Energy Inflation: Understanding Climateflation, Fossilflation, and Greenflation

Written by Aldo Raventio Adam

The acceleration of the renewable energy transition has become an urgent necessity given the increasingly evident threat of the climate crisis. In response to this challenge, German Finance Minister Christian Lindner recently referred to renewable energy as "Freedom Energies" illustrating humanity's liberation from the use of fossil fuels. This acceleration makes investment in renewable energy technologies a crucial step towards creating a sustainable future.

A study on the Levelized Cost of Electricity (LCOE) in Germany predicted that by 2030, the cost of electricity from PV-battery systems would be more economical than combined cycle gas turbines (CCGT). By 2040, the LCOE for small-scale (home) PV-battery systems is expected to range between €3.58 and €6.77 per kWh, which is below the €9 per kWh for CCGT. With the projected downward trend in renewable energy costs, every solar panel installed, every hydroelectric power plant built, and every wind turbine added to the grid brings us closer to energy independence and a greener economy.

However, this article will not focus on the success of renewable energy transition in replacing fossil fuels, but rather on the "cost" of these Freedom Energies. Transitioning to this new state does not come for free; there is a price to pay for switching to greener energy. As we build a more sustainable economy, we will face a new era of energy inflation with three distinct but interrelated shocks: climateflation, fossilflation, and greenflation. These three types of energy inflation need to be considered as they can lead to prolonged periods of inflationary pressure.

Climateflation

According to a speech by Isabel Schnabel, a member of the ECB Executive Board, "climateflation" refers to the direct effect of climate change on price levels through the impact of physical damage to infrastructure and goods production. Using natural disasters as an example, Schnabel explains that extreme weather events have destructive effects on physical infrastructure and agricultural crops, leading to reduced availability of goods and infrastructure, or even potential loss of life. In economic terms, when the amount of infrastructure and goods available for sale decreases, prices rise, causing inflation. This type of inflation, resulting from the direct effects of climate change, is referred to as Climate Inflation.

The rising trend of environmental damage due to climate change is evidenced by various reports from international organizations revealing the extent of climate inflation that has occurred. In a 2018 report, the OECD cited estimates that the annual global damage from urban flooding reached $120 billion. Research published in the journal Nature estimates current annual global damage from tropical cyclones at $26 billion. In November 2022, the World Economic Forum reported that economic damage from drought increased by 63% in 2021 compared to the 20-year average, citing research from the World Meteorological Organization (WMO).

Fossilflation

The second type of inflation is "fossilflation," which reflects the legacy costs of reliance on fossil fuel energy sources, which have not been sufficiently reduced over the past decades. The need for private companies and governments to meet their commitments to net-zero temperature increases by 2050 will force them to shift investments from fossil fuels to renewable energy and electrification. When this happens, fossil fuel production should decline, which, if not matched by a decrease in demand, will cause prices to rise.

As noted by James Luke, Malcolm Melville, and Dravasp Jhabvala from Schroders, "the fact that climate mitigation policies increase demand for commodities like copper and nickel is already well known and receives much attention. However, the impact on the supply side changes is arguably greater and affects various commodities. The focus of producers, governments, and investors on supporting strategies consistent with policies to reduce climate change impacts and achieve these goals directly limits investment in new supply growth for fossil fuels and metals." (cited from: NordSip)

In 2019, the European Central Bank (ECB) stated that petroleum products and natural gas still accounted for 85% of total energy use in Europe. The interaction between fuel prices and product prices over the past year shows how strong the grip of fossil fuels is on the economy.

However, broader estimates of the causes of excessive gas and oil price increases above pre-pandemic levels indicate the ability of energy producers to regulate supply in oligopolistic markets. "Oil and gas markets are often deliberately kept tight, pushing up prices at the expense of energy importers like the euro area," said Schnabel.

To exit fossilflation, a shift towards more electricity usage powered by renewable energy (solar, wind, etc.) for driving cars, homes, and businesses is necessary. Reducing dependence on fossil fuels will significantly lessen their influence on overall economic inflation. It is still too early to conclusively argue the extent to which the energy transition causes fuel price increases. Whether through carbon taxes, emission quotas, and trading rights, or through reduced investment, it seems the energy transition will indeed play a significant role in future price increases.

Greenflation

The third type of inflation is 'greenflation' or ‘green inflation,’ referring to price increases that occur when conventional cost inflation is exacerbated by the costs of transitioning to green energy. Expecting that a task as large and complex as the energy transition can be accomplished without causing dislocation is unrealistic. This is primarily due to the large amounts of commodities required to increase clean energy production. 

For example, building a 100-megawatt wind farm requires 30,000 tons of iron ore, 50,000 tons of concrete, and 900 tons of non-recyclable plastic. Meanwhile, lithium-ion batteries in most electric vehicles (EVs) require about 25 pounds of lithium and 30 pounds of cobalt, as well as amounts of nickel, copper, graphite, steel, and aluminum. According to the International Energy Agency, the number of EVs is expected to increase to 145 million by 2030, from 11 million today. Nonetheless, this number is just a fraction of the approximately 1.2 billion combustion engine vehicles currently on the roads, so the demand for batteries will remain high for years to come.

The question then becomes how policymakers, particularly in Indonesia, should react to greenflation. If greenflation proves persistent, as it seems likely to be, and begins to affect inputs across the economy (such as wage levels), then monetary policy needs to be tightened to restore price stability. If we look at the US Federal Reserve, they recently indicated there would be at least six interest rate hikes during 2022, the first of which was a quarter percentage point increase announced on March 16, with markets expecting more.

The problem is that interest rate increases can create tension between the central bank (BI) and the government, which is under pressure to increase spending to drive recovery from the pandemic, compensate households (especially the poor) for rising prices, and, of course, finance the energy transition. There is no easy solution, as combating climate change and protecting people's living standards are both crucial, but prioritizing one seems to hinder the other.

One potential way is to focus not only on decarbonizing supply (the power grid, transportation, and industry) but also on decarbonizing demand. In other words, reducing the amount of carbon we generate by changing how we travel, eat, and live. This too has significant social and ethical implications, though some of these can be addressed through social spending funded by, for example, higher carbon taxes. Ultimately, in terms of the energy transition, there is no free lunch – and greenflation today is just the first example.

To conclude the discussion and highlight the distinct differences between greenflation, fossilflation, and climateflation, the image below effectively illustrates the key distinctions between these three types of energy inflation.