Climate change: possible
macroeconomic implications
Quarterly Bulletin 2022 Q4
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Published on 21 October 2022
Content
Summary
1: Introduction
2: Effects on macroeconomic fluctuations
Physical impacts
Transition impacts
Box A: Case study – flooding and house prices in the UK
Box B: The Balanced Net Zero Pathway (Climate Change Committee, 2020)
Box C: Amplification channels and international spillovers
3: Effects on the long-run equilibrium interest rate, R*
The determinants of R*
Physical impacts
Transition to net zero
4: Monetary policy considerations
Climate and monetary policy strategy
Monetary policy trade-offs
Possible changes in the transmission mechanism of monetary policy
5: Conclusion
Annex
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By Marilena Angeli, Cassandra Archer, Sandra Batten, Ambrogio Cesa-Bianchi, Lucio
D’Aguanno, Alex Haberis, Theresa Löber, Sarah Maxwell, Rana Sajedi, Michelle van der
Merwe, Boromeus Wanengkirtyo and Chris Young from the Bank’s Climate Hub,
International Directorate, Monetary Analysis Directorate and Research Hub.[1]
Summary
Climate change – and the response of governments at home and abroad to it – will affect the
macroeconomy in a number of ways, both over shorter horizons and the longer term. Since it
influences key economic variables such as output and inflation, climate could change matter for
monetary policy makers such as the Monetary Policy Committee (MPC). Monetary policy clearly
cannot solve climate change, but climate change may have macroeconomic implications that
could be relevant for monetary policy makers. This article explores the macroeconomic effects of
physical impacts from climate change (such as extreme weather) and the transition to a net-zero
economy (such as through less carbon intensive investment), with a particular focus on the UK
economy. It considers what the longer-term changes associated with climate change might mean
for the macroeconomic landscape within which monetary policy operates. It also provides an
initial assessment of some possible monetary policy considerations. Many of the questions in this
area are new, open and worthy of further research. That reflects new analytical challenges
associated with climate change, including related to macroeconomic modelling and data quality
and availability. In addition, there are many dimensions of uncertainty, not least in relation to how
the physical effects of climate change and governments’ policy responses to it evolve over the
coming years and decades.
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1: Introduction
In the UK, the MPC sets monetary policy to meet HM Government’s 2% inflation target, and,
subject to that, to support the economic policy of the Government, including its objectives for
growth and employment.
In response to macroeconomic developments in the UK, including spillovers from the rest of the
world, the MPC adjusts its policy instruments in order to meet the 2% inflation target. The two
main policy actions that the MPC can take are to change the interest rate that the Bank of
England charges commercial banks to borrow (‘Bank Rate’) and to change the stock of assets
that the Bank holds on its balance sheet as a result of outright purchases (‘quantitative
easing/tightening’).
When assessing the outlook, the MPC typically looks at how the economy is likely to develop over
the next two to three years, the horizon over which monetary policy can sustainably bring inflation
back to target. Unanticipated economic events, often called ‘shocks’, will affect the outlook for the
economy over that period, sometimes materially; the sharp and significant rise in wholesale and
domestic energy prices since Russia’s invasion of Ukraine is a recent example. The MPC also
monitors and assesses longer-term, and sometimes more gradual, developments to understand
structural economic changes that are happening in the economy over a number of years. An
example here is the increased integration of emerging economies into the world economy along
a number of dimensions from the early-2000s, sometimes called ‘globalisation’, which for a
sustained period reduced the prices of manufactured goods imported by advanced economies.
In some sense, climate change comprises another set of economic shocks and structural
changes for monetary policy makers to assess and monitor in order to achieve the inflation target.
However, climate change presents new challenges to monetary policy makers in a number of
respects, including its global dimension, its very long time horizon and the degree of uncertainty
about both climate policy and how economic agents will respond. That is particularly so given the
non-linear nature of climate change leading to irreversible effects (‘tipping points’).
Physical impacts from climate change, and governments’ policy responses to climate change
such as to support the transition to a net-zero economy, have the potential to impact the
macroeconomy in numerous ways. They are likely to influence key economic variables such as
output and inflation, which in turn are directly relevant to the decisions taken by the MPC. For
instance, increased severity and/or frequency of extreme weather events at home and abroad
could lead to supply disruptions and a rise in some prices, including of food. Moreover, over the
coming years and decades, UK legislation to achieve net-zero emissions by 2050 (Climate
Change Act 2008 , amended in 2019 ) requires ambitious changes across all parts of the
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economy, from power generation to transport to how we heat and build our homes.
