Climate policy and monetary policy: interactions and implications - speech by Catherine L. Mann

Speech

The effects of climate change and climate mitigation policies have become an actively debated topic in macroeconomic and central bank circles over the last few years.^{footnote [1]} Some central banks now have references to supporting government climate change policies within the secondary objectives of their remits, including the Bank of England.^{footnote [2]} Not everyone agrees on what role central banks should play in achieving climate change objectives.

To me, one thing is clear: When climate change has macroeconomic effects – whether physical impacts from extreme weather events and higher average temperatures or transition effects associated with transforming to a net zero economy, including explicit implications for inflation – it becomes a concern for monetary policymakers, directly within a price stability mandate. That applies whether the monetary policymaker’s remit includes a reference to climate change or not.

The Bank of England has been a leader on raising awareness of the risks that climate change presents for economies, beginning with former Governor Mark Carney’s 2015 speech “Breaking the Tragedy of the Horizon”. Since then, much work has focused on the impact on financial stability, financial sector risks, and financial policy from climate change.

Today I want to focus on a topic that has received less attention: The consequences for monetary policy of the pathway to net zero. There are two dimensions: First, the implications for monetary policy of the macroeconomic effects of climate change itself. Second, more nuanced but perhaps more novel, the monetary policy implications of climate mitigation policies. Despite net zero being a long-term target, both of these are also relevant over my monetary policy horizon.

Is the climate change-monetary policy nexus something new facing central bankers? One could argue that macroeconomic changes from shocks, structural changes in the economy, and various government policies are what central banks face all the time. What is different about climate shocks, transformation, and policies? First, it is the global nature of the challenge along with specific policy approaches, which may cause unanticipated international spillovers. Second, climate change and mitigation policies have the potential to change how once-familiar shocks, for instance demand shocks or monetary policy itself, transmit through the economy. And finally, it is the long-term horizon of these effects, even if the monetary policy horizon is only short-term (some 2-3 years).

This latter point is all the more important in the light of the time-inconsistency problem of policy (Hovi et al., 2009). From climate science we know that shocks and structural change will happen. From political pledges and commitments to net zero we know that policies are being deployed. What we don’t know is when the changes will occur, how they might manifest, and what difference policies might make. In particular, there are uncertainties relating to the timing, coverage, and types of policies national governments and international organisations might implement. All economies will be subject to the impacts of climate change in various ways, and as a small open economy, the UK’s macroeconomic environment will be affected by the spillovers of climate mitigation policies set abroad, particularly by its largest trading partners.

As economists, we can categorize the economic effects of the climate and policy nexus into lower-frequency (‘trend’) and higher-frequency (‘cycle’) effects. ^{footnote [3]} These have analogues in other areas of macroeconomics such as demographics, employment and labour market variables, or total factor productivity, investment, and the supply capacity of an economy, as well as the trend in interest rates. The boundaries between trend and cycle are not bright, but this is a familiar, if vexing, challenge facing central bankers. It would be impossible to cover all aspects of the climate policy-monetary policy nexus in just one speech, so today I would like to focus on the more short-term cyclical effects of climate mitigation policies.^{footnote [4]}

We all are hopeful that the world rises to the challenge of limiting global warming to well below 2 degrees, as agreed in the Paris Agreement. From a monetary policy perspective, it is important to recognise that there is no “no climate change” scenario to fall back on. It is not a “if we do nothing, it is business as usual”, particularly as familiar shocks may transmit differently under different climate policies – already now. More research is essential, so that monetary policymakers can update their toolkit and econometric models to better understand, analyse, and model the risks and policies, as well as what might be the appropriate monetary policy response.

I am not arguing that every climate event will require monetary policy action, but as a monetary policymaker it is my job to be forward-looking, to monitor and make an informed decision about how all this affects inflation at my 3-year policy horizon in order to achieve the 2% inflation target sustainably in the medium-term. Not only is it within my remit to respond to the macroeconomic effects of climate change, but, in my view, my remit requires me to do so.

The mechanics of climate mitigation policies

As it is probably already clear, I come to the study of climate change not from the environmental science perspective, but as an economist, and international economist. In economics, the climate problem presents as the classic example of market failure where social value and private value differ. The market fails because a market is missing, specifically in the climate case, the market for emissions. Various policy interventions are designed to create the missing market that will send price signals to consumers and businesses to elicit changed behaviours that reduce emissions.

In the past, emissions have been practically costless, and have thus been over-produced from a societal welfare perspective. Emissions have negative external effects which are borne mainly not by those emitting, but by third parties, future generations, different social classes, and different parts of the world (Stern, 2008). One direct approach to completing the market is to put a price on emissions that forces emitters to internalise the social and environmental costs of their emissions (the externality). The cost of emissions is then borne directly by producers, presumably to be passed on fully or in part to consumers, which prompts the behavioural change needed to reduce emissions. Consumers themselves can demand products and services with a lower carbon footprint, thus raising their prices at least initially, which induces firms to invest in these less-emissions-intensive products. This sounds easy, “Just put a price on carbon to ‘complete the market’”, but in practice, of course, it is not.

