Climate change: possible macroeconomic implications

Summary

Climate change – and the response of governments at home and abroad to it – will affect the macroeconomy in a number of ways, both over shorter horizons and the longer term. Since it influences key economic variables such as output and inflation, climate could change matter for monetary policy makers such as the Monetary Policy Committee (MPC). Monetary policy clearly cannot solve climate change, but climate change may have macroeconomic implications that could be relevant for monetary policy makers. This article explores the macroeconomic effects of physical impacts from climate change (such as extreme weather) and the transition to a net-zero economy (such as through less carbon intensive investment), with a particular focus on the UK economy. It considers what the longer-term changes associated with climate change might mean for the macroeconomic landscape within which monetary policy operates. It also provides an initial assessment of some possible monetary policy considerations. Many of the questions in this area are new, open and worthy of further research. That reflects new analytical challenges associated with climate change, including related to macroeconomic modelling and data quality and availability. In addition, there are many dimensions of uncertainty, not least in relation to how the physical effects of climate change and governments’ policy responses to it evolve over the coming years and decades.

1: Introduction

In the UK, the MPC sets monetary policy to meet HM Government’s 2% inflation target, and, subject to that, to support the economic policy of the Government, including its objectives for growth and employment.

In response to macroeconomic developments in the UK, including spillovers from the rest of the world, the MPC adjusts its policy instruments in order to meet the 2% inflation target. The two main policy actions that the MPC can take are to change the interest rate that the Bank of England charges commercial banks to borrow (‘Bank Rate’) and to change the stock of assets that the Bank holds on its balance sheet as a result of outright purchases (‘quantitative easing/tightening’).

When assessing the outlook, the MPC typically looks at how the economy is likely to develop over the next two to three years, the horizon over which monetary policy can sustainably bring inflation back to target. Unanticipated economic events, often called ‘shocks’, will affect the outlook for the economy over that period, sometimes materially; the sharp and significant rise in wholesale and domestic energy prices since Russia’s invasion of Ukraine is a recent example. The MPC also monitors and assesses longer-term, and sometimes more gradual, developments to understand structural economic changes that are happening in the economy over a number of years. An example here is the increased integration of emerging economies into the world economy along a number of dimensions from the early-2000s, sometimes called ‘globalisation’, which for a sustained period reduced the prices of manufactured goods imported by advanced economies.

In some sense, climate change comprises another set of economic shocks and structural changes for monetary policy makers to assess and monitor in order to achieve the inflation target. However, climate change presents new challenges to monetary policy makers in a number of respects, including its global dimension, its very long time horizon and the degree of uncertainty about both climate policy and how economic agents will respond. That is particularly so given the non-linear nature of climate change leading to irreversible effects (‘tipping points').

Physical impacts from climate change, and governments’ policy responses to climate change such as to support the transition to a net-zero economy, have the potential to impact the macroeconomy in numerous ways. They are likely to influence key economic variables such as output and inflation, which in turn are directly relevant to the decisions taken by the MPC. For instance, increased severity and/or frequency of extreme weather events at home and abroad could lead to supply disruptions and a rise in some prices, including of food. Moreover, over the coming years and decades, UK legislation to achieve net-zero emissions by 2050 (Climate Change Act 2008, amended in 2019) requires ambitious changes across all parts of the economy, from power generation to transport to how we heat and build our homes.

Monetary policy clearly cannot solve climate change, but climate change may have macroeconomic implications that could be relevant for monetary policy makers. This implies that the greatest contribution monetary policy can make to facilitate the transition to the green economy is to secure price stability and maintain the credibility of the monetary regime through the transition.

This article explores how the physical impacts from climate change and the transition to net zero might impact the economy and so could matter for monetary policy. It first explores the macroeconomic effects of physical and transition impacts, with a particular focus on the UK economy (Section 2). Section 3 then considers what the longer-term changes associated with climate might mean for the macroeconomic landscape within which monetary policy operates. Section 4 provides an initial assessment of some possible monetary policy considerations, before Section 5 concludes.

The article provides a complement to the extensive body of work in recent years by the Bank of England and other institutions focused on understanding the financial risks from climate change and the transition to a net-zero economy.^{footnote [2]} It also contributes to recent debates – including in the economic literature, the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) and Bank research^{footnote [3]} – on the potential impacts of climate change on the macroeconomy and the implications for monetary policy. For example, recent years have seen speeches by senior officials from, among others, the Federal Reserve (Brainard (2019)), the European Central Bank (Lane (2022); Schnabel (2022)), the Bank of England (Bailey (2021)) and the Reserve Bank of Australia (Debelle (2019)). It is worth noting at the outset that many of the questions in this area are new, open and worthy of further research. That reflects new analytical challenges associated with climate change, including related to macroeconomic modelling and data quality and availability. In addition, there are many dimensions of uncertainty, not least in relation to how the physical effects of climate change and governments’ policy responses to it evolve over the coming years and decades.

2: Effects on macroeconomic fluctuations

Physical impacts

Physical impacts from climate change have the potential to impact the macroeconomy in numerous ways, influencing key economic variables such as output and inflation.

