“Greenflation”: transitory or persistent?

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February 2022
 
In the global shift to clean energy, what are the costs and ramifications of such a transition? Here the Global Economic and Investment Analysis team outline the arguments and discuss the variables that will factor into achieving a greener world.

Prices convey news, and “greenflation” (an ugly word)—referring to the rising costs of the raw materials necessary for the clean-energy transition— is alerting observers to the expense of implementing a green agenda today and likely in the future.

Currently the data prove out: commodity prices were up by 27% in 2021.1 Of green-required materials, aluminum (used in electric vehicles and wind turbines), for example, was up 42%,2 while rare-earth elements such as cobalt and lithium (both used in electric batteries) were up more than 119% and 280%, respectively3; and the list goes on.

Greenflation isn’t the same as generalized inflation, however. The green transition will raise the demand for raw materials and commodities necessary for clean-energy production, and this will raise the price of those inputs relative to the prices of other goods and services over time. Central banks will continue to target overall inflation, so if the rise in relative green prices adds to overall inflationary pressure, interest rates will have to rise, and the prices of other goods and services will rise more slowly in order to keep the overall inflation rate near target.

We believe that the decarbonization of economies will be expensive but affordable. Shamik Dhar, chief economist at BNY Mellon Investment Management, and team have estimated that $90-100 trillion of investment in “clean” assets will be required if the global capital stock is to become compatible with “net zero” by 2050—the year committed to by 196 signatories of the negotiated 2015 Paris Agreement. “This roughly $3 trillion per year of investment is far larger than the amount we’ve seen flowing into ESG/climate-type investments to date, but it’s not unaffordable, since it amounts to around 15% of total expected global capital formation out to 2050,” Dhar said.

Besides the impact on raw materials prices, the ultimate impact on overall inflationary pressure depends on at least three other things: 1) technological progress; 2) geopolitics; and 3) government policy.

Technological progress

While raw materials prices have been rising, clean energy costs for the consumer have been falling thanks to technological advances. In the past 10 years, for example, the cost of commercial solar power has dropped by more than 89%, and the cost of onshore wind power has dropped by 70%.4 These numbers reflect technology-driven productivity growth in the renewables sector that exceeds that of the economy at large—not unlike the “Moore’s Law” effect on chip prices.

Dhar commented: “The standard view is that costly investment over the next 20–30 years will help avert an even costlier climate crisis in the second half of the twenty-first century. That’s probably right, but there’s a rosier world view that suggests our investments up front may not be as costly as most think if vast spending on clean, technologically advanced capital has spillover effects to the rest of the economy. It’s not impossible that clean investment could boost productivity economy-wide, raising living standards and reducing overall inflationary pressure.”

Even if green investment is costly, it’s not clear who will bear those costs over the longer term. It may be the consumer, if firms can pass costs in into prices. But if competitive forces prevent that, then firms and shareholders may have to shoulder some of the cost in the form of a lower return on capital, or workers in the form of lower real wages. Finally, taxpayers may share the burden too, if many of these investments have to be subsidized. In truth, those costs will probably be shared, so once again, greenflation doesn’t necessarily imply higher inflationary pressure, let along actual inflation.

Geopolitics: who controls what?

There are certain metals and rare-earth elements (17 of them, including lithium and cobalt5) which are used in technologies that are a part of the clean-energy transitions. These materials are often in concentrated hands. China, for example, provides more than 85% of rare-earth elements (REEs),6 which don’t exist individually in nature (they must be chemically separated by using liquid-liquid extraction) and are vital to a variety of electronics components (in part because of the magnetic properties of REEs, such as those used in wind turbines). Other nations have concentrated resources—Bolivia, for example, has 25% of the world’s lithium,7 while the Republic of the Congo has 64% of coltan8 which is used in capacitors. Allocation of these resources then becomes subject to issues surrounding trade and geopolitics.

For example, in 2019 China threatened to withhold critical REEs from US technology companies.9 China also restricts the supply of REEs through quotas, licenses, and taxes. This displays the corollary that whoever has the ability to delay providing product has the ability to impose costs on others.

Monopolistic behavior that threatens national security interests, however, tends to have repercussions. For instance, we have seen a national rush to “lock up” years’ worth of minerals and metals and REEs—in effect REE stockpiling.

Moreover, there are ways to sidestep some of China’s dominance over metals and elements. One electric vehicle maker, for example, began buying its nickel (for batteries) directly from a mine in the South Pacific.10 Other companies are beginning to follow suit.

Meanwhile, competition for raw materials is anticipated to intensify as the drive toward decarbonization of economies increases. In fact, the motivation to secure future supplies has become a key national security issue in many countries, including the US.11

The government steps in, but a large burden falls on the private sector

How governments choose to support the green transition will be important, too. The precise form may vary, but, ultimately, they’ll be looking to “tax” or discourage carbon-intensive economic activities and subsidize or encourage clean activities. This could intensify some of the big relative price changes referred to above.

A large investment program (in R&D and green infrastructure, for example) could generate a multiplier effect, stimulating demand and inflationary pressure. However, much of this investment will be in clean capital that replaces existing dirty capital rather than being a net addition to the capital stock and overall demand or supply—so the overall impact is far from clear.

Responsible investment is the right thing to do, but it’s also the economically sensible thing to do, in our opinion. There is no long-term trade-off between good social/environmental and good economic outcomes. That said, it is politically unrealistic to expect from governments alone to meet the nominal investment in “clean” assets to reach “net zero” targets by 2050. We believe that the private sector, however, can achieve this at relatively low cost. As guardians of the value of future savings and capital, asset managers have a key role to play here, by focusing on investments that direct capital toward sustainable activities, which ultimately could reduce macroeconomic and market volatility (as well as make the world a nicer place).

What’s next?

Inflation can be unnerving, and its threat today seems ever present, for various reasons unrelated to the green transition. Most suspect the green transition will be costly and that could add to inflationary pressure over the medium term. But there will be offsetting effects too—perhaps from rapid technological advance in green technologies that spill over elsewhere, or because those costs are borne by shareholders and taxpayers rather than consumers. In any case, higher inflationary pressure more likely translates into higher interest rates than higher inflation over long periods of time.

So, until we reach net-zero carbon emissions, the flywheel effect of green transition may be transitory inflation—while increased installed capacity, cheaper electricity, and cheaper renewables may well be larger than we think. Come what may, responsible investors who take account of all the subtleties should find great investment opportunities in the long term.

1 Bloomberg, January 2022.

2 Ibid.

3 Ibid.

4 “The price of solar electricity has dropped 89% in the 10 years,” Fast Company.com, December 9, 2020.

5 US Geological Survey website; accessed January 2022.

6 Mining.com, February 26, 2021.

7 “Top six countries with the largest lithium reserves in the world,” NS Energy Business.com, November 19, 2020.

8 “Why it’s hard for Congo’s coltan miners to abide by the law,” The Economist, January 21, 2021.

9 “The Chinese scramble to mine Africa,” Mining.com, December 2021.

10 “Can a Tiny Territory in the South Pacific Power Tesla’s Ambitions?” The New York Times, December 30, 2021.

11 “Critical Minerals and Materials,” part three of executive order 14017, “America’s Supply Chains,” released June 8, 2021.

 

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