The Green Transition and Inflation in the Euro Area

April 30, 2024Published by International Monetary Fund

European central bankers can support the green transition without fear of derailing price stability objectives, as increased carbon prices are likely to have only a modest and short-run inflationary impact, says this research from the International Monetary Fund (IMF). Over the longer-term, increased carbon pricing may even have deflationary consequences by driving technological change and economies of scale in green sectors, causing green prices to fall.

The authors – Maximilian Konradt, Thomas McGregor, and Frederik Toscani – examine the effect carbon price increases can, and have had, on euro area inflation. Overall, the research shows inflationary effects primarily emerge in energy prices, without significant increases to headline inflation.

They used a three-part methodology, consisting of panel econometric techniques, event studies and input-output table simulations. The methods chosen allowed them to model the dynamic response of inflation to changes in carbon prices over short- to medium-term horizons, including macroeconomic feedback effects and national variations.

Based on three decades of backwards looking national data, the paper projects that a €30 increase in the effective price of CO2 per tonne – from the 2021 baseline of approximately €40 per tonne – would only increase headline inflation by around 0.1 % after two years before the effect fades out.

However, the authors caution against relying only on backward-looking analysis to estimate the impacts of more ambitious carbon-pricing policies in the future.

As European countries ramp up their climate action, it is crucial for central banks to understand the nuanced inflation dynamics this will entail so they can facilitate the shift to a low-carbon economy while maintaining their core objectives, say the authors.

To address this, they conduct an input-output table simulation exercise to estimate the inflationary impact of the Fit for 55 commitments made by euro area countries, as well as an effective carbon price of €150 per tonne of CO2 by 2030.

The results show carbon price increases under this more ambitious climate policy scenario could raise consumer prices by 0.2-0.4% annually until 2030.

Such effects represent only a fraction of the price instability following the Russian invasion of Ukraine, in which supply shocks saw diesel and electricity prices increased by 55% and 280% respectively over eight months.

The results also show that a persistent inflationary environment may exacerbate the inflationary effects of a higher carbon price, underscoring the importance of central banks considering prevailing macroeconomic conditions when assessing potential risks arising from climate policies.

Finally, the authors note that the inflationary effects of carbon pricing may be counteracted by other non-price climate policies, such as regulations and subsidies, which highlights the importance of evaluating the broader policy mix, not just carbon pricing.

This page was last updated April 30, 2024

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