The physical impacts of climate change stem from both the increased frequency and severity of acute weather events like flooding, extreme temperatures and windstorms, and gradual or chronic changes in the climate, such as those associated with gradually rising temperatures and sea levels. The impacts associated with both acute and chronic changes transmit through many channels, affecting both the supply and demand sides of the macroeconomy. In this section, we explore the macroeconomic effects of the physical impacts associated with climate change with a particular focus on the experience of the UK economy and drawing on international evidence from countries who may have experienced more severe events than typically found in the UK. In terms of the response of monetary policy to these physical impacts, a key challenge is to assess the macroeconomic effects over the next two to three years, the horizon over which monetary policy can sustainably bring inflation back to target.

This section next discusses the different channels of physical effects on economic growth, inflation, as well as gradual changes and global spillovers.

Effects of extreme weather on economic growth

The economic literature shows that extreme weather events tend to have a predominantly negative effect on economic growth, in some cases up to several years. Reasons include damage to the economy’s stock of physical and infrastructure capital, the impact on the labour force (including through displacement or migration) or losses in productivity (due to breaking supply linkages, for instance).

As a proxy for possible physical effects of climate change, we can look at natural disasters. Their effect on economic growth is mixed (Cavallo and Noy (2009)). Using data on natural disasters since 1900, Raddatz (2009) estimates natural disasters persistently reduce real GDP per capita by at least 0.6% in a panel of countries. However, this covers a wide range of natural disasters and is an average effect: the impact tends to be smaller for wealthier countries (Botzen et al (2019); Noy (2009)) particularly in those cases where the events are sufficiently insured (von Peter et al (2012)). In contrast, Loayza et al (2012) observe that after earthquakes and storms there are positive growth effects which are attributed to reconstruction of infrastructure and capital. However, severe disasters tend to put economies on slower growth paths. Hsiang and Jina (2014) find that national incomes fall and do not recover within the first twenty years following a cyclone. Clearly there are limits to which we can extrapolate from these studies for climate change, not least because changes in the climate are not linear, but the likely increase in frequency and severity of extreme weather events means such effects may be bigger in the future. Box A looks at flooding and UK house prices as a case study.

Effects of extreme weather on inflation

Extreme weather events can also affect inflation, at least temporarily. Heinen et al (2019) study the impact of hurricanes and floods on the monthly inflation rates of 15 Caribbean islands. They conclude that although the average inflation impact of hurricanes is small, it can be greater for more severe events. Similarly, Cavallo et al (2014) find that even with the severe supply disruptions that major earthquakes can bring, prices remain stable. They attribute it to retailers avoiding perceptions of price-gouging, ie preferring to run out of stock in response to a supply disruption, rather than increase prices. Parker (2018) finds that droughts seem to be the only type of natural disaster with an impact on headline inflation which persists for a number of years, with food prices a key channel. Peersman (2022) shows that exogenous (weather-driven) food price shocks have a strong impact on consumer prices in the euro area, suggesting that inflation volatility in advanced economies may rise with an increased frequency of global extreme weather events. Taken together, these factors suggest it is likely that inflation may become more volatile, particularly in geographies subject to more frequent extreme weather events.

While physical impacts of climate change have been shown to temporarily raise inflation, in particular food prices, such effects have tended to dissipate in the medium term. As noted above, however, the impacts of such events may be greater in the future if extreme weather events are more frequent and more severe.

Gradual changes in the climate system: macroeconomic effects

Physical impacts from climate change may also reflect chronic changes in the climate system, such as those associated with a gradual rise in average global temperatures. This causes an increase in the frequency and intensity of weather-related natural disasters as previously discussed. For example, global warming is associated with a slowdown in warm-water currents in the Atlantic Ocean, which in turn leads to changing heavy precipitation patterns in the tropics and Europe, and stronger storms in the North Atlantic (IPCC (2021)). However, the gradual rise in itself could cause negative effects on economic growth, both in the short and long run, driven by a range of factors, including reduced labour productivity, slower human capital accumulation, diminished human health and political instability (Dell et al (2012)).The negative economic effects from gradual temperature rises can increase in a non-linear way as the temperature deviations from historical norms get larger (Felbermayr et al (2014); Burke et al (2015)). Moreover, most of the effects appear larger in emerging economies, with more extreme temperature variations and institutional factors creating challenges to adaptation.

The UK’s infamously cloudy – but moderate – weather makes it somewhat less likely to be significantly directly exposed to gradual changes. For example, the University of Notre Dame Global Adaptation Index ranks the UK fifth (out 182 countries) least vulnerable to physical impacts of climate change. While the UK is somewhat less directly affected by physical risk compared with other low-lying countries, for example, Box C explores the different channels by which the economic effects of physical (and transition) impacts can transmit across countries.

Key takeaways

• Gradual warming and extreme weather events have a negative impact on GDP, although there may be a temporary boost from reconstruction. Physical impacts of climate change appear to temporarily raise inflation, in particular food prices, but such effects have tended to dissipate in the medium term in past data. These weather events may largely be the same as in previous decades, although their likely size and frequency may be greater, such that impacts could become more pronounced.
• Insofar as there are more and larger weather events that may require a more active role for monetary policy. However, some of these effects may be more evident over relatively short horizons, whereas monetary policy can sustainably return inflation back to target over the next two to three years. But as discussed in Section 3, gradual warming and increasing frequency of extreme weather events may have an important influence in the economy in the long run, such as via uncertainty, investment and trend productivity growth.  

