What is Greenflation? Meaning, definition, explanation

Greenflation (from “green” and “inflation”) means that the energy transition triggers inflation. This can be observed to some extent and is feared even more. There are two main causes for this:

  • #1 The energy transition requires certain raw materials, for example rare earths for photovoltaic modules and a lot of steel for wind turbines. Raw material prices are already rising. The energy transition is creating even higher demand, which is driving up prices (fuelling inflation).
  • #2 The investment market for green financial assets has been humming for some time and has now exceeded the two-trillion-euro mark in Europe alone. So much capital is also driving up prices.

Greenflation: The problem with raw materials

The problem with commodities is very real. Their prices are rising, admittedly, for a variety of reasons: because of the strengthening global economy in general, because of political uncertainties in some producing regions, and since 2020 also because of the corona pandemic, which sometimes brings supply chains to a standstill due to lockdowns and quarantine measures. Now, however, there is also the gigantic demand for raw materials for plants that produce renewable energy. Take silicon for solar cells, for example: This is already inherently scarce because it is costly to produce and it takes about two years to ramp up a new production facility.

In the past, manufacturers tended to invest cautiously because a gigantic boom in solar cells with the corresponding silicon demand was not necessarily foreseeable until around 2015. But now the energy turnaround is picking up speed worldwide, because the consequences of climate change can no longer be ignored anywhere on the planet. Demand for silicon is therefore rising rapidly, with other factors contributing to this: there may be enough steel for wind turbines, but wind turbines often meet with resistance from the population, at least on land. Solar cells would be the much less visible and, above all, noiseless alternative. The fact that this would make solar modules, and therefore silicon, more expensive is practically inevitable. That is just one example. Another would be rare raw materials such as lithium and cadmium for batteries, which are also very urgently needed if we really want to get our electricity predominantly from renewable energies that are highly volatile in generation.

Since the sun does not shine at night and the wind is unpredictable, surplus electricity from solar and wind power urgently needs to be stored on a large scale. There is a threat of shortages of these commodities and thus an upward spiral of high demand and tight supply that can be extremely price driving. This is greenflation, which could indeed assume considerable proportions. And we haven’t even considered the agricultural sector yet. Here, too, cheap production with pesticides and factory farming is to give way to an environmentally friendly and sustainable economy – which will be more expensive. It is not for nothing that the new Minister of Agriculture, Cem Özdemir (Bündnis 90/Grüne), announced higher food prices at the beginning of 2022.

Expert opinions on greenflation

Experts have been noting the trend toward higher commodity prices, which is also being triggered by the energy transition, for some time now. Karl Lichtblau, head of the IdW (Institut der deutschen Wirtschaft)told Redaktionsnetzwerk Deutschland at the beginning of 2022 that the energy turnaround was definitely threatened by the shortage of raw materials.

The Cologne-based economist pointed to procurement problems for 22 important raw materials, including lithium, copper and platinum. Copper is important for wind turbines, lithium for battery production and platinum for the production of hydrogen. Ruchir Sharma, chief strategist at Morgan Stanley, explicitly mentioned the new term “greenflation.” He fears that prices will rise so sharply that global climate policy will be jeopardized. Sharma also sees a problem in new environmental policy requirements of most countries, which make the extraction of important raw materials – including bauxite (for aluminum production) and copper – more expensive. This raw material extraction has so far gone hand in hand with major overexploitation of nature, but this must be stopped. That’s welcome, Sharma said, but: carbon dioxide-free electricity is likely to become much more expensive on balance than the global community had previously assumed.

Bremen-based economist Rudolf Hickel warns of the sociopolitical consequences of greenflation. He points to the addition of politically intended (see Özdemir, agricultural sector) and market-driven price increases. These would inevitably place a very heavy burden on low-income earners and transfer recipients. If housing, energy and food became more expensive, this would seriously affect the substance, according to Hickel. The economist criticizes that the new traffic light coalition has not yet sufficiently analyzed all the effects of such developments. This will also have political repercussions, he said. The exploding prices are likely to reduce acceptance among the population for the energy turnaround. This phenomenon could even slow down the energy turnaround worldwide, the expert added. While larger transfers to low-income earners are conceivable in Germany and other developed countries, this is not the case in the majority of countries.

What impact does green finance have on greenflation?

Green investments have been around since the 1990s, but they began to boom in the new millennium. Then, in 2007, the EIB (Luxembourg-based European Investment Bank) launched new Green Bonds to allow investors to contribute directly to climate action through earmarked bonds.

Green bond capitalization exceeded two trillion euros in 2021. As this capital flows into green investments, it can drive up prices. This was investigated by financial experts Simon Jessop and Sujata Raoder on behalf of Reuters. They found that the flow of money from green bonds did indeed cause prices to rise in certain areas, but noted that this did not necessarily mean that there was a general rule: there was also the opposite effect. Since capital also accelerates technological and entrepreneurial developments, in some places there are even price-reducing effects due to greater efficiency in production.

However, Jessop and Raoder drew attention to another possible effect of greenflation: According to the economists, this could cause central banks to tighten their monetary policy due to inflationary pressure. This would then generate feedback effects on stock, bond and currency markets. This effect had been ignored until 2021 only because the ECB’s key rate has already been at 0.0% since 2016 and the other major central banks (Fed, BoE, BoJ, SNB) also operate with extremely low key rates. A little inflation was even longed for until early 2021. Now it is here, greenflation is coming. This should certainly heed, if not worry, the financial world, according to Jessop and Raoder.

Influence on the Real Economy

Greenflation seems inevitable, so it is important to examine its impact on the rest of the real economy. The latter is expected to become greener and more sustainable, but it is also likely to produce more expensively in the future. In response to this, companies have two means at their disposal, which they can also combine in the sense of a compromise:

  • #1 They pass on the price pass-throughs to their customers, which fuels inflation. Consumers respond by demanding wage increases, which also drive inflation.
  • #2 Businesses are living with lower profit margins. This is not as unlikely as it first appears. Companies also have a green conscience, plus there is competition in this regard. Price drivers could disappear from the market.

It is inevitable that there will be huge changes in the real economy. The largest industries will be affected: steel production, which will use hydrogen as an energy carrier; the automotive industry, which will produce electric cars instead of internal combustion engines; the construction industry, which will build for energy efficiency; the environmental industry (manufacturers of wind and solar power plants); and the agricultural sector. Consumers will have to prepare for price increases in some areas. They may also have to abandon certain habits and behaviors because they simply become too expensive. One example might be vacation travel on a low-cost airline.

Conclusion: Greenflation

Greenflation is real, but it is also manageable. Moreover, it is basically without alternative, because without a restructuring of the economy and consumption, the planet will inevitably collapse in terms of climate.

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