% over the last ten years, for example, and wind power has also seen a large decline in costs. Though the big decline in prices may already have occurred and the pace at which prices are falling is now slowing, there is still scope for further reductions as production is scaled up.

In addition, government policies can help to mitigate the build-up of inflationary pressures, for example by using revenue from carbon taxes to provide subsidies to more vulnerable members of their populations. This is important as inflation tends to have a disproportionate impact on the less wealthy members of society, those who do not have the savings or earnings potential to absorb the hit from higher prices for essential goods. To ensure this is a just transition, it will be incumbent on investors and businesses to allocate capital towards climate solutions that enable social progress. Alquity additionally supports projects through our Transforming Lives programme that provide opportunities for those at the bottom of the economic ladder.

Meanwhile, policies to rein in excessive consumption, which is putting an unsustainable strain on the planet’s resources, could also be deflationary. However, while these factors may help to offset some of the inflationary forces, it is hard to believe that the disruption caused by a complete reshaping of the energy supply mix over the coming years will not drive up costs overall.

From an investment point of view, these trends will still present interesting opportunities, however. Bonds, of course, tend not to perform well in a higher inflation environment, as the rise in nominal yields that follows is often offset by higher prices. As a result, real yields do not usually increase by much. But while bonds may not offer attractive returns in a higher inflation world, equities still offer value. This is especially so for those operating in sectors that will benefit from the technological shift needed for the green transition, where growth potential is huge, or those that benefit from higher inflation.

Electric vehicle producers in the transport sectors, battery manufacturers and companies in the solar and wind sectors are all obvious examples. Companies operating in other renewable energy sectors, such as biomass, hydro and tidal power also could offer opportunities, as could businesses operating in economies with very high renewable energy investment rates, such as China. Meanwhile, businesses that offer other meaningful green energy initiatives, such as carbon offsets or low carbon alternatives to existing products, are also potentially attractive investments.

Examples of companies that target the environmental and social footprint with high ESG quality companies, including those that are directly involved in renewable power and climate change mitigation. includes Sunrun, the biggest home solar, battery storage and energy services provider in North America and West Fraser Timber, a diversified wood products company that is leading the integration of timber as an alternative to fossil fuel-based materials into building designs. In emerging markets, due to the unreliability of energy pricing from governments, we tend to avoid renewable power generation directly, focusing instead on supporting industries that benefit indirectly from these trends. An example is Century Iron and Steel in Taiwan, which is a producer of wind turbine components sold to renewable energy providers.

On the inflation front, banks should benefit in a higher inflation, higher interest rates world, while energy producers will gain from higher prices, as will commodity producers operating in some of the sectors mentioned above, such as rare earths. In addition, some markets with persistently high inflation rates will still offer attractive opportunities because of powerful long-term structural dynamics.

This is especially so in many emerging markets, such as India, where the benefits from favourable demographic forces and increasing urbanisation rates can trump the drag from elevated inflation pressures, driving significant equity returns. One example is Escorts, an Indian manufacturer of tractors and construction equipment. This firm has benefited from increased mechanisation in the Indian agricultural sector since we first invested in 2016, as well as a greater corporate focus on ESG issues, with the share price rising almost eight times higher over the 5-1/2-year period that we were invested.

Overall, then, while a higher inflation world will be challenging for many, the investment that a new green economy needs means that there will still be ample opportunities for attractive returns from careful, well-targeted stock selections.