Transition impacts

As the economy adjusts to a low-carbon and ultimately a net-zero economy, there are a number of transition impacts on the macroeconomy that arise out of the process of adjusting policies, preferences and technology. These impacts can be orderly, leading to a ‘smooth transition’, whereas a ‘disruptive transition’ may induce amplified effects on the economy through the various channels discussed here. This section explores what we can learn about the macroeconomic effects associated with the adjustment of the UK economy toward net zero, as in Section 2, drawing on UK evidence as well as lessons from abroad. An important caveat is that most of the economic literature on transition risks examine market-based climate policy mechanisms that have been introduced over the past decade or so. But many other climate policies will need to be deployed to deliver the transition to net zero, of which we have much less understanding. The first and second parts of this section focus on mitigation policies and their role in changing prices faced by households and companies in the economy, which is in turn likely to generate a reallocation of activity between sectors of the economy towards those that are less carbon intensive. The third part looks the role of expectations, including the role of uncertainty, in the transition to net zero.

The macroeconomic impacts of mitigation policies

Governments over recent years in many countries have introduced a range of policies to lessen the impacts of climate change by preventing or reducing the emission of greenhouse gases (de Silva and Tenreyro (2022)), as well as measures to adapt to the effects of climate change. These can be grouped into three broad categories. First, there are economic incentives, such as carbon taxes, emission trading schemes, and subsidies for investing in research and development (R&D), adopting green technology, and using clean energy. Second, there are regulations, such as bans on coal usage, or production and mandatory technology requirements. Third, there are institutional approaches, such as voluntary industry standards for climate disclosures. The introduction of mitigation policies by governments, and the pace at which they are strengthened, are likely to have effects both on the demand and supply side of the economy.

Some mitigation policies, including subsidies and direct regulations, encourage cleaner forms of energy production or reduce energy consumption by households or firms. One example is green energy subsidies to encourage greater use of renewables such as wind power. These policies lower the overall cost of renewable energy provided to power grids and, over time, reduce the average cost of this form of energy provided to firms and households, which may lower inflation (although energy prices do not always reflect average production costs across all sources of energy). The overall effect on the economy’s productive capacity and aggregate demand is more ambiguous, however. It depends in part on how the subsidies were financed – in particular, whether and what type of tax increases would be required, or the diversion of other types of government spending.

On the other hand, policies that subsidise research and development into green technologies are more likely to boost the economy’s productivity and growth. Its impact on inflation would depend on the balance between the relative effects on supply and demand, which could vary at different horizons.

There could also be various regulatory initiatives to discourage carbon-intensive production or simply enforce lower carbon inputs into production. The economic literature on this is limited, but such regulatory initiatives may raise costs and consumer prices, at least in the short run.

Chart 1: Carbon prices in the CBES

Footnotes

• Source: Bank of England Climate Biennial Exploratory Scenario (CBES).

Another potentially important tool in the transition to net zero is carbon pricing. By charging for greenhouse gases emissions, the policy puts a price on emissions and also encourages investments into energy-efficiency improvements. The price can be determined through a range of ways, for example, via market mechanisms (such as the UK and EU Emissions Trading Schemes (ETS) in which governments sets the maximum amount of emissions), directly though taxation or via policies such as standards and regulations. The UK uses a combination of the carbon cap-and-trade (UK ETS) and various carbon taxes – direct taxes such as the Climate Change Levy and the Carbon Price Support, and indirect carbon taxes, such as fuel duties.

Given there are many examples of carbon-pricing schemes that have been active for some time, such as those in the EU and Canada, there are a number of attempts in the economic literature to assess the macroeconomic effects of these policies. Overall, the impacts depend crucially on the design of the mitigation policies, including the extent to which and how any revenues from the policy are used by the fiscal authority (for example, by reducing other taxes, increasing subsidies or raising government spending). Fiscal policy tools can support activity and help to offset some of the negative direct impacts on output from carbon pricing if the revenues raised from the carbon tax are recycled back to households and firms (Yamazaki (2017)).

There are two typical empirical findings, although results in this literature are mixed rather than definitive. First, a reduction in the quantity of carbon credits and allowing market mechanisms to dictate carbon prices raises inflation and reduces economic growth (Kaenzig (2022)). Second, in contrast, several studies show setting a carbon price directly through carbon taxes has a broadly neutral impact on inflation and output, although as discussed below these results are based on a low level of carbon prices.^{footnote [4]}

There are at least two reasons to explain the different impacts on inflation. First, as carbon taxes set a path for the carbon price directly (in contrast to an ETS, under which prices could be more volatile), firms can plan ahead to a greater degree – for example, in managing other costs and investing in green technologies. Second, Konradt and Weder di Mauro (2022) suggest carbon taxes may have a disproportionate impact on low-income households, given their consumption baskets are more energy intensive. That could reduce their demand, offsetting the initial inflationary impact of the carbon tax.

But an important caveat and reason why the estimated empirical effects tend to be small is that the historical carbon prices on which these studies have been based have been and still currently are low. Konradt and Weder di Mauro (2022) document that the majority of taxes in Europe and Canada are below US$30 per tonne as of 2018, with some as low as US$0.08.^{footnote [5]} Estimates of the potential paths carbon prices would need to take in order to meet net-zero targets indicate a substantial rise in carbon prices from their current levels. One such estimate is from the Bank of England’s Climate Biennial Exploratory Scenario (CBES), which simulates a substantial increase in carbon prices, rising from US$30 as at end-2020 to US$900 per tonne of carbon dioxide equivalent (in 2010 dollars) by 2050 under an ‘Early Action’ scenario (Chart 1). If policy action is delayed (‘Late Action’), carbon prices remain at US$30 until 2030 but the simulated increase is more abrupt and results in a higher carbon price in the later years (over US$1,000 by 2050).

