What is Fossilflation?

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    Stockholm (NordSIP) – Climate change presents a number of challenges to modern society the world over. As weather volatility increases and economies race to adjust to the new reality, daily habits and long term expectations will have to adapt. At a time of rising inflation, investors, particularly in the fixed-income segment, will be well served by understanding the myriad ways in which climate change interacts with price movements.

    Beyond the direct effects of climate change and the extreme weather events on infrastructure and goods that characterise climateflation, fossilflation refers to the effect of rising fossil fuel prices on the economy.

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    The term does not actually have to be associated with climate change at all. Much like discussing the inflation occurring in consumer goods or in commodity prices, it is possible to go one step further into the latter category and distinguish fossil fuels, such as oil and gas from other commodities, such as minerals and food stocks. Fossilflation is a simple portmanteau for inflation in fossil fuel prices. In this sense, we could speak of the fossilflation created by the oil shocks of the 1970s or about the 2022 Ukraine War’s fossilflation.

    The Invasion of Ukraine

    Clearly, Geopolitical tensions play a role in driving the ongoing bout of inflaiton. “Embargos on Russian oil imports imposed by the United States and the United Kingdom as well as the European Commission’s plan to reduce Russian gas imports by two-thirds by the end of the year mean that fossilflation, and its broader repercussions on other input and output prices, is likely to remain an important contributor to headline and underlying inflation in the foreseeable future,” Member of the Executive Board of the ECB Isabel Schnabel explains.

    Although stark increases in energy prices are generally understood to be mostly a result of the Russian-Ukrainian conflict and its slowdown of post-pandemic oil supply recovery, climate change/driven “fossilflation” could still represent an important contributor to price increases.

    Climate Change-Mitigating Fossilflation?

    These facts notwithstanding, the term has come to be associated with the rising prices of fossil fuels brought about by the government policies implemented to mitigate and adapt to climate change. “In 2019 petroleum products and natural gas still accounted for 85% of total energy use in the euro area. The fight against climate change is one factor that is contributing to making fossil fuels more expensive, and hence their environmental damage more visible,” Schnabel argues.

    As Mikael Apel, Senior advisor at the Department of Monetary Policy of Sweden’s Riksbanken puts it “an important part of the strategy to limit global warming is to make it more expensive to use fossil fuels. Products and services that contribute to greenhouse gas emissions will thus become more expensive than those that do not – their relative price will increase. In this way, demand and production are steered towards more environmentally friendly alternatives.”

    Apel explains that fossilflation can work through two main mechanisms: carbon taxes on greenhouse gas (GHG) emissions and GHG emission rights trading. The first increases the price of goods proportionate to the emission of GHG by the company. According to Schnabel, “the price of carbon [in the EU] remains measurably above pre-pandemic levels despite recent elevated volatility”.

    According to Christiane Nickel from the ECB focuses on carbon taxes. “ECB staff performed a sensitivity analysis of euro area inflation to an increase in effective carbon taxes. The results point to limited but non-negligible effects on inflation in the gradual adjustment scenario until 2024.”

    The ECB considered two scenarios. In the first “the simulations imply a pass-through from producer costs and prices onto final consumer prices, which results in HICP inflation being around 0.15 percentage point higher per year. (…) The second scenario, however, shows more sizeable increases in HICP inflation of over 0.4 percentage point in 2022-23 and 0.3 percentage point in 2024.[ 19 ] This is partly owing to the input channel playing a stronger role compared with the first scenario, but also due to a stronger increase in the consumption taxation paid by households than in the first scenario.”

    The GHG emission rights trading approach limits the amount GHG emissions companies are allowed to generate in the process of their production. As GHG emission rights are reduced, as is the plan, the decreasing amount of emissions will lead to an increase in the price at which they are traded causing inflation, which would thus be associated with the emissions burning fossil fuel. With CO2 prices rising above €100 in February 2023, this driver cannot be dismissed.

    Fossil Fuel Crowding out?

    Another mechanism through which the energy transition is the substitution effect that the energy transition is exerting on fossil fuel investments. The need of private companies and governments to fulfil their commitments to net-zero temperature increases by 2050 will force them to shift investments from fossil fuels to renewable energies and electrification. As this takes place, fossil fuel production should decrease, which if it is not matched by decreasing demand, should cause prices to rise.

    As Schroders’ James Luke, Malcolm Melville and Dravasp Jhabvala note “the fact that climate mitigation policies bolster demand for commodities such as copper and nickel is well known and gets a lot of attention. However, the impact in changes to the supply side are arguably both larger and affect a wider range of commodities. The focus of producers, governments and investors on supporting strategies that are consistent with policies to mitigate the effects of climate change and achieve these goals is directly limiting investment in new supply growth in fossil fuels and metals.”

    Oligopolistic Power

    Nevertheless, broader estimates of the drives of excess price rises in gas and oil prices over and above their pre-pandemic levels point to energy producers’ ability to steer supply in an oligopolistic market. “Oil and gas markets are often artificially tight, pushing up prices at the expense of energy importers, such as the euro area,” Schnabel argues.

    It is still too early to argue conclusively the extent to which the energy transition is causing fossil fuel prices to increase. However, whether it is through carbon taxes, emissions quotas and trading rights or through investment crowding out, it seems that the energy transition will indeed play a significant role in future price increases as

    Note: This article is part of a series on the effects of climate change on inflation. Click here to read an introduction to the series and find its accompanying articles.

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