In reality, governmental authorities are deploying different types of policies to create the missing market and guide the transition to net zero: Market-based incentives include putting a price on carbon^{footnote [5]} via carbon taxes, via an emissions trading system (ETS), or via a border carbon adjustment (BCA); subsidies can promote ‘green’ investment (reducing the price of lower-emissions products) relative to emissions-intensive investment or incentivise consumption of lower-carbon-footprint products (e.g. electric vehicles). There are also non-market-based climate policies and regulation that range from bans on fossil fuels to limits on emissions, as well as direct government investment, for instance into green R&D.

There are many different reasons why governments may choose one or the other policy, and most choose a combination considering for instance cost effectiveness, effectiveness in reducing emissions, equity considerations, domestic employment objectives, and trade-offs among all of these. Such broad-ranging fiscal and regulatory policy design is outside the scope of most monetary policymakers’ remit. However, the research highlighted in this speech will show various channels through which climate policy strategies, at home and abroad, affect macroeconomic variables key to central bank decision-making: specifically inflation and economic activity.

In the rest of this section, I plan to give an overview of global carbon pricing coverage, followed by a simple theoretical discussion on how carbon taxes and ETS work, drawing on an analogy to quotas and tariffs from international trade. Before moving to the research section on the evidence of macroeconomic effects of climate change policies, I will briefly discuss the recent UK energy price experience.

Global carbon pricing coverage

Chart 1 shows that just under a quarter of global greenhouse gas (GHG) emissions are currently covered by some form of carbon pricing mechanism, dominated largely by ETS in the last few years. I consider this a lower bound estimate however, as the data only captures the coverage of the policy as designed on introduction. So bars increase when more countries introduce a carbon tax or ETS respectively, but not when the industry coverage of an existing programme is expanded (adding more sectors for instance), or the tax is increased. And of course, stringency is expected to increase over time to be consistent with a net zero economy.

Chart 1: Share of global greenhouse gases covered by ETS and carbon taxes^{footnote [6]}

As market-based mechanisms, the ETS and carbon tax are often viewed as isomorphic with respect to the signals they send, even as one is a quantity-based mechanism and the other a price-based mechanism. Because these are popular policies to complete the market for carbon, I am going to spend a few minutes walking through the economics of these two instruments.

Then I would like to consider these mechanisms from my standpoint as an economist more familiar with tariffs and quotas on international trade. To me, the ETS looks like an import quota and the carbon tax looks like an import tariff, and these are not isomorphic given perturbations to demand (see Dunn and Mutti, 2004). As quantitative research presented later shows, demand shocks, say coming from monetary policy decisions, have different implications for prices and activity (at home and abroad), depending on the emissions mechanism.

Carbon tax vs. ETS and the market for emissions

A carbon tax fixes the price of emissions, which increases the marginal cost of production to those industries on which the tax is levied, typically energy-intensive sectors. Under a carbon tax, the price of carbon is determined directly by the policymaker, rather than by the supply and demand for emissions, generating smaller price fluctuations.

An ETS, on the other hand, is based on a ‘cap-and-trade’ principle, where the government issues a fixed supply of permits for companies to emit harmful greenhouse gases. Permits can be traded on a secondary market, which consists of the sale of permits by those firms that do not require their full emissions allowance. A government creates price incentives by regulating the quantity of emissions permitted and making them scarce: firms that emit more need to pay for additional emissions, and those that emit less are rewarded with the ability to sell their extra permits.^{footnote [7]}

As a quantity-based instrument, the ETS fixes the quantity of emissions by fixing the maximum supply of permits. The price of emissions then varies depending on the demand for emissions. As the supply of permits is reduced by the governmental authority, the price per permit (i.e. the cost per unit of emissions) rises. In the short-run, higher permit costs raise firms’ marginal costs of production, which may reduce firms’ profits, or which may be passed along to the consumer, raising the price of energy-intensive products. In either case, in the short-run, prices rise, and output and the demand for permits falls (moving along the demand curve). In the longer-term, the most energy-intensive firms are less competitive vis-à-vis firms with less emissions-intensive production or products. This change in the relative price of goods and services might mean that the carbon-intensive producer exits the market, or it encourages firms to invest into lower emissions production as consumers’ behaviour shifts toward less energy-intensive producers and products. Either way, ultimately demand for permits shifts downward.

So, is there any difference between carbon taxes and ETS? I’ll illustrate using the international trade example, discussed below.