Therefore, the macroeconomic effects of past carbon-pricing schemes may not be a good guide to the macroeconomic effects of future carbon-pricing schemes’ rises. Structural modelling can also complement empirical analysis and help us understand the potential effects of future carbon price increases. The IMF’s October 2022 World Economic Outlook has a chapter that finds limited inflationary impacts of carbon-pricing initiatives. However, there are a number of quite specific assumptions in the baseline model, in particular firms and households are very forward looking and mitigation policies are known with certainty. In response to the anticipated rise in energy prices, firms and households in the model cut investment and consumption – reducing aggregate demand that offsets the inflationary impacts of the carbon taxes. It is also worth noting that this model only simulates a 25% reduction in emissions.

It will be important for central banks to understand the expected macroeconomic effects of different mitigation policies, particularly on inflation, in order to set monetary policy. Section 4 provides an initial assessment of some possible monetary policy considerations.

Investment and economic activity across sectors during the transition in the UK

One important feature of the transition that monetary policy will need to monitor is its effect on investment in less carbon intensive capital, sometimes called ‘green investment’ (such as investments into low-carbon energy like wind turbines, or into energy-efficient infrastructure like electric vehicles). Meeting the net-zero targets will require investments in energy and transport infrastructure alone to more than double from current levels over the next decade and thereafter maintain that level until 2050 (Lenaerts et al (2021)). The International Energy Agency’s (IEA (2021)) pathway to net zero highlights that current energy investment is US$2 trillion (2.5% of global GDP) but needs to rise to almost US$5 trillion to meet net-zero targets. The World Energy Investment report (IEA (2022)) finds that global clean energy spending had remained flat for several years, but it has been increasing since 2021. If this is sustained, it could lead to an overall increase in global investment, and thus boost demand, though the rise in green investment may be partially offset by a fall in more carbon-intensive investment.

To understand how the transition towards greener activities is affecting economic activity, the Bank of England asks firms directly through its Agency network, as well as the Decision Maker Panel (DMP) survey.^{footnote [6]} Reports from the Agents over the first half of 2022 suggest firms that supply goods and services for the net-zero transition – such as those supplying wind power or heat insulation – have continued to experience strong growth in demand. This reflects how investment intentions will vary by sector, based on a sector’s role in supporting the transition, as well as their existing carbon intensity (and therefore the extent to which they need to decarbonise). See Box B for the sectoral effects in the Climate Change Committee’s (2020) Balanced Net Zero Pathway.

Similarly, the DMP survey in September and October 2021 suggested 44% of UK firms intend to increase climate-related investments over the next three years (Chart 2).^{footnote [7]} We can map this to each sectors’ importance in the UK economy using their Gross Value Added (GVA), which measures the value of each sector’s production. The DMP shows that some sectors with relatively large GVA shares – like the wholesale and retail and manufacturing sectors – currently plan to strongly increase climate-related investments over the next three years, while for other sectors their investment plans related to climate and the transition are comparatively modest (Chart 3). The Office for National Statistics’ Business Insights and Conditions Survey (BICS) suggests a majority of firms have started to take action to reduce carbon emissions, although a smaller proportion explicitly monitor climate-related risks and have a climate strategy (Chart 4).^{footnote [8]}

Chart 2: The expected effect of climate change (physical and transition) on capital expenditure over the next three years (survey: September–October 2021)

Footnotes

• Sources: DMP survey and Bank calculations.

Chart 3: Expected sectoral effect of climate change (physical and transition) capital expenditure over the next three years (survey: September–October 2021) ^(a)

Footnotes

• Sources: DMP survey and Bank calculations.
• (a) Sectoral GVA shares are 1998–2019 averages.

Chart 4: BICS survey (survey: 21 March to 3 April 2022)

Footnotes

• Source: Office for National Statistics.

Expectations and uncertainty effects

The transition to net zero will be a long-run process, with many changes in the structure of the economy due to occur into the future. However, economic behaviour and asset prices are also driven by forward-looking expectations and so affect monetary policy.

Investments into green technologies often have a long horizon and are particularly susceptible to increased uncertainty. This includes general macroeconomic uncertainty, but also climate policy uncertainty (IEA (2017); Fried et al (2021)). Much like how individuals can postpone deciding on a weekend’s activities until they see a more accurate weather forecast closer to the date, an increase in uncertainty induces firms to delay investments, particularly those with long payback periods. The (negative) effect on aggregate demand and economic growth by increased uncertainty is well documented (Leduc and Liu (2016); Basu and Bundick (2017)). A previous Quarterly Bulletin article showed how a rise in uncertainty – then associated with the UK’s exit from the EU and the Covid pandemic – dampened UK business investment (Bunn et al (2021)).

Chart 5: Per cent of firms with climate change as a top three source of uncertainty, by sector ^(a)

Footnotes

• Sources: DMP Survey and Bank calculations.
• (a) Sectoral GVA shares are 1998–2019 averages.

The DMP survey shows some UK firms have already begun citing climate change policy as one of their main sources of overall uncertainty (Chart 5). This is particularly apparent in sectors affected by climate change, such as transportation and real estate. This suggests a clear and orderly path of climate policy during the transition that avoids inducing uncertainty would encourage higher levels of private investment.