Monetary policy clearly cannot solve climate change, but climate change may have
macroeconomic implications that could be relevant for monetary policy makers. This implies that
the greatest contribution monetary policy can make to facilitate the transition to the green
economy is to secure price stability and maintain the credibility of the monetary regime through
the transition.
This article explores how the physical impacts from climate change and the transition to net zero
might impact the economy and so could matter for monetary policy. It first explores the
macroeconomic effects of physical and transition impacts, with a particular focus on the UK
economy (Section 2). Section 3 then considers what the longer-term changes associated with
climate might mean for the macroeconomic landscape within which monetary policy operates.
Section 4 provides an initial assessment of some possible monetary policy considerations,
before Section 5 concludes.
The article provides a complement to the extensive body of work in recent years by the Bank of
England and other institutions focused on understanding the financial risks from climate change
and the transition to a net-zero economy.[2] It also contributes to recent debates – including in the
economic literature, the Network of Central Banks and Supervisors for Greening the Financial
System (NGFS) and Bank research[3] – on the potential impacts of climate change on the
macroeconomy and the implications for monetary policy. For example, recent years have seen
speeches by senior officials from, among others, the Federal Reserve (Brainard (2019) ), the
European Central Bank (Lane (2022) ; Schnabel (2022) ), the Bank of England (Bailey
(2021)) and the Reserve Bank of Australia (Debelle (2019) ). It is worth noting at the outset that
many of the questions in this area are new, open and worthy of further research. That reflects new
analytical challenges associated with climate change, including related to macroeconomic
modelling and data quality and availability. In addition, there are many dimensions of uncertainty,
not least in relation to how the physical effects of climate change and governments’ policy
responses to it evolve over the coming years and decades.
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2: Effects on macroeconomic fluctuations
Physical impacts
Physical impacts from climate change have the potential to impact the macroeconomy in
numerous ways, influencing key economic variables such as output and inflation.
The physical impacts of climate change stem from both the increased frequency and severity of
acute weather events like flooding, extreme temperatures and windstorms, and gradual or chronic
changes in the climate, such as those associated with gradually rising temperatures and sea
levels. The impacts associated with both acute and chronic changes transmit through many
channels, affecting both the supply and demand sides of the macroeconomy. In this section, we
explore the macroeconomic effects of the physical impacts associated with climate change with a
particular focus on the experience of the UK economy and drawing on international evidence from
countries who may have experienced more severe events than typically found in the UK. In terms
of the response of monetary policy to these physical impacts, a key challenge is to assess the
macroeconomic effects over the next two to three years, the horizon over which monetary policy
can sustainably bring inflation back to target.
This section next discusses the different channels of physical effects on economic growth,
inflation, as well as gradual changes and global spillovers.
Effects of extreme weather on economic growth
The economic literature shows that extreme weather events tend to have a predominantly
negative effect on economic growth, in some cases up to several years. Reasons include
damage to the economy’s stock of physical and infrastructure capital, the impact on the labour
force (including through displacement or migration) or losses in productivity (due to breaking
supply linkages, for instance).
As a proxy for possible physical effects of climate change, we can look at natural disasters. Their
effect on economic growth is mixed (Cavallo and Noy (2009) ). Using data on natural
disasters since 1900, Raddatz (2009) estimates natural disasters persistently reduce real
GDP per capita by at least 0.6% in a panel of countries. However, this covers a wide range of
natural disasters and is an average effect: the impact tends to be smaller for wealthier countries
(Botzen et al (2019) ; Noy (2009) ) particularly in those cases where the events are
sufficiently insured (von Peter et al (2012) ). In contrast, Loayza et al (2012) observe that
after earthquakes and storms there are positive growth effects which are attributed to
reconstruction of infrastructure and capital. However, severe disasters tend to put economies on
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slower growth paths. Hsiang and Jina (2014) find that national incomes fall and do not
recover within the first twenty years following a cyclone. Clearly there are limits to which we can
extrapolate from these studies for climate change, not least because changes in the climate are
not linear, but the likely increase in frequency and severity of extreme weather events means such
effects may be bigger in the future. Box A looks at flooding and UK house prices as a case study.
Effects of extreme weather on inflation
Extreme weather events can also affect inflation, at least temporarily. Heinen et al (2019)
study the impact of hurricanes and floods on the monthly inflation rates of 15 Caribbean islands.