Climate policies from an international economist’s perspective

To see the differences between carbon taxes and ETS and their analogy to tariffs and quotas, consider first the market for emissions, which I have illustrated in Chart 2. What follows is a very stylized exploration of the economic effects of climate policies. It abstracts from any time dimension and from any anticipation effects or behavioural change (factors that are addressed in the empirical work cited later). This simple presentation builds the intuition for the research later on.

To presage the outcome, although these charts look like simple supply and demand curves, the interaction of climate policies, emission markets, and macroeconomic outcomes are not so simple at all.

Let me build up the charts line by line. There exists an optimal supply schedule for carbon emissions, denoted by the upward-sloping supply of emissions line, in orange, which is the same in both the tariff (i.e. carbon tax) and the quota (i.e. ETS) setting. It reflects the fact that a high level of emissions implies large social costs.^{footnote [8]} Demand for emissions is denoted by the downward-sloping, aqua line. At the intersection of the two we find the socially optimal level of emissions (Q_opt) and its associated optimal price (P_opt).

Due to the market failure, however, pre-policy intervention, emissions are under-priced. Market participants don’t internalise the social cost of emissions, leading to a flat supply schedule at P₀, at which emissions are over-produced.

Chart 2: Tariff vs quotas with perturbations of demand

Tariffs (LHS) and quotas (RHS)

Focusing on the carbon tax policy (left-hand side): A carbon tax shifts the flat supply curve up (in green), by fixing the price per unit of emission at a particular level P_T. This also reduces the quantity of emissions produced. Now picture any form of shock to the demand for emissions (denoted by the dotted aqua lines). As for tariffs, the price of emissions stays fixed, no matter in which direction, and by how much demand shifts, causing variation only in the quantity of emissions. The policymaker will have to set P_T such that, in expectation, it is consistent with the optimal quantity of emissions. Actual, realised emissions can, however, be higher or lower than the social optimum.

Moving to the ETS policy (right-hand side): An ETS caps the quantity of emissions, denoted by the vertical lines. If the quantity of emissions permits is more than, or equal to, the pre-intervention level of emissions, as in the dashed gold line, emissions remain at P₀ (absent anticipation effects). But if the cap is binding, as in the green line, the price of emissions rises. In a static world we can recreate the tax- or tariff-equivalent price P_T and its associated quantity. But again, imagine a case where the demand for emissions fluctuates (denoted by the dotted aqua lines). The intersection of the binding supply constraint in green, and the new demand curve causes the price for emissions to rise, while the quantity of emissions remains the same.^{footnote [9]}

What this stylised theoretical chart helps to show is that, on the market for emissions, a carbon tax fixes the price of emissions, and lets quantities adjust in response to demand fluctuations. Under the ETS, it is the opposite, where the quantity of emissions is fixed by the policy, and prices adjust in response to demand.

For now, these examples are about costs of production and the price of emissions. But as a central banker, I am ultimately interested in the implications for aggregate prices and aggregate output. In these stylized examples, in the short-run, before any demand response reduces emissions, carbon abatement strategies lead to an increase in prices and a reduction in output, reflecting a combination of higher marginal costs of firms and behavioral signals to consumers. In the longer term, the emissions price and its contribution to the overall price level will depend on a variety of factors, but ultimately boils down to the relative size of the shift in supply (determined by the quantity of permits supplied by the governmental authority) and the shift in demand (determined by how effective the policy is in shifting preferences and capital flows to ‘greener’ alternatives of production and products).

Now, keeping in mind that any carbon price increases marginal costs to production, Chart 3 maps the effects of carbon taxes and ETS into an aggregate demand and aggregate supply (AD-AS) framework, and talks through a thought experiment on how perturbations of demand affect the price level and output.

Chart 3: AD-AS effects of carbon pricing

Carbon taxes (LHS) and ETS (RHS)

First, focus only on the solid aqua and orange lines, which represent the post-carbon price introduction equilibrium, which we assume is identical for both the tax and the ETS.

For the carbon tax (left-hand side panel), an expansionary demand shock causes the AD curve to shift outwards (denoted by the top-most dotted aqua line), such that output and the price level rise in the short-run. Contractionary demand shocks, on the other hand, cause the demand curve to shift inward (lower dotted aqua line) and output and prices fall. So, under a carbon tax, demand fluctuations lead to proportional fluctuations in output and prices, in the same direction as the shock.

Moving to the ETS (right hand side panel). This is a more complex story; so I will focus only on the contractionary demand shock. The AD curve shifts inwards to the aqua dotted line by the same amount as in the carbon tax example. This time, however, we don’t just move along the solid orange AS line to a new equilibrium with a lower price and lower output. This time, we see a shift outward in the AS curve. Why? As we derived above, the ETS price moves with the demand for emissions permits and is thus pro-cyclical. In other words, in the face of an adverse aggregate demand shock, firms produce less, reducing their demand for emissions permits, which pushes down on the carbon price, reduces firms’ marginal cost, and thus shifts the AS curve out.