Inflation expectations are another example of how expectations about the future can affect current economic decisions. If firms reprice their products infrequently, they must set prices in advance to anticipate their future demand and costs. Therefore, news about higher future costs – for example, from a continued rise in carbon prices, such as in the CBES scenario – could lead to higher inflation in the near future. Inflation expectations could also ‘propagate’ shocks to firms’ costs arising from carbon prices: making the inflationary impacts longer lasting that the direct impact of the initial shock (Coibion and Gorodnichenko (2015)), though its quantitative importance is uncertain (Wong (2015)). If increases in carbon prices are inflationary, these could lead to ‘second-round effects’ – leading into higher inflation expectations, and consequently, to more inflation later on. Moreover, increases in carbon taxes may be announced and so anticipated a number of years in advance. By contrast, standard economic shocks are unexpected and can arise in either direction. As a result, further analysis is required to better understand how carbon price changes may affect inflation, inflation expectations and economic activity. Monetary policy plays an important role here, and a credible monetary regime that anchors inflation expectations would help minimise the potential inflationary impact. The monetary policy implications are further discussed in Section 4.

Key takeaways

• Most of the economic literature on transition impacts examine market-based climate policy mechanisms that have been introduced over the past decade or so. But many other climate policies will need to be deployed to deliver the transition to net zero, of which we have much less understanding. Additionally, relative to a smooth transition, a disruptive transition may induce amplified effects on the economy through the various channels discussed here, and potentially others too. A credible path for future policy for the transition is vital to reduce uncertainty and enable economic agents to react smoothly and appropriately.
• Some initial findings are that climate policies that encourage the transition to net zero are likely to have both supply and demand effects on the macroeconomy, though it depends on institutional factors, such as the climate policy mix and how carbon tax revenues are used by the government.^{footnote [9]} The estimated empirical effects tend to be small but that could be simply because historical carbon prices on which these studies have been based on are currently low; prices will need to rise significantly from their current levels to be consistent with net-zero targets.
• A survey of UK companies shows that 44% of firms plan to increase capital expenditure in response to climate change, about a third of these by 10% or more. This is consistent with net-zero scenarios of sharply increased investment. This increase is highly uneven across sectors in the economy, with some planning to invest much more than others.

3: Effects on the long-run equilibrium interest rate, R*

While monetary policy is typically focused on responding to cyclical shocks, it does so within a broader macroeconomic landscape, which is shaped by a number of slow-moving structural factors (Bailey (2022)). Given the potentially permanent effects on the environment, physical climate-related events will impact economic factors such as risk and productivity in the long run. Furthermore, given the scale and duration of the necessary adjustment, the transition to net zero requires a large structural economic change, with consequences particularly for the future path of investment. Therefore, in addition to the impacts discussed in the previous section, both the physical impacts from climate change and the transition to net zero are likely to significantly shape the longer-term macroeconomic landscape within which monetary policy operates.

Economists use a number of so-called ‘equilibrium’ concepts to summarise the macroeconomic landscape, and therefore the policy-relevant impact of structural changes in the economy. One such concept, which is of particular importance to monetary policy, is the ‘equilibrium real interest rate’ – defined as the real interest rate (ie the interest rate adjusted to remove the effect of inflation) that sustains the actual output level of the economy in line with its potential and inflation at target. As such, the equilibrium real interest rate can act as a guide to monetary policy over the medium to long run. Long-run structural changes in the economy, like those implied by climate change and policies, affect the long-run trend in the equilibrium real interest rate, which we refer to as R*.

The determinants of R*

In an organising theoretical framework for understanding its determinants, R* is also the price that brings the demand and supply for capital into balance (see Bailey et al (2022)), for a more complete exposition). The demand for capital arises from firms that want to invest in capital for production.^{footnote [13]} The supply of capital is from households accumulating wealth, and who put this wealth into capital by (directly or indirectly) holding corporate shares or bonds, and government bonds. Within this framework, R* is the risk-free rate of return on government bonds, and, in equilibrium, it is equal to the return to an additional unit of capital minus the ‘risk premium’, which compensates households for the volatility in the return to capital.

Importantly, for an open economy like the UK, R* will be determined on the global capital market, because frictions that impede the free international movement of capital are weaker at this longer-term horizon. In other words, structural factors that determine the global supply and demand for capital will pin down a ‘Global R*’, and it is this concept of R* which acts as a long-term anchor for the UK's domestic equilibrium real interest rate (Cesa-Bianchi et al (2022)).

There are a large number of potential channels through which both physical impacts from climate change and the (global) transition to net zero may affect the long-run trend equilibrium interest rate, R*. Some forces could put upward pressure on R*, such as an increase in trend productivity growth or additional green investment. Other forces could work in the opposite direction, such as an increase in the risk premium.

Physical impacts

With respect to physical impacts of climate change, one of the key influences on R* is that the increased probability of natural disasters, and the subsequent increase in the volatility of output, which may raise the risk premium. In other words, with higher macroeconomic volatility, risk-averse households will require a larger compensation for lending to firms, relative to holding risk-free bonds. All else equal, this increases firms’ financing costs, therefore reducing their demand for capital, and, in equilibrium, this lowers R* (Kozlowski et al (2018); Dietrich et al (2022)). Similarly, households facing higher volatility in their own incomes or costs, due to climate risks such as reconstruction after flooding, will choose to accumulate more wealth as a precaution against this volatility. All else equal, a higher supply of wealth to finance investment also lowers R* (Auclert and Rognlie (2018)).