They conclude that although the average inflation impact of hurricanes is small, it can be greater
for more severe events. Similarly, Cavallo et al (2014) find that even with the severe supply
disruptions that major earthquakes can bring, prices remain stable. They attribute it to retailers
avoiding perceptions of price-gouging, ie preferring to run out of stock in response to a supply
disruption, rather than increase prices. Parker (2018) finds that droughts seem to be the only
type of natural disaster with an impact on headline inflation which persists for a number of years,
with food prices a key channel. Peersman (2022) shows that exogenous (weather-driven) food
price shocks have a strong impact on consumer prices in the euro area, suggesting that inflation
volatility in advanced economies may rise with an increased frequency of global extreme weather
events. Taken together, these factors suggest it is likely that inflation may become more volatile,
particularly in geographies subject to more frequent extreme weather events.
While physical impacts of climate change have been shown to temporarily raise inflation, in
particular food prices, such effects have tended to dissipate in the medium term. As noted above,
however, the impacts of such events may be greater in the future if extreme weather events are
more frequent and more severe.
Gradual changes in the climate system: macroeconomic effects
Physical impacts from climate change may also reflect chronic changes in the climate system,
such as those associated with a gradual rise in average global temperatures. This causes an
increase in the frequency and intensity of weather-related natural disasters as previously
discussed. For example, global warming is associated with a slowdown in warm-water currents in
the Atlantic Ocean, which in turn leads to changing heavy precipitation patterns in the tropics and
Europe, and stronger storms in the North Atlantic (IPCC (2021) ). However, the gradual rise in
itself could cause negative effects on economic growth, both in the short and long run, driven by a
range of factors, including reduced labour productivity, slower human capital accumulation,
diminished human health and political instability (Dell et al (2012) ).The negative economic
effects from gradual temperature rises can increase in a non-linear way as the temperature
deviations from historical norms get larger (Felbermayr et al (2014) ; Burke et al (2015) ).
Moreover, most of the effects appear larger in emerging economies, with more extreme
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temperature variations and institutional factors creating challenges to adaptation.
The UK’s infamously cloudy – but moderate – weather makes it somewhat less likely to be
significantly directly exposed to gradual changes. For example, the University of Notre Dame
Global Adaptation Index ranks the UK fifth (out 182 countries) least vulnerable to physical
impacts of climate change. While the UK is somewhat less directly affected by physical risk
compared with other low-lying countries, for example, Box C explores the different channels by
which the economic effects of physical (and transition) impacts can transmit across countries.
Key takeaways
Transition impacts
As the economy adjusts to a low-carbon and ultimately a net-zero economy, there are a number of
transition impacts on the macroeconomy that arise out of the process of adjusting policies,
preferences and technology. These impacts can be orderly, leading to a ‘smooth transition’,
whereas a ‘disruptive transition’ may induce amplified effects on the economy through the various
channels discussed here. This section explores what we can learn about the macroeconomic
effects associated with the adjustment of the UK economy toward net zero, as in Section 2,
drawing on UK evidence as well as lessons from abroad. An important caveat is that most of the
economic literature on transition risks examine market-based climate policy mechanisms that
have been introduced over the past decade or so. But many other climate policies will need to be
deployed to deliver the transition to net zero, of which we have much less understanding. The first
and second parts of this section focus on mitigation policies and their role in changing prices
faced by households and companies in the economy, which is in turn likely to generate a
reallocation of activity between sectors of the economy towards those that are less carbon
intensive. The third part looks the role of expectations, including the role of uncertainty, in the
transition to net zero.
Gradual warming and extreme weather events have a negative impact on GDP, although there
may be a temporary boost from reconstruction. Physical impacts of climate change appear to
temporarily raise inflation, in particular food prices, but such effects have tended to dissipate in
the medium term in past data. These weather events may largely be the same as in previous
decades, although their likely size and frequency may be greater, such that impacts could
become more pronounced.
Insofar as there are more and larger weather events that may require a more active role for
monetary policy. However, some of these effects may be more evident over relatively short
horizons, whereas monetary policy can sustainably return inflation back to target over the next
two to three years. But as discussed in Section 3, gradual warming and increasing frequency
of extreme weather events may have an important influence in the economy in the long run,
such as via uncertainty, investment and trend productivity growth.
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The macroeconomic impacts of mitigation policies
Governments over recent years in many countries have introduced a range of policies to lessen
the impacts of climate change by preventing or reducing the emission of greenhouse gases (de
Silva and Tenreyro (2022) ), as well as measures to adapt to the effects of climate change.
These can be grouped into three broad categories. First, there are economic incentives, such as
carbon taxes, emission trading schemes, and subsidies for investing in research and
development (R&D), adopting green technology, and using clean energy. Second, there are
regulations, such as bans on coal usage, or production and mandatory technology requirements.