As a result, the aggregate price level changes by more than under the tax, but the output response is attenuated. If we compare the different equilibrium outcomes between a small AS shift (to the dotted orange line) compared to a large AS shift (to the dashed orange line), we see that output need not even fall. Both involve a reduction in the price level, but one implies a fall, and the other a rise in output relative to the previous equilibrium Y_n. So while a contractionary demand shock reduces the price level, the effect on output is ambiguous and depends on the relative size of the AD and AS shifts. All we know is that the possible ETS equilibria lie to the southeast of the tax equilibria for a contractionary demand shock (and to the northwest for an expansionary one).

To conclude on this little exercise, while carbon taxes and ETS can be made to look the same in the simplest examples, as soon as we allow for demand perturbations or demand shocks, they imply different reactions of macroeconomic aggregates. A crucial point is that the climate policy choice has the potential to change the way ‘traditional’ shocks are transmitted through the economy. As climate policies are deployed and ‘bite’, it will be increasingly important that these changes be reflected in the aggregate multipliers embodied, for example, in our forecasting toolkit.

There are other climate mitigation policies too

I have focused so far on carbon pricing, but of course subsidies are also in the portfolio of climate policies. In an effort to accelerate the transition to net zero, this policy option has received quite a bit of attention recently, with the announcement of the US Inflation Reduction Act (IRA)^{footnote [10]} and the Next Generation EU package.^{footnote [11]} Against the backdrop of subsidies to promote carbon friendly production and consumption, it is important to note that last year, direct and indirect subsidies worth 7% of global GDP were spent on fossil fuels such as oil, coal and natural gas.^{footnote [12]} So thinking about the macroeconomic effects of subsidies should include both the introduction of new, climate-specific subsidies, and also the elimination of fossil fuel subsidies.

In principle, the effects of climate-related subsidies should be familiar. Economists have studied the effects of subsidies for decades and climate-related subsidies come with caveats and side effects of other subsidies: such as allowing the policymaker to ‘pick winners’ in the transition, as well as potentially causing an inefficient allocation of resources (WTO, 2006). But given well-defined objectives, governments may implement subsidies to promote investment and innovation by lowering the cost of capital for low-carbon investments or by subsidising households directly to shift preferences towards greener consumption. To the extent that increased real and financial investment are key to finance and facilitate a transition to net zero, subsidies may be used in conjunction with carbon pricing policies to complete markets or address externalities, such as for innovation or public infrastructures.^{footnote [13]}

On the effect of subsidies on the macroeconomy, the announcement of the IRA has already had a large impact, for instance on the US construction industry.^{footnote [14]} Many parts of the IRA support construction by directing funds towards the construction of renewable energy infrastructure, tax credits for the construction of energy efficient homes, and greener construction materials, amongst other things. Chart 4 shows the equity price performance of the construction industry relative to that of the whole market. Anything above the 0 line therefore denotes an outperformance of the construction industry. The US construction industry has outperformed both the US equity market, but also construction industries in the UK and EA quite considerably. While this is a point about correlation rather than causation, expected future earnings for construction firms also has increased notably since the introduction of the IRA. This subsidy scheme has already brought about macroeconomic effects, corroborated also by realized spending data in the US, including in other sectors such as power generation (Zhang, 2023).

Chart 4: Equity price performance of construction relative to the market

Relative performance of sectoral “construction” equity index, to the headline index, for the UK, US and EA

Abstracting from the macroeconomic effects, subsidies can be challenging for governments to enforce from a geopolitical standpoint, because they are viewed (rightly or not) to unfairly advantage domestic firms in international competition, which may lead to what has been coined as a “green subsidy war”. This, among other reasons, is why I would like to speak a bit more about the macroeconomic effects of spillovers of climate mitigation policies, and their impact on trade.

Cross-border differences in strategies to price emissions likely will yield differences in emissions costs and product prices, with implications for international competitiveness of producers and products. Producers and consumers choosing the location and products with a greater supply of permits or lower carbon taxes also will contribute to so-called ‘carbon leakage’^{footnote [15]}, and less of a reduction in carbon emissions than intended by the domestic policies.

To avoid these outcomes, Border Carbon Adjustments (BCAs) could ensure that incoming products bear the same carbon cost as domestically produced products, by imposing a tariff. One example is the EU’s Carbon Border Adjustment Mechanism (CBAM), which the EU has implemented in a transitional phase from 1 October 2023.^{footnote [16]} Exporters to the EU will have to purchase emissions allowances at the prevailing price, which would equate the carbon cost between domestic and foreign producers (Böning et al., 2023). The impact is hard to gauge because it is highly dependent on the design of the policy. But, in general, cutting off cheaper (and in this case more carbon-intensive) imports would be inflationary in the short-term, via raising import prices. But, in the longer-term would augment the important price signals to consumers to buy greener products and producers to invest in greener technologies, both domestically and abroad (Clausing and Wolfram, 2023).