Physical impacts of climate change could also lower productivity in the long run, either directly through the effects of climate events, or by diverting investment towards abatement rather than productivity-enhancing technologies (NGFS (2020)). This lower productivity reduces the marginal product of each unit of capital, therefore lowering firms’ demand for capital, and hence, R* (Riksbank (2020)).

We can also think of physical risks as an increase in the depreciation rate of the capital stock, as extreme climate events periodically destroy physical capital. This would reduce the marginal product of capital, by effectively reducing the future value of existing capital, and therefore also reduce firm investment (the demand for capital) and push down on R*.

Transition to net zero

In terms of the transition to net zero, a main channel is that the transition entails a large increase in investment into new green capital. As discussed in Section 2, meeting the net-zero targets will require large investments in many sectors across the economy, reflected also in the Agency intelligence and DMP survey responses. This rise in demand for capital will push up on R*.

Other than directly increasing firm investment, this transition towards green capital and green technologies may have other effects. The risk premium on green investments may be different. For example, if investors perceive these new investments to be riskier as some new technologies may not pay off, then the risk premium may rise, pushing down on R*. The long-run productivity growth may also differ; if green technologies have higher productivity, this would raise the marginal productivity of capital, raising firm investment, and with it, R*. Finally, transition to net zero may have large up-front costs, including requiring updated infrastructure (such as decarbonising buildings, subsidising the move away from gas boilers), and so it may require a rise in public debt levels (Office for Budget Responsibility (2021)). This would raise the supply of government bonds, which, all else equal, leaves less wealth to finance firm investment, therefore pushing up on R* (NGFS (2020)).

Key takeaways

• There are a large number of potential channels through which both physical impacts from climate change and the transition to net zero may affect the long-run trend equilibrium interest rate, R*.
• Some forces could put upward pressure on R*, such as an increase in trend productivity growth or additional green investment. Other forces could work in the opposite direction, such as an increase in the risk premium.
• More work is needed to understand and quantify these various channels, in particular to understand their net effect and whether their relative importance is different at different horizons. Most importantly, we will learn over time how the risks associated with climate change are priced into returns, how productivity develops both in the face of climate events and the transition towards a green economy, and how governments, corporates and households respond to these changes.

4: Monetary policy considerations

Monetary policy clearly cannot solve climate change, but climate change may have macroeconomic implications that could be relevant for monetary policy makers. This section explores how the macroeconomic effects of climate change as discussed may have implications for the conduct of monetary policy, both in the short and long term. As described above, climate change is likely to be a source of shocks to inflation and activity, lead to structural changes in the economy and to reshape the longer-term macroeconomic landscape in which the MPC operates. This section considers climate and monetary policy strategy, monetary policy trade-offs and possible changes to the transmission mechanism of monetary policy.

Climate and monetary policy strategy

The remit for the MPC, as set out by the government, outlines its objectives and provides guidance for its strategy. As discussed in the Introduction, it requires the MPC to set monetary policy to meet the inflation target of 2%, and, subject to that, to support the economic policy of the government, including its objectives for growth and jobs. In March 2021 HM Government updated the MPC remit to ‘reflect the government’s economic strategy for achieving strong, sustainable and balanced growth that is also environmentally sustainable and consistent with the transition to a net zero economy’.

The primacy of the price stability objective remains at all times. In 2016, as part of a broader stimulus package, the MPC launched the Corporate Bond Purchase Scheme (CBPS). It is a monetary policy tool: the MPC judged it was necessary at the time to impart sufficient stimulus to the economy to meet its inflation target. However, the structure of CBPS holdings provided an opportunity in which monetary policy could further support the Government’s net-zero objectives. As such, in 2021 the MPC announced plans to ‘green’ the CBPS portfolio to incentivise companies to reduce emissions by adjusting the composition of CBPS investments, for example requiring firms to satisfy climate-related eligibility criteria for their bonds to be purchased by the CBPS. As the macroeconomic conditions changed, the MPC decided to run down the CBPS holdings in its February 2022 meeting. The primacy of the inflation target in the MPC’s remit meant that, despite the benefits of the CBPS from the perspective of climate change mitigation, this did not prevent or delay the decision to reduce the stock of corporate bonds in order to meet the inflation target.

Insofar as investments into green capital and R&D that facilitate the transition to net zero tend to pay off over a long horizon, an important mechanism through which monetary policy can facilitate the transition to the green economy is ensuring the continuation of price stability and credibility of the monetary regime. This minimises the inflation risk premia component of interest rates, and therefore, reducing the financing costs of long-horizon green investments.

Monetary policy trade-offs

The MPC’s remit also allows consideration to be placed on the variability of output. The implications for monetary policy of climate change can therefore be seen in the context of the MPC’s remit and guidance around trade-off management.

Over the short run, the MPC adjusts its policy instruments in response to macroeconomic developments, depending on their effects on inflation and activity. Some economic developments push inflation and activity in the same direction, such in a rise in green investment which would tend to push up on both activity and inflation. In this case, monetary policy can adjust its instruments to bring inflation back to target and restore activity to equilibrium at the same time.

Other economic developments push inflation and activity in different directions. As discussed in Section 2, the transition to net zero will make carbon-based energy sources more expensive. That could push overall energy prices up, depending on how much and at what speed that is compensated for by cheaper renewable energy sources. But it may reduce activity. By pushing up on inflation and down on activity, that creates a ‘trade-off’ for monetary policy, given monetary policy instruments typically push on both activity and inflation in the same direction. The remit provides flexibility for the MPC to allow inflation to deviate from the target temporarily, in order to avoid undesirable volatility in output in some circumstances so that the MPC is able to manage trade-offs (Carney (2017)).

