Economic outlook: Climate change for the near term

It has become harder and harder to consider climate change as only a concern for the long term, rather than short or medium-term economic forecasts. While extreme weather events may grab news headlines, for developed economies, it is policymaker action that increasingly means that climate change is already impacting the economy and the near-term economic outlook.

Policymakers are increasingly stepping up to address the challenges of climate change now. That brings transitional economic consequences forward, including more fiscal spending, cost pressures and labour market disruption.

Policymakers stepping up

At the 2021 Earth Day climate summit in April, the US, EU, Japan, the UK and Canada committed to new targets for reduced greenhouse gas emissions. The targets were stated differently, but all imply a significant targeted reduction in emissions from pre-pandemic levels to 2030. The upcoming COP26 conference (November) could see more binding climate change plans, co-ordination and further funding commitments. Firmer plans, policy action and funding are still needed (see, for example, the Climate Action Tracker assessment), but assuming that governments are fully committed to meeting the targets they’ve already set, these will require significant economic change including within the next two to three years.

Not all the changes required to meet these goals are being driven by governments of course, but governments and regulators have some particularly powerful tools at their disposal to encourage (and force) change. Those include direct fiscal spending, regulation, taxation and more direct attempts to facilitate and incentivise technological breakthroughs. Disclosure requirements can also be important, as can signalling (e.g. making clear to consumers that gas boilers and emissions-producing cars will be phased out). Several countries/regions also have established emissions/carbon trading schemes that have, in some cases, proven to be a useful tool in reducing carbon emissions.

Trade policy and foreign policy may be used more in future too. The US Trade Representative, Katherine Tai, highlighted a commitment to tackling climate change through trade policy in her first major policy speech earlier this year, citing a willingness to use trade tools. The EU continues to move forward with its carbon border adjustment mechanism proposal (putting a carbon price on imports of certain goods from outside the EU) and there is certainly scope for environmental provisions within trade agreements to be more strongly worded and enforced. China’s recent pledge not to build any more coal-fired power projects internationally was notable, and on foreign policy more generally, it isn’t difficult to imagine a future where sanctions are regularly imposed on certain governments for climate-related issues.  

Even at the risk of appearing piecemeal, a combination of all these approaches may be needed to really drive change. ‘Throwing more government spending’ at the problem is unlikely to succeed on its own (or be politically acceptable to taxpayers). A multi-pronged approach might also help insulate actions mitigating climate change, at least to a degree, from political change.

Central banks are also involved in the fight against climate change. The European Central Bank’s recent climate change plan includes further incorporating climate change into its monetary policy framework, but also including climate change in its policy operations with respect to disclosure requirements for private sector assets (e.g. eligibility requirements or to form the basis for differentiated treatment of assets), risk assessment, collateral framework and corporate sector asset purchases (e.g. adjusting the framework for corporate bond purchases to incorporate climate change criteria). Central bank stress tests have also included climate change scenarios (e.g. Bank of England).

Fiscal spending for climate change goals

Before the Covid crisis, it was becoming increasingly clear that public spending levels would need to rise to tackle the challenges of climate change. Despite the huge hit to public finances from tackling the Covid crisis, a willingness to allocate funds toward climate change objectives appears to remain. The US reconciliation bill being argued over in Congress at least for now includes funding for environmental issues, e.g. clean energy and vehicle tax credits (though not all measures may make it through to a final version of the bill). The EU’s latest long-term Budget and so-called ‘NextGenerationEU’ fiscal package includes €14.5bn for environment and climate action. Canada’s recent Budget included C$17.6bn to fight climate change.

It is conceivable that funding costs could be lower for government investing in climate change mitigation projects, incentivising further spending. Brazil’s sovereign debt already arguably carries an ‘ESG penalty’. Recently issued sovereign green bonds have traded at a so called ‘greenium’ over conventional bonds.   

The Covid crisis has left economies with higher burdens of government debt already and many developed economies were already on unsustainable fiscal paths thanks to ageing populations. That may point towards many governments ultimately shifting more of the near-term cost of their carbon promises onto regulation and taxation. For now, however, increasing spending on climate change goals can be part of efforts to support economies post-pandemic while borrowing costs remain relatively low and demand for sovereign green bonds high in developed economies.

Cost pressures and another push for inflation

The pressure for firms to reduce emissions is significant. Taxation and regulation are key tools in the fight against climate change at a firm level, as are investor pressure and public opinion. From a company perspective, however, these transitions generally come at a cost. The demand for investment products such as green bonds can lower the finance cost of transitions, but that won’t be an option for all firms. Efforts being made to mobilise financing are welcome in that regard. As with other costs, these may be passed onto customers, reduce margins, or result in cost-cutting elsewhere (e.g. wage bills). Those such cost pressures are relatively broad – multi-country/industry-wide may make it more likely that the costs are passed on and result in somewhat higher inflation.

Transitions to lower emissions will mean different things for different companies and for households, but such transitions will include the need to invest in new buildings and new equipment. With governments speeding up the transition to lower levels of CO2 /Greenhouse gas emissions, that investment will need to be bought forward, raising demand for commodities – particularly industrial metals. At the same time, mining and metals processing industries are transitioning too, including in China, which seems likely to affect supply. That may imply a prolonged period of higher commodity prices, further raising cost pressures throughout the economy.

Labour market disruption

Investment in human capital will also be needed to ensure that the workforce have the appropriate skills for a decarbonised economy. Climate change and associated company transitions and government investment is likely to alter the balance of employment opportunity away from carbon intensive operations, with new opportunities opening up in ‘greener’ industries and roles.

These shifts may lead to sizeable skills matches if change proceeds at speed. It takes time to retrain workers and some may drop out of the labour force altogether. That may result in some inflationary bottlenecks as firms are unable to expand fast enough to meet demand in some industries and as competition for skilled labour raises measured pay growth. For a time, the equilibrium unemployment rate may rise.

Well designed policies and effective government involvement can smooth the adjustment to a lower carbon economy for households and firms, but changes are being brought forward and make climate change an increasingly relevant factor to draw even into near-term economic forecasting. Although the effects of climate change are locked in and we can expect more extreme weather-related headlines no matter the policy action today, the transition risks and costs nevertheless ultimately reduce physical climate risk and, arguably, the transition costs faced now will be worse the longer policymakers wait.

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