Turning down the heat: how the green transition supports price stability

9 November 2022

By Irene Heemskerk, Carolin Nerlich and Miles Parker

The current energy crisis has sent gas and electricity prices skyrocketing and brought the potential challenges and opportunities of the green transition into sharper relief. Does that mean that the green transition must now wait until the current crisis is resolved? The answer is firmly no. Humanity must act today to mitigate the devastating effects of climate change^[1] and the earlier the green transition takes place, the lower the ultimate costs will be. For central banks globally, fighting climate change and fighting inflation can go hand in hand. The ECB Blog explains why.

The unexpectedly sharp increase in fossil fuel prices, in particular after the Russian invasion of Ukraine, has generated substantial uncertainty. The high energy prices have eaten into households’ real income and business profitability, which makes investing in low-carbon technologies and activities difficult for now. European governments have provided substantial subsidies to businesses and households to cushion the impact of energy price rises. At the same time, they have scrambled to secure energy supplies, undertaking substantial investment in fossil-fuel infrastructure. That includes re-opening mothballed coal-fired plants and constructing liquefied natural gas terminals.

These actions risk hindering the green transition. New fossil fuel infrastructure can reinforce reliance on, and lock in usage of, carbon-intensive fuels. Broad-based energy price subsidies mask the price signals given by the relatively more expensive fossil fuel prices compared with other products including clean energy. Yet, these relative price changes are needed to incentivise lower consumption of fossil fuels, behavioural changes and greater investment in green technology. Broad-based energy subsidies also risk burdening public finances. Government support instead needs to be made temporary and better targeted towards vulnerable households and small businesses, while preserving relative price signals.

Hastening the shift towards a green economy

The current situation also offers opportunities to hasten the green transition. The shortage of energy has brought home the urgent need to reduce reliance on fossil fuels and to foster energy efficiency. Recently made policy proposals such as RePowerEU, even if not sufficient, point in the right direction.^[2] Challenges remain related to their implementation, though.

In the medium term, and once pressure on fossil fuel prices eases, governments should price in the negative effects of carbon more effectively. Already committing today to a gradual and predictable future increase in carbon taxes would allow households and businesses to timely prepare. Besides, pricing carbon would provide an incentive to steer financial flows towards green energy sources and low-carbon production and offers governments revenues to support these investments. The green transition is ultimately a question of structural transformation. It cannot happen without green investment.

Price stability and the green transition

Advancing the green transition is not necessarily at odds with price stability. Gradual relative price changes caused by carbon taxes do not inevitably result in higher headline inflation. This is especially true when accompanied by green technological advances and higher energy efficiency.^[3] That said, the overall impact of the green transition on inflation is highly uncertain and depends on many factors, including the climate actions taken and the policy responses made.

Increasing the share of renewables can reduce total energy prices in the long run, while also supporting energy security. The price of wind and solar power has plummeted in the past decade due to technological improvements and economies of scale and is now substantially cheaper than fossil fuels. The EU aims to increase the share of renewables. For example, renewables are supposed to account for 45% of gross final energy consumption by 2030 according to REPowerEU.^[4] This will help to unwind the recent spike in energy prices and reduce the malign influence of fossil fuels on inflation volatility in the long run.^[5]

Chart 1

Fossil fuel prices drive inflation

Annual percentage changes and percentage point contributions

Likewise, an environment of price stability is important for the green transition. Anchoring longer-term inflation expectations at the central bank’s target helps contain long-run financing costs and is conducive to investment in green technologies in the long run.

By contrast, failure to advance the green transition poses risks for price stability. Climate extremes such as droughts or floods can damage infrastructure, ravage harvests, and disrupt supply chains. This can affect the prices of key products and drive inflation volatility.^[6] These impacts will only be magnified if we fail to achieve the objectives of the Paris Climate Agreement of limiting global warming to 2°C and making efforts to keep it below 1.5°C.

Government must drive the green transition

The principal responsibility for driving the green transition lies with governments, particularly through properly pricing the negative effects of carbon. But they also have the tools to dismantle the regulatory barriers that currently impede the uptake of renewable energy and to catalyse innovation and investment in green technology.

The ECB is committed within its mandate to account for climate change. In doing so, it supports the green transition, which will reduce risks to price stability in the long run. We have already made significant progress in implementing our climate change action plan and we will continue to do so.^[7]

A well-planned green transition goes hand in hand with energy security and can also contribute to price stability in Europe. Now is the time to redouble our collective efforts and hasten along the path of decarbonisation.