Climate change and the transition to net zero is an example of a ‘relative price shock’, which the MPC has faced in the past. Section 1 mentions one previous example: the globalisation following China’s accession to the World Trade Organization in 2001, which led to low tradeable goods inflation rates (Spange and Young (2007)). Ultimately, monetary policy must allow the economy to adjust to such shocks. It should respond only where the shocks exert a generalised and persistent effect on inflation. For example, following the depreciation in sterling that followed the UK’s EU referendum, the MPC traded-off the associated inflationary pressure against undesirable volatility in output, and there was a temporary deviation in inflation from target, as allowed for under the MPC’s remit.

On the other hand, the relative price shocks associated with the transition to net zero may be different to the types of shocks that the MPC has faced in the past. In particular, in transition scenarios, the price of carbon (whether set via a tax, emissions trading scheme, or other means) rises steadily over time. Therefore, it is possible that the impact on inflation may become generalised and persistent.^{footnote [14]} In that case, there would likely need to be an adjustment in monetary policy in order to meet the inflation target.

A related consideration in achieving the inflation target is the speed of the structural adjustment in the economy. For example, in a paper presented at the Jackson Hole Symposium in 2021, Guerrieri et al (2021) argue that in the face of reallocation of resources across different sectors of the economy and downward wage rigidities, monetary policy may need to be looser than otherwise in the absence of this reallocation. Although this paper focused on sectoral reallocation due to the Covid pandemic, Bartsch et al (2022) have drawn a parallel between its findings and the reallocation required for transition to net zero.

Another monetary policy strategy consideration relates to the trend equilibrium real interest rate. As discussed in Section 3, this can act as a long-run guide to monetary policy. To the extent that climate change affects the trend real rate, we would expect this to influence the medium to long-run path the MPC set for Bank Rate. Therefore, it would be important for central banks to monitor and understand possible changes in the trend equilibrium real interest rate.

More generally, there are many open questions and further research and analysis is required to help guide policymakers to achieving their mandates for price stability in the face of the challenges posed by climate transition and physical risks.

Possible changes in the transmission mechanism of monetary policy

Monetary policy affects the economy via the so-called ‘monetary transmission mechanism.’ This can be thought of as a set of channels through which changes in Bank Rate or the stock of asset purchases ultimately affect inflation. The nature of the monetary transmission mechanism is ultimately determined by the structure of the economy – how production is organised, the structure of capital and labour markets, the economy’s interaction with the rest of the world, and so on.

As discussed above, it is likely that climate change and its mitigation policies will result in structural changes to the UK and world economies. These in turn would have implications for the monetary transmission mechanism. Monetary policy works largely via the impact of interest rates on aggregate demand in the economy. In particular, policy rates work their way into spending, saving and investment decisions through several of channels, including market interest rates, asset prices, credit supply, expectations and exchange rates.^{footnote [15]}

One of the channels runs through market interest rates. Interest rates in the broader economy are affected when the MPC make changes to Bank Rate, as Bank Rate serves as the benchmark interest rate for the broader economy. When market interest rates change, they alter firms’ and households’ incentives to save or invest, which in turn directly affects aggregate demand in the economy. The market interest rate channel could be affected by climate change, for example if households increased saving and firms delayed investments during the transition in response to uncertainty about the nature and the timing of the structural transformation (see Section 2). Such behaviours could reduce the sensitivity of aggregate demand to interest rate movements.

Another channel through which monetary policy operates is via asset prices. Particularly if there is a ‘delayed adjustment’ rather than a smooth transition to net zero, there could be sharp revaluations of a wide range of assets in the economy. This could be triggered by a sudden shift in government policy or an extreme weather event. Such asset revaluations could affect the value of firms’ and households’ collateral, changing their ability to borrow. Asset revaluations may affect the capital and liquidity positions of banks and financial intermediaries, which may also affect their ability to lend to the wider economy.

Understanding how such changes in the structure of the economy may affect the monetary transmission mechanism is important for understanding the implications of climate change for monetary policy, as emphasised by the NGFS (2020) and ECB (2021).

Key takeaways

• Climate change may involve new sources of trade-offs for monetary policy. For instance, the relative price shocks associated with the transition to net zero may exert a generalised and persistent effect on inflation, making it different from the average shock that the MPC has faced in the past.
• By leading to structural changes in the economy, climate change may also alter the channels through which the instruments of monetary policy affect inflation and economic activity.

5: Conclusion

Monetary policy clearly cannot solve climate change, but climate change may have macroeconomic implications that could be relevant for monetary policy makers.

In some sense, climate change comprises another set of economic shocks and structural changes for monetary policy makers to assess and monitor in order to achieve the inflation target. However, climate change presents new challenges to monetary policy makers in a number of respects, including its global dimension, its very long time horizon and the degree of uncertainty about both climate policy and how economic agents will respond. That is particularly so given the non-linear nature of climate change leading to irreversible effects (‘tipping points’).

It is too early to tell the potential impact of climate change on the economy. Many of the effects will only become clear over time. That applies both to the manifestations of climate change and the evolution of official policies to mitigate it, including via regulation and economic incentives to reduce carbon intensive activity. It is for governments to set out a pathway to net zero and the policy levers that will be used to deliver it; while monetary policy cannot solve climate change, monetary policy makers need to monitor and understand its macroeconomic implications in order to achieve the inflation target.