Third, there are institutional approaches, such as voluntary industry standards for climate
disclosures. The introduction of mitigation policies by governments, and the pace at which they
are strengthened, are likely to have effects both on the demand and supply side of the economy.
Some mitigation policies, including subsidies and direct regulations, encourage cleaner forms of
energy production or reduce energy consumption by households or firms. One example is green
energy subsidies to encourage greater use of renewables such as wind power. These policies
lower the overall cost of renewable energy provided to power grids and, over time, reduce the
average cost of this form of energy provided to firms and households, which may lower inflation
(although energy prices do not always reflect average production costs across all sources of
energy). The overall effect on the economy’s productive capacity and aggregate demand is more
ambiguous, however. It depends in part on how the subsidies were financed – in particular,
whether and what type of tax increases would be required, or the diversion of other types of
government spending.
On the other hand, policies that subsidise research and development into green technologies are
more likely to boost the economy’s productivity and growth. Its impact on inflation would depend
on the balance between the relative effects on supply and demand, which could vary at different
horizons.
There could also be various regulatory initiatives to discourage carbon-intensive production or
simply enforce lower carbon inputs into production. The economic literature on this is limited, but
such regulatory initiatives may raise costs and consumer prices, at least in the short run.
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Another potentially important tool in the transition to net zero is carbon pricing. By charging for
greenhouse gases emissions, the policy puts a price on emissions and also encourages
investments into energy-efficiency improvements. The price can be determined through a range
of ways, for example, via market mechanisms (such as the UK and EU Emissions Trading
Schemes (ETS) in which governments sets the maximum amount of emissions), directly though
taxation or via policies such as standards and regulations. The UK uses a combination of the
carbon cap-and-trade (UK ETS) and various carbon taxes – direct taxes such as the Climate
Change Levy and the Carbon Price Support, and indirect carbon taxes, such as fuel duties.
Given there are many examples of carbon-pricing schemes that have been active for some time,
such as those in the EU and Canada, there are a number of attempts in the economic literature to
assess the macroeconomic effects of these policies. Overall, the impacts depend crucially on the
design of the mitigation policies, including the extent to which and how any revenues from the
policy are used by the fiscal authority (for example, by reducing other taxes, increasing subsidies
or raising government spending). Fiscal policy tools can support activity and help to offset some
of the negative direct impacts on output from carbon pricing if the revenues raised from the
carbon tax are recycled back to households and firms (Yamazaki (2017) ).
There are two typical empirical findings, although results in this literature are mixed rather than
definitive. First, a reduction in the quantity of carbon credits and allowing market mechanisms to
dictate carbon prices raises inflation and reduces economic growth (Kaenzig (2022) ).
Second, in contrast, several studies show setting a carbon price directly through carbon taxes
Chart 1: Carbon prices in the CBES
Source: Bank of England Climate Biennial Exploratory Scenario (CBES).
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has a broadly neutral impact on inflation and output, although as discussed below these results
are based on a low level of carbon prices.[4]
There are at least two reasons to explain the different impacts on inflation. First, as carbon taxes
set a path for the carbon price directly (in contrast to an ETS, under which prices could be more
volatile), firms can plan ahead to a greater degree – for example, in managing other costs and
investing in green technologies. Second, Konradt and Weder di Mauro (2022) suggest
carbon taxes may have a disproportionate impact on low-income households, given their
consumption baskets are more energy intensive. That could reduce their demand, offsetting the
initial inflationary impact of the carbon tax.
But an important caveat and reason why the estimated empirical effects tend to be small is that
the historical carbon prices on which these studies have been based have been and still currently
are low. Konradt and Weder di Mauro (2022) document that the majority of taxes in Europe
and Canada are below US$30 per tonne as of 2018, with some as low as US$0.08.[5] Estimates
of the potential paths carbon prices would need to take in order to meet net-zero targets indicate
a substantial rise in carbon prices from their current levels. One such estimate is from the Bank of
England’s Climate Biennial Exploratory Scenario (CBES), which simulates a substantial
increase in carbon prices, rising from US$30 as at end-2020 to US$900 per tonne of carbon
dioxide equivalent (in 2010 dollars) by 2050 under an ‘Early Action’ scenario (Chart 1). If policy
action is delayed (‘Late Action’), carbon prices remain at US$30 until 2030 but the simulated
increase is more abrupt and results in a higher carbon price in the later years (over US$1,000 by
2050).
