Two big events for the markets marked the end of 2021: First, COP26 was held in Glasgow in November. It shone a light on sustainability issues and how the world would respond to the drive towards net zero in the coming years.
There was also the return of inflation. For the last decade inflation has kept a low profile – supressed by a combination of slow economic growth and, arguably, financially repressive central bank policies. A post-pandemic economic resurgence, global supply chain issues and a shortage of workers in certain sectors have all started to put upwards pressure on prices.
So it’s no surprise that the two themes we think will have a big influence on the world of investment this year are climate transition and inflation. But how do the two interlink? And could the push towards net zero and the control of inflation be in conflict? Maybe.
At first glance, the shift to net zero could be interpreted or viewed as inflationary. For example, reduced supply of fossil fuels will inevitably mean higher prices. A scramble for transition commodities like nickel and zinc will mean higher prices too. And if a carbon price – the measure of the external cost of greenhouse gas emissions – ever happens, this could also lead to prices being pushed higher.
But there are three reasons why a shift towards lower carbon targets might not mean higher prices and why we think net zero isn’t necessarily inflationary.
Cost declines matter
The argument here is subtle. All else being equal, the cost of producing fossil fuels is likely to grow over time. This is because production generally moves from the cheapest, easiest-to-extract sources first to the more expensive ones later as resources dwindle. So prices of fossil fuels will invariably climb, correlated to the cost of extracting them.
By contrast, once installed, renewable energy never runs out. This means producers do not have to keep looking for new, more expensive sources. As such, renewable energy costs may well fall over time, rather than rise. Indeed, the cost of production in renewable energy has been in steep decline in recent years, largely due to technological improvements. This is also disinflationary, as is the widespread adoption of digital goods which often have zero price. Similar trends may be at play for other net zero technologies, such as electric vehicles (EVs). Battery pack prices for EVs fell by about 90% from 2010 to 2019 and the evidence suggests this trend is likely to continue.
Higher prices vs inflation
There is a distinction between higher prices and inflation. A world of higher energy prices does not necessarily mean higher inflation. Inflation is a climb in price levels and a fall in the purchasing power of money. Fossil fuel energy may get more expensive but that does not imply that energy prices will continue to rise year on year.
It is also important to distinguish between prices in the basket of goods and the price of the whole basket. If energy does become more expensive over time, other goods and services could become cheaper, keeping overall inflation steady.
Inflation may fall after the introduction of a carbon price because higher energy prices reduce the prices of goods and services that require a lot of energy consumption. Take cars – if petrol prices were to double, lots of people might think twice about buying another car. Therefore, demand for cars would decline, which would reduce the price of cars.
Consumer behaviour
Consumer choice will affect whether the world hits net zero. In a growing number of countries in the west, travelling by air is perceived as something to feel guilty about, while second-hand clothes and electronic goods are becoming commonplace – people are thinking twice before using items and throwing away and want products to last. Said differently, there is evidence the economy is becoming more ‘circular’ – the move towards reusing, repairing and recycling. So perhaps the world is entering a new phase of lower consumer spending as more people recognise overconsumption is environmentally destructive. That should exert some downward pressure on inflation because the economy’s supply side will be plentiful relative to demand.
The net-zero transition is an exciting opportunity to own companies that are helping the world to decarbonise. Many of these companies are expanding quickly, providing some interesting opportunities for growth investors looking to invest in businesses that are expected to grow faster than the overall economy, other industry segments or their competitors. This is helpful in an environment of higher prices.
Whether inflation continues to spiral remains to be seen, but we don’t necessarily think the move towards net zero will add to any long-term inflationary pressure. In fact, it might influence it in the right direction. So net zero could be good for the planet and be financially beneficial for consumers too.
Patrick Thomas is investment director and head of ESG investing at Canaccord Genuity Wealth Management and editorial panellist for ESG Clarity
