“Every economic decision will be impacted by energy prices and our climate.”
Two shocks rippled across America last week. One was economic. The price of gasoline in California is back above $6 a gallon. The other was meteorological. New York City was inundated by 8 inches of rain.
Individually, the events are just more news noise. But taken together, they provide crucial clues on what Christine Lagarde, the powerful president of the European Central Bank (ECB), says are the critical challenges of a “new” economy we have now entered.
How to manage this new economy was why Europe’s leading bankers gathered last weekend at a conference organized by the International Energy Agency (IEA), the ECB, and the European Investment Bank (EIB). Their focus was urgent: With the climate crisis escalating, so too are growing fears of a disorderly energy, monetary and societal transition.
Central bankers have lots of experience with energy and inflation shocks, as anyone old enough to remember gas lines in the 1970s will attest. What is new is an unprecedented environmental crisis requiring a rapid transition away from a fuel source that powers 80 percent of all the world’s energy. This is also happening as post-pandemic Europe adjusts to the additional energy supply and price shocks following Russia’s invasion of Ukraine.
Future shock is now: Unchartered waters
All this pushes central banks into uncharted waters, profoundly challenging their mandate to manage systemic risk, ensure price stability, and keep inflation low. Unlike previous historical monetary and economic shocks, there is no precedent for climate risk. It has not, in bank stress test parlance, been “backtested.” Lagarde and her central bank colleagues may as well be Marco Polo or Jonas Salk.
Unlike previous historical monetary and economic shocks, there is no precedent for climate risk. It has not, in bank stress test parlance, been “backtested.”
“The green transition poses a uniquely difficult policy challenge because the stakes of failure are so high, and yet the path to success is so complex,” she told attendees. First and foremost in her mind is how all this climate-focused economic change will affect monetary policy, particularly price (in)stability and inflation expectations. Then comes the need for an unprecedented amount of investment in renewable energy. Finally, she worries about how Europe will help the less fortunate buffer these relentless economic shocks – because if it doesn’t, many predict social unrest and many more climate refugees.
While the principal responsibility for driving the clean energy transition lies with governments and industry, the fight against climate change goes to the heart of the ECB’s mandate to maintain price stability and a new commitment to account for climate change in its monetary policy framework.
Amid rising concern that climate change might pose greater systemic risk than financial institutions have realized, Lagarde and the ECB also increasingly worry about how climate change will impact inflation, investment flows, and ultimately, household pocketbooks. Price stability and manageable inflation expectations, the ECB says, are “key requisites” to support the clean energy transition and encourage sustainable investment.
A brave new world
There are no easy fixes. For example, European policymakers have long thought they had a magic climate bullet: a tax on carbon. It would spur the push away from fossil fuels and provide revenue for the massive front-loaded government spending needed to build a climate-resilient global economic infrastructure. But the Ukraine war–induced energy shock was a rude wake-up call. Too much energy price volatility posed as great a political and social threat as the war itself.
The U.K.’s climate reversal
The reality, like it or not, is most people will be far more concerned about climate-fueled inflation than the actual physical risk of climate change. Perhaps the best example is the surprise reversal last month by U.K. Prime Minister Rishi Sunak on the country’s climate goals promises because they posed “unacceptable costs” to ordinary people.
His actions infuriated the EU. Last week, Lagarde all but name-checked Sunak, warning that leaders like Sunak may think they are “smoothing out the cost of the transition by pushing back climate targets,” but in fact, “they are only making it worse.” Procrastination, she said, “is likely to increase the bill we will end up having to pay.” She points to a recent ECB survey that revealed that consistent climate standards provide a stronger incentive to invest than the physical impact of climate change.
The reality, like it or not, is most people will be far more concerned about climate-fueled inflation than the actual physical risk of climate change.
The key to a stable transition, Lagarde says, is to ensure there is enough renewable energy to replace fossil fuels in order to maintain a steady supply and avoid spiraling energy costs. Without this, she warned that Europe “runs the risk of ending up in a halfway house where we are phasing out polluting energy sources before we can replace them with clean ones — a recipe for more price volatility and political backlash.”
The demand is huge. In 2023, a record EUR 1.7 trillion will be spent on clean energy projects worldwide. But that is not enough. Since 2019, EU clean energy investment has increased by 80%. However, to align with the IEA’s net-zero scenario, the EU needs to raise EUR 530 billion by 2030 from EUR 330 billion in 2022.
This is why Lagarde is championing the need to complete the EU’s Capital Markets Union (CMU) – as well as dramatically increasing the issuance of green bonds. That same ECB survey says three-quarters of European firms are ready to make climate-related investments within the next five years. However, they have been held back by the cost of financing.
A robust, green capital market, Lagarde argues, will “sharpen incentives by tilting our corporate bond purchases towards companies with a better climate performance” and “limit the share of assets issued by entities with a high carbon footprint.”
Solar to the rescue
Lagarde will be aided by the accelerated development of renewable energy sources, particularly solar. Defying its legion of critics, new renewable energy coming online, particularly solar, is growing exponentially. As Danny Kennedy points out in Climate & Capital, renewable energy growth, particularly solar energy, continues to defy expectations, outpacing even the boldest projections, and is rapidly asserting itself as a dominant player in the global energy landscape. BloombergNEF’s prediction of adding 392 gigawatts of solar power in 2023 alone highlights the immense momentum of this industry.
“The answer is to follow through with the transition by understanding the challenges it entails and ensuring that the costs are shared fairly.”
Don’t forget, people need to pay electric bills
But even the best-laid renewable energy policy will not buffer everyone against periodic spikes in energy prices. And that means doing something to protect those with the lowest incomes from the vagaries of weather and energy costs. To ensure fairness, measures like temporary caps on high energy prices or income support must be “part of the policy toolkit,” she says.
Big vision
It has been decades since U.K. Prime Minister Margaret Thatcher warned U.S. President George H.W. Bush not to “wobble” following the invasion of Kuwait by Iraq. But there were echos of that sentiment in Lagarde’s remarks over the weekend. “The solution to our climate crisis,” she said, is “not to dilute our ambition. It is not to detract our focus from the goal of net zero. And it is not to delay the time for action. The answer is to follow through with the transition by understanding the challenges it entails and ensuring that the costs are shared fairly.”
