Macroeconomic & Geopolitical

A Fresh Approach to Climate Anxiety

October 2022 – 3 min read

Understanding the differentiated macroeconomic impacts of the climate transition can shape better investment and policy strategies.

My guilt ratchets higher every fall as the Atlantic hurricane season reminds me how little I have done again this year to save the planet. I feel a twinge every time I stare at the bewildering choices among the "recycling," "composting," or "waste" bins meant to process what's left of my takeout lunch. Midterm election campaigns compound my sense of helplessness as candidates insist climate action requires choosing between killing the economy or killing the planet.

Investors who incorporate environmental, social, and governance (ESG) considerations are often caught in this crossfire, accused alternately of empty “greenwashing” or fueling inflation by refusing to finance fossil fuels. But the climate transition has macroeconomic dynamics that are far more complex than a choice between cheap gasoline today and rising seas tomorrow. Even a slightly more nuanced approach can help clarify the difficult trade-offs for investment and policy.

Climate progress is impossible without markets that reward innovation and policies that help skew the incentives. Together, they should encourage energy generation that produces less carbon and additional forest protection to absorb more of what is released. The “simplest” analyses, patterning the Nobel-prize winning work of Yale’s William Nordhaus, attempt courageous calculations of the discounted future costs of fires, hurricanes, and lung disease to justify current spending on transition and mitigation. 

But as savvy economists point out, these calculations are only marginally helpful, even after making heroic assumptions about taxes, technology, and weather itself. Estimates of future costs don’t adequately incorporate the risks of tipping points, when climate deterioration might accelerate. Moreover, even estimates of very large costs, say, at the end of the century, don’t amount to much when actually discounted back to today.

Of course, there are already very real costs from climate change today: rising premiums for Rocky Mountain fire insurance, the falling price of floodplain real estate, the rising value of English vineyards, the falling price of solar panels.

If analyzing discounted cash flows of a single transition doesn’t help, much smarter approaches separate forces reshaping the global economy into four separate macroeconomic dynamics.

First, there are the obvious costs that get so much attention. These are mainly imposed by governments in carbon pricing, environmental regulations, and new financial disclosure requirements to discourage the use of fossil fuels. The climate skeptics are right that these measures add costs to the economy and distort market incentives. They will in fact feed the forces of inflation and recession.

For limited parts of the economy, there is a second and much worse set of looming challenges. California’s ban on new cars with internal combustion engines after 2035 may be the clearest signal yet that large parts of the oil and gas industry will end up one day as stranded assets, essentially worthless as demand for gasoline evaporates. That day may still lie many decades hence, but it will steadily tilt the economy toward deflation and recession as it draws near.

A third dynamic, by contrast, doesn’t require sophisticated discounting calculations. From Joe Biden’s America to Xi Jinping’s China to the European Union’s Europe, governments are planning massive spending for more resilient infrastructure, including electrical vehicle charging stations. Economically, these billions may fuel inflation on the margin, but they will also deliver substantial growth.

Fourth, and most tantalizing, are opportunities that come from clean technology innovation that helps mitigate climate costs. Some of these require initial government investment or tax incentives to develop; some will flourish on their own. They ultimately contribute to deflation and growth.

Without solving all the trade-offs, this framework can help clarify where the climate transition conjures up headwinds or tailwinds to prices and demand.

For all the additional costs from the regulation of old energy, there is massive investment in the new. For all the stranded assets that will appear, there is rapid innovation. Good investing means concentrating on areas that boost growth and ideally those areas where technology can bring down prices and raise profits at the same time. A government contract to build a seawall is a good place to be; a cheaper approach to geothermal power generation is even better. 

Good policy means rising above debates on balancing immediate costs with distant benefits. It means understanding when the transition’s inflationary squalls may need compensation from tighter monetary policy. It means recognizing that the deflationary impact of a fossil fuel industry heading toward obsolescence will require subsidies that support the transition.

These are not magic formulas here, but it helps me see the glimmer of a path toward progress as I stand helplessly deciding if the plastic top of my coffee cup gets recycled with the cardboard sleeve.

22-2443021

Christopher Smart, PhD, CFA

Chief Global Strategist & Head of the Barings Investment Institute

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