Ultimately, climate policy is likely to be a mix of different instruments: price-based instruments (carbon tax), quantity-based instruments (ETS), subsidies, and regulation. How revenues (from auctioned permits or taxes) are redistributed or subsidies financed is key for macroeconomic outcomes.^{footnote [17]} More research is required to understand how policies may interact, and the macroeconomic consequences thereof.^{footnote [18]}

How important are energy prices anyway to central banks?

To summarize so far on the key topic of how climate mitigation policies might affect inflation rates and price volatility, since these are of direct concern to me as a monetary policymaker with the remit of price stability:

1. In the short-term (which I would say is within the monetary policy horizon), binding carbon pricing instruments raise carbon prices, and if there are no revenues to redistribute, will reduce output of carbon-intensive products.
2. In the longer-term (which is relevant to the monetary policy terminal rate), price signals induced by the carbon instruments would induce greener investments and reduce consumption of carbon-intensive products. The net effect on carbon prices depends on elasticities.^{footnote [19]}
3. If there are macroeconomic demand shocks, the quantity-based instruments would induce greater price volatility than would the price-based instruments.

But, given carbon pricing instruments only apply to a fraction of goods and services, are there significant macroeconomic effects that I need to consider in my policy horizon? The recent period of high inflation has shown us that a shock to or the permanent increase in the level of energy prices can have significant impacts not just on energy-intensive imported goods. As shown in Chart 5, shocks to widely-used intermediate goods can have pervasive and long-lasting effects across all other goods and sectors, as I have discussed before in several speeches.^{footnote [20]}

Chart 5: Contributions to annual consumer price inflation

In the current conjuncture, it is important to note that we experienced a shock specifically to fossil fuel energy prices (and after a set of other shocks). As long as the UK is reliant on fossil fuel energy, it will remain exposed to risk of further price shocks, which historically have been key drivers of very high inflation episodes (Tenreyro, 2023). Moving towards a greener mix for energy generation could in the end reduce the risk of these types of large shocks and their macroeconomic ramifications (Panetta, 2022).

The UK emissions policy and price experience

The UK implemented an ETS in 2021, replacing its past participation in the EU ETS. Chart 6 shows the evolution of the UK and EU ETS price since 2021. The chart shows a period of extreme energy price volatility associated with Russia’s invasion of Ukraine. But, ETS prices had been on an upward trend since the reopening after Covid over 2021 and most of 2022, with ETS prices roughly doubling.^{footnote [21]} However, that changed over 2023.

Chart 6: UK and EU Emissions Trading System spot and futures prices

The UK experience presents three striking observations. First is the shift in the UK forward curve from January (gold) to the latest (orange). The price at each point on the curve has nearly halved over this ten-month period. Second, since the start of 2023, we observe a stark reversal in the trend of UK ETS prices, such that the price has completely reversed the upward trend observed over 2021 and much of 2022. Finally, a large wedge between the UK and EU ETS price has opened up since mid-2022. These changes can be attributed at least in part to a less stringent evolution in emissions permits, and an associated fall in demand^{footnote [22]} for permits, also in anticipation of future reduced stringency, relative to expectations.^{footnote [23]} The data point to a dynamic of UK ETS prices that runs counter to the signals needed to achieve net zero. Large differences in UK ETS prices relative to the EU could also make UK exports to the EU subject to an import tariff under the CBAM in the future.

Uncertainty and volatility

Both the theoretical analysis as well as recent UK ETS price experiences have highlighted a role for uncertainty and volatility. As noted, the introduction of these policies themselves may introduce volatility. Price-based instruments such as carbon taxes create fluctuations in output, and quantity-based instruments such as an ETS create price fluctuations. In addition, there is added uncertainty about future changes to policy stringency that may further accentuate macroeconomic volatility.

From the literature on policy uncertainty, we know uncertainty reduces investment, consumption, and employment (Bloom, 2014; Jens, 2017) as it increases the so-called ‘option value of waiting’ (Dixit and Pindyck, 1994), with firms optimally deferring decisions in anticipation of some reduction in the future of policy uncertainty. My colleague Ben Broadbent gave a speech in 2019 on the relationship between investment and uncertainty, using the example of uncertainty around Brexit for firms.^{footnote [24]}

In the climate case in particular, there is an intertemporal externality associated with policy uncertainty and the decisions needed to get to net zero: For an individual firm, policy uncertainty increases the option value of waiting. So investments are not undertaken, and emissions continue unabated. But, for the environment, the longer we wait, the more costly the investments needed to limit global warming to 2 degrees, and the more damage that needs to be mitigated.