Different pathways to net zero will involve different mixes of taxation, subsidies, regulation etc. In some transition scenarios, the price of carbon (whether set via a tax or other means) rises significantly, steadily and over a multi-year period. That may push up on aggregate inflation, other things equal, requiring a tighter stance of monetary policy to achieve the 2% inflation target. The scale of the impact on investment, including in new technologies, and on the capital stock, as some less energy-efficient capital depreciates, is uncertain. As a result, there are different possible paths for the long-term equilibrium interest rate. A credible path for future policy for the transition is vital to reduce uncertainty and enable economic agents to react smoothly and appropriately.

In response to macroeconomic developments in the UK, including spillovers from the rest of the world, the MPC adjusts its policy instruments in order to meet the HM Government’s 2% inflation target and, subject to that, to support the economic policy of the Government, including its objectives for growth and employment. Further analysis, research and monitoring will be needed to assess how climate change and the transition to net zero will impact the macroeconomy and what that might mean for monetary policy.

Annex

• Glossary

  Adaptation policies – Policies designed to prevent or minimise the anticipated adverse effects of climate change. 

  Business Insights and Conditions Survey (BICS) survey – A survey that asks businesses from various industrial sectors and regions in the UK, run by the Office for National Statistics.  

  Capital – One of the factors of production used by firms, including tangible assets – such as plant or machinery – and intangible assets – such as software and knowledge. In equilibrium, these assets act as a store of wealth for households.

  Carbon pricing – Various schemes that ensure emitters of greenhouse gases pay for each tonne of their carbon-equivalent emissions. 

  Climate Biennial Exploratory Scenario (CBES) – Illustrations of possible paths for climate policy and global warming (not forecasts), and ran by the Bank of England to explore the effects of climate risk in the largest UK banks and insurers.

  Collateral constraints – Refers to the effect that housing wealth as collateral has on the relationship between housing prices and economic activity. For instance, in periods where house prices increase, the value of collateral increases as well, leading to higher household borrowing, which boosts consumption.

  Corporate shares and bonds – Sources of funding typically used by firms to finance investment into capital, which pay a return either through dividends (shares) or interest payments (bonds). In the standard framework, households are the ultimate holders of all shares and bonds, either directly or indirectly through deposits with a financial intermediary that invests in the firm.

  Decision Maker Panel (DMP) survey – A survey that asks small to large private sector businesses across all industries, run by the Bank of England, Stanford University and the University of Nottingham.

  Downward wage rigidities – Resistance against a reduction in wages when a negative/adverse economic event takes place.

  Emissions Trading Scheme – An example of a ‘cap-and-trade’ scheme, where a limit is set on quantity of the total greenhouse gas emissions, which ‘permits’ are then traded in a market.

  Equilibrium real interest rate – The interest rate, adjusted to remove the effect of inflation, that brings the actual output level of the economy in line with its potential and sustains inflation at target. Over the long run, this fluctuates around a global trend component, referred to as global R*.

  Forward guidance – A monetary policy tool that works by providing information about the likely path or behaviour of monetary policy in the future, based on its current assessment of the outlook for the economy and inflation.

  Global value chains (GVCs) – The linkages of firms that source intermediate inputs for production from firms in another country.

  Government bonds – Bonds issued by governments to finance any expenditure in excess of revenue. As with capital, the households buy these bonds as a store of wealth. Government bonds are considered to be safe assets, which pay a certain return with no risk.

  Gross Value Added (GVA) – The value generated by any economic unit engaged in the production of goods and services, which is one measure of economic activity.

  Human capital – Measures the economic value of intangible assets such as knowledge or experience.

  Intergovernmental Panel on Climate Change (IPCC) – The United Nations body for assessing the science related to climate change.

  Intermediate inputs of production – Intermediate goods and services, such as energy, and raw materials, are used as inputs in the manufacturing process of other goods and services.

  Labour force – The number of working age people, both employed and unemployed, who are currently willing and able to work.

  Mitigation policies – Policies designed to lessen the impacts of climate change by preventing or reducing the emission of greenhouse gases.

  Network of central banks and supervisors for Greening the Financial System (NGFS) – A group of central banks and supervisors willing, on a voluntary basis, to share best practices and contribute to the development of environment and climate risk management in the financial sector and to mobilise finance to support the transition toward a sustainable economy. 

  Net zero – When greenhouse gas emissions are cut as close to zero as possible, with any remaining emissions reabsorbed from the atmosphere.

  Potential output – The level of output consistent with keeping inflation on target over a long horizon.

  Price stability – Low and stable inflation.

  Productivity – Measures how effectively the inputs of production are used in order to manufacture a given level of output.

  Relative price shock – An unexpected change in the price of one or more goods and or services compared with the price of other good and or services. For example, an unexpected change in the price of commodities relative to the price of other goods and services in the economy.

  Risk premium – The excess return on a risky asset over and above the return on risk-free assets, which compensates the holder for risk or volatility in the return of the former.

  Solvency position – A characterisation of a firm’s ability to meet its long-term debts and other financial obligations.

  Transmission mechanism/monetary policy transmission – The way in which changes in monetary policy flow through to the real economy and inflation.

  Trend equilibrium real rate – The global trend component of the equilibrium real interest rate (see Bailey (2022)), also known as global R*.