Therefore, the macroeconomic effects of past carbon-pricing schemes may not be a good guide
to the macroeconomic effects of future carbon-pricing schemes’ rises. Structural modelling can
also complement empirical analysis and help us understand the potential effects of future carbon
price increases. The IMF’s October 2022 World Economic Outlook has a chapter that finds
limited inflationary impacts of carbon-pricing initiatives. However, there are a number of quite
specific assumptions in the baseline model, in particular firms and households are very forward
looking and mitigation policies are known with certainty. In response to the anticipated rise in
energy prices, firms and households in the model cut investment and consumption – reducing
aggregate demand that offsets the inflationary impacts of the carbon taxes. It is also worth noting
that this model only simulates a 25% reduction in emissions.
It will be important for central banks to understand the expected macroeconomic effects of
different mitigation policies, particularly on inflation, in order to set monetary policy. Section 4
provides an initial assessment of some possible monetary policy considerations.
Investment and economic activity across sectors during the transition in the UK
One important feature of the transition that monetary policy will need to monitor is its effect on
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investment in less carbon intensive capital, sometimes called ‘green investment’ (such as
investments into low-carbon energy like wind turbines, or into energy-efficient infrastructure like
electric vehicles). Meeting the net-zero targets will require investments in energy and transport
infrastructure alone to more than double from current levels over the next decade and thereafter
maintain that level until 2050 (Lenaerts et al (2021) ). The International Energy Agency’s (IEA
(2021) ) pathway to net zero highlights that current energy investment is US$2 trillion (2.5% of
global GDP) but needs to rise to almost US$5 trillion to meet net-zero targets. The World
Energy Investment report (IEA (2022) ) finds that global clean energy spending had
remained flat for several years, but it has been increasing since 2021. If this is sustained, it could
lead to an overall increase in global investment, and thus boost demand, though the rise in green
investment may be partially offset by a fall in more carbon-intensive investment.
To understand how the transition towards greener activities is affecting economic activity, the
Bank of England asks firms directly through its Agency network, as well as the Decision Maker
Panel (DMP) survey.[6] Reports from the Agents over the first half of 2022 suggest firms that
supply goods and services for the net-zero transition – such as those supplying wind power or
heat insulation – have continued to experience strong growth in demand. This reflects how
investment intentions will vary by sector, based on a sector’s role in supporting the transition, as
well as their existing carbon intensity (and therefore the extent to which they need to
decarbonise). See Box B for the sectoral effects in the Climate Change Committee’s (2020)
Balanced Net Zero Pathway .
Similarly, the DMP survey in September and October 2021 suggested 44% of UK firms intend to
increase climate-related investments over the next three years (Chart 2).[7] We can map this to
each sectors’ importance in the UK economy using their Gross Value Added (GVA), which
measures the value of each sector’s production. The DMP shows that some sectors with
relatively large GVA shares – like the wholesale and retail and manufacturing sectors – currently
plan to strongly increase climate-related investments over the next three years, while for other
sectors their investment plans related to climate and the transition are comparatively modest
(Chart 3). The Office for National Statistics’ Business Insights and Conditions Survey (BICS)
suggests a majority of firms have started to take action to reduce carbon emissions, although a
smaller proportion explicitly monitor climate-related risks and have a climate strategy (Chart 4).[8]
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Chart 2: The expected effect of climate change (physical and transition) on capital
expenditure over the next three years (survey: September–October 2021)
Sources: DMP survey and Bank calculations.
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Chart 3: Expected sectoral effect of climate change (physical and transition)
capital expenditure over the next three years (survey: September–October 2021)
(a)
Sources: DMP survey and Bank calculations.
(a) Sectoral GVA shares are 1998–2019 averages.
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Expectations and uncertainty effects
The transition to net zero will be a long-run process, with many changes in the structure of the
economy due to occur into the future. However, economic behaviour and asset prices are also
driven by forward-looking expectations and so affect monetary policy.
Investments into green technologies often have a long horizon and are particularly susceptible to
increased uncertainty. This includes general macroeconomic uncertainty, but also climate policy
uncertainty (IEA (2017) ; Fried et al (2021) ). Much like how individuals can postpone
deciding on a weekend’s activities until they see a more accurate weather forecast closer to the
date, an increase in uncertainty induces firms to delay investments, particularly those with long
payback periods. The (negative) effect on aggregate demand and economic growth by increased
uncertainty is well documented (Leduc and Liu (2016) ; Basu and Bundick (2017) ). A
previous Quarterly Bulletin article showed how a rise in uncertainty – then associated with the
UK’s exit from the EU and the Covid pandemic – dampened UK business investment (Bunn et
al (2021)).
