Inflation and Energy

This is the sixth edition of The Polycrisis newsletter, written by Kate Mackenzie and Tim Sahay. Subscribe here to get it in your inbox.

There has been little research into the inflationary implications of either climate change itself, or of responses to climate change. The majority of work on central banking and climate change is concerned with topics like firm-level or macroprudential regulation, collateral requirements, and asset-purchasing programs. Questions relating to carbon pricing and the cost versus benefits of cutting emissions are disproportionately important for climate economists.

Such a narrow focus reflects the policy preoccupations of the eras in which they emerged. Until last year, permanently low inflation was plausible, at least in the Global North. There was little concern for how a destabilizing climate or resurgent petrostate aggression might jolt logistics until the reopening after Covid lockdowns and Russia’s invasion of Ukraine wreaked havoc on markets.

Supply squeezes and higher costs in everything from medical equipment to chips to crude oil painfully illustrated the cost of allowing markets to determine prices, with little intervention even for the most critical categories.

Isabella Weber’s 2021 book How China Escaped Shock Therapy was a timely exploration of sector-specific measures, chronicling how Beijing applied market reforms selectively, retaining control over the prices of systemically important goods such as food and energy.

In the last few months of 2022, Weber served on Germany’s gas price commission, whose recommendations informed a central part of the German €200 billion response to the energy-price crisis. A new paper she co-authored with Jesus Lara Jauregui, Lucas Teixeira, and Luiza Nassif Pires identifies which prices are most important to inflation. 

The paper builds on work by Robert Hockett and Saule Omarova about the criticality of certain prices and sectors. Importantly, for us, it also sheds new light on the themes in a brief by Lauren Melodia and Kristina Karlsson of the Roosevelt Institute, which identified the inflationary implications of the inherent volatility in fossil fuel-based energy systems. The upshot of the Roosevelt brief is clear: governments that build out clean energy infrastructure are permanently reducing inflationary pressures.

In looking broadly at the drivers of inflation, the paper by Weber and her co-authors has particular salience for the energy transition. Having identified the sectors, goods, and services that are most relevant to inflation, they isolate three characteristics of  prices that are systemically-important: criticality of the sector in relation to all other sectors; price volatility; and share in personal consumption. This pertains not only to prices that one expects are important, like that of food and energy, (“petroleum and coal products” was by far the most significant) but also to prices that appear removed from day-to-day economic activity like upstream oil and gas exploration or wholesale trade. 

A key emphasis of Weber’s is that the transition to a stable energy system will require intensive and careful work from policymakers. Contrary to the notion that there will be a simultaneous implosion of fossil fuels and a green boom, Weber stresses that new energy infrastructure will need to be created before the old fossil-fuel sources can be switched off. 

The “mid-transition”

We are in a period of moving away from a fossil fuel-based economy and towards a clean one—the “mid-transition” as Emily Grubert calls it, or “getting to the other side” as David Wallace-Wells says.

A paper published in October by Aljoša Slameršak, Giorgos Kallis, and Daniel W. O’Neill explores a facet of this awkward process by modeling the energy and emissions requirements to transition the energy system. It finds that this could require a fifth of the net “budget” of carbon dioxide that can be released before the 1.5C threshold is exceeded. That means that, depending on the nature of the transition, the energy available for sectors such as aviation, steel, and cement—which are more difficult to decarbonize—might be even more limited than thought. 

The findings don’t support claims, however, that the production of solar panels, wind turbines, and electric cars are too resource-intensive to make them worth pursuing. Rather, the papers draw on ample evidence showing that the relative “energy return on energy invested (EROI)” of renewables is improving much faster than expected. At the same time, the EROI of fossil fuels is known to be gradually declining. The energy transition itself slightly increases energy use insofar as new technologies need to be produced, but the overall reduction in emissions makes it worthwhile. This is truer of a faster transition that relies more on renewables and nuclear, rather than a slower transition more dependent on fossil fuels and bioenergy plus carbon capture. 

There are numerous pitfalls in the modeling of energy transition, which attempt to reconcile shifts in technology, costs, and energy demand with other factors, including population and economic growth. Even defining the boundaries of energy systems is complex. Does one count the energy transporting fuel? Does a full lifecycle analysis account for how energy is changing? And should the benchmark be final energy demand, consumption, or production? These decisions have huge effects on which energy pathways look most appealing. 

No one expects the smooth lines of the energy transition pathways to be borne out in reality. In an interview with Kate last December, Isabella Weber spoke of how old and new energy systems will need to coexist for some time. This means that “there will be bumps, but maybe less bumps than if you were to try to mimic the straight transition path.” The full interview can be found here. 

The Polycrisis is a publication focusing on macro-economics, energy security & geopolitics.