With enough theoretical underpinnings, I will now move to discuss how the literature has helped in quantifying these theoretical dynamics for output and inflation.

The macroeconomic effects of climate mitigation policies

A broad-based literature links the physical and transition impacts of climate change with macroeconomic outcomes and monetary policy choices. The Bank of England has been a leader in this research effort. It was one of the founding members of the ‘Network for Greening the Financial System’ (NGFS) – a group of now 127 members and 20 observers with a mix of central banks, regulatory authorities and supervisors – set up in 2017 to share analysis, best practice, and research on all matters related to climate. My colleague James Talbot chairs the NGFS workstream on Monetary Policy which is a cross-institutional effort to deepen understanding of how climate change and mitigation strategies should be considered in relation to the conduct of monetary policy.^{footnote [25]} Inside, one of the Bank of England’s priority topics on its Agenda for Research^{footnote [26]} in 2023 is research on the macroeconomic implications of climate change and policies to mitigate its impact. In short, the Bank is continuing its leadership and commitment to understanding the macroeconomic implications both of physical and transition impacts, and by extension, the implications for monetary policy (see also Bailey, 2021; Angeli et al., 2022).

The research agenda is vast, because in reality the policies and their effects are far more complex than in the stylised charts I just showed. Some research emphasizes empirical work, other more theoretical, each with advantages and disadvantages. On the empirical side, there is not much historical data to go on; as the stringency of policies increase, historical data is unlikely to be a good guide for the future, and non-linearities might be particularly relevant. For the theoretical modelling approaches, as is often the challenge, results tend to be sensitive to the assumptions and choice of model parameters, which again depend on historical data.^{footnote [27]}

Perhaps particularly important, given the previous discussion on the portfolio of carbon policies, is that the literature often focuses on one policy in isolation to determine its macroeconomic effects. But policymakers need to think about the reality of a whole policy mix and its macroeconomic effects; and not just a domestic policy mix, but also in the international context where other governments may or may not be pursuing similar climate goals.

This is not to say the literature is of no use. On the contrary, there are rich conclusions that economists and researchers more generally, and monetary policymakers more specifically can take from this, being mindful of the limitations.

Carbon policy shock vs standard oil price shock

Beginning on the empirical side of carbon pricing strategies, recent staff work, using a high frequency-identified carbon policy supply proxy^{footnote [28]} in a VAR, shows that for the UK, a 1 euro-on-impact carbon supply shock leads to a 0.15% peak increase in CPI and a 0.3% decrease in output (Chart 7). This model estimates that a carbon supply shock affects carbon prices lasting for about 12 months, but on CPI for much longer. The response of CPI is also notable due to its volatility, as it first increases in response to the shock to carbon prices, but then falls as the output gap begins to open up. Just as has been experienced in the last two years, second round inflationary effects distinguish the effects of carbon supply shocks from those of a more standard oil supply shock (which is added to this chart for comparison). So, while conceptually similar, they are both trade-off inducing shocks. This analysis finds that carbon supply shocks have different macroeconomic effects to oil supply shocks, most notably in terms of volatility and higher persistence in the response of consumer prices.

Chart 7: Impulse response functions to a carbon policy supply shock

Also using carbon pricing shocks but in a so-called Environmental DSGE or E-DSGE model^{footnote [29]}, Berthold et al. (2023)^{footnote [30]} find heterogeneity in the response of emissions-intensive firms to a carbon price shock, relative to ‘green’ firms.^{footnote [31]} The relative price of emissions-intensive goods rises due to the rise in carbon price, causing its output to fall. As shown in Chart 8, output in response to a carbon price shock increases for green firms, reflecting the substitutability of demand between emissions-intensive and green goods, but given output by emissions-intensive firms contracts by more, aggregate output falls. As a result of the decline in expected profitability of emissions-intensive firms, there is a persistent decline in investment. Investment also decreases for green firms, albeit by less, as firms require more labour to support the increased demand in green goods. Due to the persistent fall in relative prices of green and emissions-intensive goods driven by the rise in carbon price, profit margins for green firms are squeezed, triggering a fall in investment. Inflation in aggregate rises due to the rising cost of emissions-intensive goods. A variety of demand and supply elasticities are relevant for the outcomes.

Chart 8: Impulse response functions to a carbon pricing shock

The authors conclude that the macroeconomic effects of climate policies may be quantitatively small, particularly for countries with a lower carbon-intensity of GDP. But a key finding is that climate policy shocks do feature significantly more persistence in the response of macroeconomic variables in the medium, and long-term. Over time, as carbon pricing policies have more ‘bite’, the quantitative effects are likely to rise.