Chart 4: BICS survey (survey: 21 March to 3 April 2022)
Source: Office for National Statistics.
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The DMP survey shows some UK firms have already begun citing climate change policy as one
of their main sources of overall uncertainty (Chart 5). This is particularly apparent in sectors
affected by climate change, such as transportation and real estate. This suggests a clear and
orderly path of climate policy during the transition that avoids inducing uncertainty would
encourage higher levels of private investment.
Inflation expectations are another example of how expectations about the future can affect current
economic decisions. If firms reprice their products infrequently, they must set prices in advance to
anticipate their future demand and costs. Therefore, news about higher future costs – for
example, from a continued rise in carbon prices, such as in the CBES scenario – could lead to
higher inflation in the near future. Inflation expectations could also ‘propagate’ shocks to firms’
costs arising from carbon prices: making the inflationary impacts longer lasting that the direct
impact of the initial shock (Coibion and Gorodnichenko (2015) ), though its quantitative
importance is uncertain (Wong (2015) ). If increases in carbon prices are inflationary, these
could lead to ‘second-round effects’ – leading into higher inflation expectations, and consequently,
to more inflation later on. Moreover, increases in carbon taxes may be announced and so
anticipated a number of years in advance. By contrast, standard economic shocks are
unexpected and can arise in either direction. As a result, further analysis is required to better
Chart 5: Per cent of firms with climate change as a top three source of
uncertainty, by sector (a)
Sources: DMP Survey and Bank calculations.
(a) Sectoral GVA shares are 1998–2019 averages.
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understand how carbon price changes may affect inflation, inflation expectations and economic
activity. Monetary policy plays an important role here, and a credible monetary regime that
anchors inflation expectations would help minimise the potential inflationary impact. The monetary
policy implications are further discussed in Section 4.
Key takeaways
Most of the economic literature on transition impacts examine market-based climate policy
mechanisms that have been introduced over the past decade or so. But many other climate
policies will need to be deployed to deliver the transition to net zero, of which we have much
less understanding. Additionally, relative to a smooth transition, a disruptive transition may
induce amplified effects on the economy through the various channels discussed here, and
potentially others too. A credible path for future policy for the transition is vital to reduce
uncertainty and enable economic agents to react smoothly and appropriately.
Some initial findings are that climate policies that encourage the transition to net zero are likely
to have both supply and demand effects on the macroeconomy, though it depends on
institutional factors, such as the climate policy mix and how carbon tax revenues are used by
the government.[9] The estimated empirical effects tend to be small but that could be simply
because historical carbon prices on which these studies have been based on are currently
low; prices will need to rise significantly from their current levels to be consistent with net-zero
targets.
A survey of UK companies shows that 44% of firms plan to increase capital expenditure in
response to climate change, about a third of these by 10% or more. This is consistent with netzero scenarios of sharply increased investment. This increase is highly uneven across sectors
in the economy, with some planning to invest much more than others.
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Box A: Case study – flooding and house prices in the UK
In the UK, one key manifestation of extreme weather events is flooding. For example,
during the 2013–14 winter many parts of the UK were affected by both inland and coastal
floods (Spencer et al (2015) ). Looking ahead, the UK Climate Change Risk
Assessment 2022 rates the adverse impact by the 2050s to ‘people, communities and
buildings’ from river and surface flooding as ‘very high’ (consistent with economic
damages or forgone opportunities costing over £1 billion per annum), and from coastal
flooding as ‘high’ (costing over hundreds of millions of pounds per annum). It also rates
risks to ‘business sites’ from flooding as ‘very high’, and to ‘infrastructure networks’ as
‘high to very high’.
One direct effect after flooding is the revaluation of properties: Garbarino and Guin
(2021) found that the sale price of flooded UK residential houses fell by 4.2% in
response to the 2013–14 floods, relative to equivalent non-flooded properties. Similar
impacts have also been experienced abroad; for instance, Beltrán et al (2018)
estimated the value of flooded inland properties in the United States, associated with a
location in the 100-year floodplain, declined by 4.6%.
Lower house prices in turn can reduce household consumption. One channel is via a
wealth effect, ie households consuming less in reflection of their lower wealth. For the UK
economy estimates of these effects tend to be quite small (Fernandez-Corugedo et al
(2003); Attanasio et al (2008) ). Lower house prices also reduce the value of
households’ collateral for loans. Cloyne et al (2019) find significant effects of house
prices on borrowing and hence consumption. They find that homeowners with lower levels
of collateral borrow much more against house price increases than do those with higher
levels of collateral. This is one example of how financial frictions can propagate the initial
economic shock arising from physical impacts, which is explored more in Box C.
