Fear of green inflation?

Some observers point to the energy transition as an inherently inflationary force, as companies feel compelled to invest less in fossil fuels despite the continued rise in the cost of renewable electricity. In the marketplace, this is referred to as green inflation - the impact of environmental policy on the cost of supplying goods and services, which is reflected in consumer prices through supply chains. In fact, a wide variety of regulations and policies have an impact on inflation. Among the forces driving prices is international resistance to globalization, for example, through the continued imposition of trade tariffs.

Green inflation will hardly affect consumer prices

The pandemic has shown how vulnerable global supply chains and logistics networks are, and now Russia's invasion of Ukraine is dragging out the impact of inflationary forces. As a result, the recovery process is moving slowly and pressure on commodity prices is increasing as the war limits access to energy, metals and grains. The cause of the U.S. inflation problem, however, is not climate policy but the excess of stimulus measures in the aftermath of the pandemic. For too long, the country has held on to its accommodating monetary and fiscal policies, and now the U.S. labor market is booming.

In the renewable energy sector, which is tied to certain commodities such as rare earth metals, high demand and limited supply could result in a multi-year commodity boom. Nevertheless, in our view, green inflation does not have a large impact on consumer price inflation in the long run. Climate policy measures are usually designed to last for several decades and are thus among the structural drivers of relative price developments. Overall, however, consumers only experience persistently high inflation if the major central banks allow it. Even in the event of sustained upward pressure on commodity prices, we would not expect headline inflation to remain above central bank targets for a prolonged period. Beyond short-term developments, we recommend that investors keep an eye on the likely inflation-dampening effect of the extended tightening of monetary policy that is emerging worldwide.

The current central bank policy is a reaction to increased inflation, and combating it is likely to remain more important than economic growth in the future. In two years, we believe that green inflation will no longer be an issue. The debate is more likely to be about the consequences of a recession that has started earlier than expected in the US. The green inflation narrative is driven by developments in the West. Overall, inflation is much lower in the Asia-Pacific region, where climate policy implementation is much less advanced and the fossil energy sector is less constrained. In addition, there is more subdued economic activity in Asian countries due to the delayed reopening of the economy after the pandemic.

The increasing importance of Asia

A key issue of interest to investors is the Asia-Pacific region's share of the technological innovation required by a global energy transition and whether this will have a dampening effect on inflation. In macroeconomic terms, the region's governments and central banks are demonstrating more restraint and less willingness to artificially stabilize the economy. Asia-Pacific is significantly less indebted, and governments in the region are less constrained and extremely capable of acting. The capital available to government and business for the energy transition is enormous.

In investment portfolios, we believe Asian companies will play an increasingly important role in the future. Without Asia, where industrial pollution has forced governments to act, there will be no energy turnaround. As a result of high investment, technology costs have fallen significantly over the past decade. Since 2015, solar energy in India has been cheaper than coal energy, allowing the country to invest heavily in renewable energy. The technological innovations of Asian companies that can solve specific global problems should be given greater consideration in investment portfolios, in our view. Some of these companies are working hard to lower the cost of green hydrogen. There are few industries for which this would be more important than China's heavily polluting manufacturing sector. Here, new energy is needed to make entire supply chains cleaner. In green hydrogen, China wants to play the same role it did before in solar and in certain wind power technologies. We are optimistic because progress in countries like India and China alone will go a long way toward solving some global environmental problems. The goal is to harness the power of capitalism and innovation for the global energy transition. However, the richer countries need to live up to their commitments and lend a hand to the poorer ones so that they are not continually left out. Although China will continue to play an important role in lowering technology costs, this will take time, and poorer countries will need support until then.

Sustainable investments: Focus on the long term

Of course, asset managers have to invest within certain parameters. Poor countries often have poor credit ratings, governance problems, or capital markets that are not fully mature. We need to find a way to mobilize capital to help these countries. This is part of the problem that needs to be solved. In the short term, some solutions will have an inflationary appearance. Electric cars, for example, are more expensive than vehicles with internal combustion engines. Yet it is electric car prices that are falling the most in relative terms. The same is true for a wide range of renewable technologies, including photovoltaics. What appears to be driving inflation today may have a dampening effect tomorrow. In addition, the time will come when commodity prices fall, and as a major exporter of raw materials, Asia will benefit strongly from this.

The task of asset managers when recommending sustainable investments is to make it clear that these are long-term decisions. Companies with high demand for raw materials and fossil fuels are performing well because production costs are rising more slowly than prices, which favors earnings and valuations. Renewables, on the other hand, were highly valued at times last year because many of them are growth companies. Rising interest rates also drove up the discount applied to earnings, leading to significant underperformance. This makes it clear that investors should expect strong variances in this area. Even if it can be assumed that the central banks will get to grips with the problem sooner or later, strategies that actively address inflation and volatility are attractive for the investment portfolio in the short term.

Authors:
Jeremy Lawson is Chief Economist at abrdn; Ken Akintewe is Head of Asian Sovereign Debt at abrdn. www.abrdn.com