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VoxEU Column Climate Change Inflation

Consequences of transitioning to a climate-neutral economy

Transition risk is the risk arising from the economy’s shift towards net-zero carbon emissions. This column applies a novel methodology to explore the causal macroeconomic effects of transition risk. Large unanticipated increases in transition risk are predominantly related to political events. In the short run, these shocks do not uniformly generate inflationary pressure, challenging the prevalent notion of ‘greenflation’. There may also be economic benefits attached to the transition. While international policy coordination is essential, policy interventions must be tailored to each nation’s unique economic context.

Economically, climate change goes hand-in-hand with a substantial increase in various types of risk. These are typically categorised as being either physical or related to economic transition (e.g. Hiebert 2024). Physical risk is the risk arising from an increase in the severity and frequency of extreme weather events, but also from longer-term developments such as higher average temperatures or rising sea levels (e.g. Eickmeier et al. 2024). Transition risk is the risk arising from the economy’s shift towards net-zero carbon emissions (e.g. Bolton and Kacperczyk 2021); it is central to our discourse on climate change mitigation. Given the urgency of the transition, comprehensively analysing transition risk is paramount.

In theory, putting a globally aligned price on all carbon emissions is the optimal approach to account for the hidden costs of climate change and, thus, to steer the green transition (e.g. van der Ploeg and Venables 2023). In practice, however, the transition – and therefore also transition risk – is shaped by a myriad of factors. Across the globe, policymakers employ a diverse array of tools, and their actions are marked by fragmentation and varying degrees of ambition. Furthermore, other drivers besides policy also shape the transition, including technological progress and consumer preferences, with the latter driven, for instance, by the rising awareness that combating climate change is an urgent matter. This complexity poses unique challenges for empirically analysing the costs and benefits of the transition.

Equally worrisome, some proxies proposed in the literature, like carbon taxes, can also be endogenously related to the transition. Such taxes are not merely independent tools to encourage an emission reduction; they are themselves shaped by economic conditions that evolve as the economy adapts to new green policies. This two-way relationship complicates efforts to isolate the true exogenous (and thus causal) effects of transition risk on the economy (e.g. Känzig 2023).

A robust and comprehensive approach to studying the causal effects of transition risk

In our study (Meinerding et al. 2023), we acknowledge this complexity and propose a robust and comprehensive approach to studying the causal macroeconomic effects of transition risk. Our method builds on the premise that the overarching theme connecting all instances of economic risks posed by the transition is ‘stranded assets’, i.e. sunk investments that cannot be used or sold profitably due to changes in the market or regulations spurred by the transition. Particularly, our method identifies instances where there is a significant exogenous increase in the aggregate probability of asset stranding, which we interpret and label as ‘shocks to transition risk’.

Practically, our approach combines information from equity returns of carbon-intensive versus non-carbon-intensive firms with textual analysis of newspaper archives (Figure 1), relying on very mild and uncontroversial assumptions. Therefore, our understanding of transition risk is comprehensive, accommodating the variety of reasons why transition risk may increase.

Figure 1 Identification of shocks to transition risk

Figure 1 Identification of shocks to transition risk

Source: Deutsche Bundesbank.

Transition risk shocks are related to major political events

We apply our method to US data from 2010 to 2018 and find four transition risk shocks. We identify political events such as the climate deal between the US and China in November 2014 and the Paris Agreement in December 2015, among others, as transition risk shocks. We also apply our method to data from Germany and the UK. Again, we find major political events that can convincingly be regarded as transition risk shocks, like the aftermath of the parliamentary elections in the UK in May 2015 and in Germany in November 2017. Arguably, this finding indicates that abrupt exogenous shocks to transition risk are mostly related to political decisions.

Shocks have sizeable effects, both on aggregate and for transition-sensitive sectors

We then evaluate the causal macro-financial implications of our shocks. Figure 2 displays a few selected impulse responses. We find that our transition risk shocks negatively impact transition-sensitive sectors, for example, by reducing industrial production of energy materials or increasing uncertainty in the oil sector. Sectors that are less affected by the transition show much smaller effects, consistent with our identified narratives.

Figure 2 The impact of shocks to transition risk on selected variables

Figure 2 The impact of shocks to transition risk on selected variables

Note: The red line shows the median, and the grey range includes 68% of the most probable values, illustrating the uncertainty around the median.
Source: Deutsche Bundesbank.

Additionally, we show that the shocks significantly and strongly deteriorate credit conditions and raise volatility in financial markets, as indicated by the volatility indices. They also have sizeable aggregate effects. In the US, a shock significantly lowers the economic outlook for several months, reducing both industrial production and prices. The response of the price level suggests that, other than narrowly defined carbon price shocks, in the short run, transition risk shocks do not need to be inflationary.

While certain findings hold across countries, notable distinctions also arise. For Germany, the response of industrial production is positive and the response of the price level is insignificant. For the UK, both responses are slightly negative but hover around zero. We hypothesise that such differences in the responses to transition risk shocks are rooted in varying degrees of the economies’ ‘greenness’ and their readiness for the transition to net zero, with Germany being ‘readier’ over the sample period than the UK or the US. Interestingly, in Germany, we observe a strong rise in uncertainty in the automobiles and parts sector, suggesting elevated transition risk within this sector.

However, it is important to recognise that such statements may be subject to change. The transition to net zero is clearly evolving and dynamic, which may or may not imply revisions of some of these results in the future. In particular, significant policy shifts continue to happen, an example being the recent US Inflation Reduction Act, which may affect the US economy’s readiness for the transition going forward.

Conclusion

We offer a robust and comprehensive methodology to identify exogenous shocks to transition risk and apply it to Germany, the UK, and the US. Our findings indicate that shocks to transition risk are predominantly politically driven and have significant macroeconomic implications. Interestingly, our analysis challenges the widespread notion of ‘greenflation’, as – at least in the short run – the shocks do not necessarily exert inflationary pressure.

Additionally, the importance of country-specific factors emerges, suggesting that economic benefits may also be associated with the transition. Therefore, while international policy coordination remains crucial, our findings underscore the necessity of designing policy interventions that also respect and respond to each nation’s unique economic context.

References

Bolton, P, and M Kacperczyk (2021), “Global pricing of carbon-transition risk”, VoxEU.org, 24 March.

Eickmeier, S, J Quast, and Y Schüler (2024), “Large, broad-based macroeconomic and financial effects of natural disasters”, VoxEU.org, 26 May.

Hiebert, P (2024), “A macroprudential approach to managing climate risk”, VoxEU.org, 17 January.

Känzig, D (2023), “Climate policy and economic inequality”, VoxEU.org, 25 June.

Meinerding, C, Y Schueler, and P Zhang (2023), “Shocks to transition risk”, Deutsche Bundesbank Discussion Paper No. 04/2023.

Van der Ploeg, F, and A Venables (2023), “Radical climate policies”, VoxEU.org, 25 February.