Broadening the menu of policies, economic structures, and outcomes

So far, evidence has suggested upward pressure on inflation, downward effects on output, and generally a tendency for climate pricing shocks to be more persistent and volatile. On the other hand, Diluiso (2023), looking at the differing effects on output and inflation from different policy measures, finds that carbon taxes, public investments, and subsidies are all inflationary (Chart 9), though subsidies require a longer time for inflation to return back to its original level. Subsidies and investment increase output, while carbon taxes decrease output. In other words, investment and subsidies transmit as positive demand shocks, while carbon taxes resemble a negative supply shock.

Chart 9: Impulse response functions to different climate policy shocks

Nominal rigidities and expectations are important additions to the modelling methodology because both affect the output-inflation trade-off and the monetary policy response. Del Negro et al. (2023) consider a tax on the emissions-intensive sector and a subsidy on the green sector. When prices are more flexible in emissions-intensive sectors (which they find in their empirical work), an inflation-targeting central bank needs to allow for a larger negative output gap, as higher costs in the emissions-intensive sector due to a carbon price pass through more quickly to inflation. Considering expectations, Ferrari and Nispi Landi (2023) find that increases in carbon taxes are inflationary, but expectations for tax increases in the future have a negative effect on demand in the current period, acting as a disinflationary counterweight.

On how agents evaluate and process information

Expectations for future climate policy could influence inflation today (as is suggested by the UK ETS market data). However, the extent of this will depend on the credibility and predictability of government policies, as well as the degree to which agents rationally take on this information. Annicchiarico et al. (2022) find that fully rational agents more fully internalise the hit to permanent incomes from a permanently higher carbon price compared to non-rational agents. The fully rational agents therefore consume less, which causes output to fall faster. Importantly, inflation increases by less than when agents are not fully rational, because these agents are slow to adjust (Chart 10). Recent evidence on data from the UK shows persistence in inflation, which points to some degree of backward-lookingness in the behaviour of agents in their assessment of future inflation.^{footnote [33]}

Chart 10: Impulse response functions to a permanent increase in carbon price

In their research, Annicchiarico et al. (2022) model the impact of a permanent carbon price shock in a setting in which agents are not fully rational. More precisely, some agents are backward-looking. The authors show that the ‘counterweight’ on inflation that arises from fully rational agents expecting negative output in the future is dampened – resulting in a larger upwards impact on inflation. Naylor (2023), by modelling agents as having information frictions, specifically as being rationally inattentive^{footnote [34]}, shows that the inflationary dynamic can be particularly strong in the event of a sequence of anticipated carbon price shocks. In this setting, while inflation may fall on impact (given the significant downward effect on output over the horizon), inflation subsequently rises as sticky price firms are able to adjust prices (Chart 11). The upwards inflationary forces become persistent, as the inattentive agents’ expectations are slow to return to target, and the sequential shocks are not fully internalised by agents.

Chart 11: Impulse response functions to a sequence of permanent increase in carbon prices with rationally inattentive agents

Heterogeneous climate policies and spillovers

Although the UK has made significant progress in reducing carbon emissions over the last thirty years, there is still a long way to go.^{footnote [35]} But, as a small, open economy the UK is subject not only to the macroeconomic effects of its own climate mitigation policies and the associated structural change, but also to considerable policy spillovers from its largest trading partners. Uncertainty about timing, coverage, and precise nature of policies that governments and international organisations might implement presents a challenge to monetary policy here.

Taking a stab at this topic, Annicchiarico and Diluiso (2019), using a two-country E-DSGE model, consider the international transmission of a monetary policy shock under a carbon tax and an ETS.^{footnote [36]} This is different to the work I have talked about so far, because it is not looking at a shock arising from a climate mitigation policy, but it is observing the effect of a monetary policy shock, given different climate mitigation policies in place. In this regard, this research looks more like the international trade analogue I presented earlier. In the case of demand variability (induced by, say, a monetary policy shock) the quota (analogue ETS) yielded more price volatility than did the tariff (analogue carbon tax).

Their results, illustrated in Chart 12, show that the transmission of monetary policy is affected by the choice of climate mitigation policy. Consider just the home country: A contractionary monetary policy shock ‘at home’ causes output to fall and inflation too, as expected. Under cap-and-trade ETS, output falls by less than with the carbon tax because the pro-cyclicality of emissions prices mitigates some of the cost-induced output loss.^{footnote [37]}

Chart 12: Impulse response functions to a 50 basis point monetary policy shock

On the other hand, rather than levels, consider volatility. Under the carbon tax, volatility in home output is larger than under the ETS, where the carbon price adjusts pro-cyclically. But, volatility in inflation is higher under the ETS, for essentially the same reason.