In the Bank of England’s Climate Biennial Exploratory Scenario (CBES), most of the
increase in projected average annual losses in UK general insurers arise from flooding,
and it finds the impact on their solvency positions is likely to be manageable. However, the
CBES also highlights that insurance on some properties, especially under the ‘No
Additional Action’ scenario, would become unaffordable once the Flood Re scheme
ends.[10]
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Box B: The Balanced Net Zero Pathway (Climate Change
Committee, 2020)
One illustration of the different sectoral impacts of the transition to net zero can be seen in
the Climate Change Committee (2020) Balanced Net Zero Pathway. For example,
the electricity generation sector is a large source of UK carbon emissions (15% of 2018
emissions), and they estimate that to reach net-zero targets, the sector will need to
reallocate away from using fossil fuels towards cleaner sources of energy generation
(Chart A).[11] At the same time, Chart A also shows it has to invest into more than doubling
its output by 2050 to support the transition of other sectors. This includes the electrification
of the surface transport sector, which has to implement an 83% reduction in emissions
from 2019 levels by 2035, in order to meet net-zero targets (Chart B).
Chart A: Illustrative electricity mix for the Balanced Net Zero Pathway
Source: Climate Change Committee (2020) .
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Chart B: Change in 2019–35 sectoral emissions under the Balanced Net
Zero Pathway
Source: Climate Change Committee (2020) .
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Box C: Amplification channels and international spillovers
The UK has been, and is expected to be, less directly exposed to the physical impacts
associated with climate change compared to other countries. However, as an open
economy engaged in the production and global trade of goods and services, it can still be
affected by the impacts – both related to physical and transition effects – taking place in
other economies through what are referred to as international spillovers. In this Box, we
explore spillovers associated with both physical and transition impacts. Financial frictions
are well known to be able to amplify and propagate various macroeconomic shocks
(domestically and internationally), perhaps illustrated most clearly in the 2008–09 financial
crisis.[12] Less is currently understood about other channels, such as mass migration,
although looking forward these may increasingly act as spillovers.
With global trade having evolved in recent decades into a ‘global value chains’ (GVCs)
model, whereby the production chain for goods and services is located across multiple
borders, extreme weather events in one country that result in supply disruptions and/or
changes in climate policies can create spillover macroeconomic effects in many others
because of the way that production is as concentrated in a few central ‘hubs’. Carvalho et
al (2021) found a key role for production networks in the propagation of the initial shock
from the 2011 Japanese earthquake upstream and downstream along supply chains.
Commodity markets – in particular, food and energy – could also transmit physical risk
shocks across boundaries because of their highly traded nature. Peersman (2022)
estimated that international food supply shocks (driven by droughts and harvest failures)
already explain 30% of euro-area inflation volatility between 1961 and 2016. By contrast
for intermediate and finished goods, GVCs offer diversification among foreign suppliers
which can lower volatility, by lowering the exposure to any single country (including
domestic suppliers) (D’Aguanno et al (2021)).
Transition impacts can directly affect financial sector balance sheets, for example through
stranded assets that become unviable because of their incompatibility with carbon-neutral
activities (NGFS (2019a) , (2019b) ). Similarly, damages to the capital stock from
physical impacts can affect valuations of asset holdings by firms, households and could
also transmit to the financial sector. This capital destruction (by flooding, for example) can
lead to an increase in loan defaults from the inability of households and firms to repay,
which ultimately generates losses at banks. This impairs the health of banks (a reduction
in bank capital), which in turn can reduce their ability to lend to the real economy
(Gambacorta and Mistrulli (2004) ). The climate-induced losses reduce the ability of
firms and households to borrow, and thus their capacity to invest and consume – in the
economics literature, this is known as a financial accelerator mechanism.
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These financial accelerator channels can cause economic contractions and have
historically played an important role in business cycles (Gilchrist and Zakrajšek (2012)
; Christiano et al (2014) ). Contacts from the Bank’s Agency network indicate that
there remains a risk of adjustment in the valuations of carbon-intensive assets, such as
commercial diesel vehicles, but the scale and speed is uncertain. These shocks could
also transmit internationally, particularly in countries like the UK with internationally
integrated financial and credit markets. Cesa-Bianchi and Sokol (2022) provide
evidence that adverse financial shocks in the US transmit to a tightening in credit
conditions and slower economic activity in the UK.