These results are corroborated by Annicchiarico et al. (2022), a paper I already mentioned earlier, who find that an ETS causes more inflation volatility and higher inflation than carbon taxes. They find that under either climate policy, a more activist response of the policymaker to fluctuations in macroeconomic variables can help in moderating inflation volatility and reducing the pressure on prices.^{footnote [38]}

Now consider spillover implications facing the foreign central bank, which is not undertaking any policy but is affected by both its own and its neighbour’s carbon policy choices. In the case of the ETS, foreign firms enjoy a cost-reduction from the tradeable lower permit price, which supports output even as inflation there falls. Given the same monetary policy shock by the ‘home’ central bank, if a carbon tax were deployed instead, the unit cost of emission does not change, output falls in both the home and foreign country, as does inflation. One central bank action, but different policy spillovers depending on the choice of carbon policy. If inflation and output in the foreign economy were at equilibrium, the monetary policy shock spillover requires different reactions from the foreign central bank depending on the carbon policies at home and abroad.

Three important takeaways for monetary policy. First, the transmission mechanism of monetary policy may change with the choice of carbon price policy. Second, the choice of climate policies affects inflation and output volatility differently. Third, a foreign country may experience macroeconomic effects from climate policies of their trading partners. Abstracting from the macroeconomic effects of climate mitigation policies themselves, the existence and choice of climate policies can change the way monetary policy shocks transmit to the economy and can change the way an economy responds to monetary policy shocks from abroad. ^{footnote [39]}

Conclusion

Central bank policy cannot solve climate change. It is a global and generational issue which requires commensurately global and generational solutions. But monetary policymakers are interested parties and do have a part to play. As noted in the introduction, there is no ‘no climate change scenario’. If governments fail to rise to the challenge to put into place sufficient climate policies to achieve net zero sufficiently swiftly, then transition impacts may not be the main concern for monetary policymakers, but physical impacts will be.^{footnote [40]} Either way, monetary policy decisions will be affected through multiple channels by climate change strategies or lack thereof. Therefore, central banks should raise awareness of climate issues along with continuing efforts to understanding how those risks translate into policy challenges.^{footnote [41]}

This note is quite long, so as to review the most recent work relating climate and monetary policy. But I still have only addressed some of the shorter horizon channels and impacts of heterogeneous climate policies. The findings most relevant for monetary policy from this current batch of research seem to me to be:

• Carbon price shocks are not the same as oil price shocks, as they seem to precipitate more persistence in the response of other macroeconomic variables, including inflation.
• In the case of macroeconomic demand shocks, inflation volatility is elevated in the case of an ETS system relative to a carbon tax.
• Heterogeneous climate policies at home and abroad create differing spillovers between domestic and foreign economies, given a monetary policy shock at home.
• A tightening of monetary policy at home in the case of a carbon tax, spills over to the foreign country yielding lower output and lower inflation, with the foreign central bank needing to loosen. On the other hand, with tradeable ETS certificates, the foreign central bank finds itself facing increased output but a negative inflation shock, putting that central bank into policy trade-off territory.
• The redistribution of revenues earned through carbon taxes or emission-certificate auctions, and how subsidies are funded will matter for monetary policy decisions. These choices are outside the control of the monetary policymaker, but because they have macroeconomic effects, they are of direct interest for monetary policy.

All this does not mean that monetary policy should be poised to respond to all climate-related shocks. Indeed, central bankers could decide to look through the shock and the consequences for inflation if deemed transitory and small. A proper toolkit will help us make this assessment.

Much more research is needed to understand the full effects of climate change on the macroeconomy. Research on the impacts and interactions between carbon policies domestically and abroad is particularly relevant for the UK, where a government commitment to net zero in 2050 has already been made. The effect of uncertainty around climate policies, and the behaviors of agents under different scenarios is also important for monetary policymakers to understand.

Central banks need to stick to their remit, which in my case is achieving 2% inflation sustainably in the medium term. The research here points to increased inflation, increased inflation persistence, and increased inflation volatility associated with climate shocks, policies, and spillovers. My job is to be forward-looking, to monitor and make an informed decision about how these dynamics affect inflation at my 3-year policy horizon. Not only is it within my remit to respond to the macroeconomic effects of climate change, but my remit requires me to do so.

The views expressed in this speech are not necessarily those of the Bank of England or the Monetary Policy Committee.

Acknowledgments

I would like to thank in particular Natalie Burr and Lennart Brandt, as well as Raphael Abiry, Andrew Bailey, Sarah Breeden, Alan Castle, Ambrogio Cesa-Bianchi, Francesca Diluiso, Federico Di Pace, Chris Faint, Lukasz Krebel, Josh Martin, Jessica Murray, Matthew Naylor, Martin Seneca, Michelle van der Merwe, and Boromeus Wanengkirtyo for their comments and help with data and analysis.

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