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3: Effects on the long-run equilibrium interest
rate, R*
While monetary policy is typically focused on responding to cyclical shocks, it does so within a
broader macroeconomic landscape, which is shaped by a number of slow-moving structural
factors (Bailey (2022)). Given the potentially permanent effects on the environment, physical
climate-related events will impact economic factors such as risk and productivity in the long run.
Furthermore, given the scale and duration of the necessary adjustment, the transition to net zero
requires a large structural economic change, with consequences particularly for the future path of
investment. Therefore, in addition to the impacts discussed in the previous section, both the
physical impacts from climate change and the transition to net zero are likely to significantly
shape the longer-term macroeconomic landscape within which monetary policy operates.
Economists use a number of so-called ‘equilibrium’ concepts to summarise the macroeconomic
landscape, and therefore the policy-relevant impact of structural changes in the economy. One
such concept, which is of particular importance to monetary policy, is the ‘equilibrium real interest
rate’ – defined as the real interest rate (ie the interest rate adjusted to remove the effect of
inflation) that sustains the actual output level of the economy in line with its potential and inflation
at target. As such, the equilibrium real interest rate can act as a guide to monetary policy over the
medium to long run. Long-run structural changes in the economy, like those implied by climate
change and policies, affect the long-run trend in the equilibrium real interest rate, which we refer
to as R*.
The determinants of R*
In an organising theoretical framework for understanding its determinants, R* is also the price that
brings the demand and supply for capital into balance (see Bailey et al (2022) ), for a more
complete exposition). The demand for capital arises from firms that want to invest in capital for
production.[13] The supply of capital is from households accumulating wealth, and who put this
wealth into capital by (directly or indirectly) holding corporate shares or bonds, and government
bonds. Within this framework, R* is the risk-free rate of return on government bonds, and, in
equilibrium, it is equal to the return to an additional unit of capital minus the ‘risk premium’, which
compensates households for the volatility in the return to capital.
Importantly, for an open economy like the UK, R* will be determined on the global capital market,
because frictions that impede the free international movement of capital are weaker at this
longer-term horizon. In other words, structural factors that determine the global supply and
demand for capital will pin down a ‘Global R*’, and it is this concept of R* which acts as a longterm anchor for the UK’s domestic equilibrium real interest rate (Cesa-Bianchi et al (2022)).
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There are a large number of potential channels through which both physical impacts from climate
change and the (global) transition to net zero may affect the long-run trend equilibrium interest
rate, R*. Some forces could put upward pressure on R*, such as an increase in trend productivity
growth or additional green investment. Other forces could work in the opposite direction, such as
an increase in the risk premium.
Physical impacts
With respect to physical impacts of climate change, one of the key influences on R* is that the
increased probability of natural disasters, and the subsequent increase in the volatility of output,
which may raise the risk premium. In other words, with higher macroeconomic volatility, riskaverse households will require a larger compensation for lending to firms, relative to holding riskfree bonds. All else equal, this increases firms’ financing costs, therefore reducing their demand
for capital, and, in equilibrium, this lowers R* (Kozlowski et al (2018) ; Dietrich et al (2022)
). Similarly, households facing higher volatility in their own incomes or costs, due to climate risks
such as reconstruction after flooding, will choose to accumulate more wealth as a precaution
against this volatility. All else equal, a higher supply of wealth to finance investment also lowers R*
(Auclert and Rognlie (2018) ).
Physical impacts of climate change could also lower productivity in the long run, either directly
through the effects of climate events, or by diverting investment towards abatement rather than
productivity-enhancing technologies (NGFS (2020) ). This lower productivity reduces the
marginal product of each unit of capital, therefore lowering firms’ demand for capital, and hence,
R* (Riksbank (2020) ).
We can also think of physical risks as an increase in the depreciation rate of the capital stock, as
extreme climate events periodically destroy physical capital. This would reduce the marginal
product of capital, by effectively reducing the future value of existing capital, and therefore also
reduce firm investment (the demand for capital) and push down on R*.
Transition to net zero
In terms of the transition to net zero, a main channel is that the transition entails a large increase
in investment into new green capital. As discussed in Section 2, meeting the net-zero targets will
require large investments in many sectors across the economy, reflected also in the Agency
intelligence and DMP survey responses. This rise in demand for capital will push up on R*.
Other than directly increasing firm investment, this transition towards green capital and green
technologies may have other effects. The risk premium on green investments may be different.
For example, if investors perceive these new investments to be riskier as some new technologies
may not pay off, then the risk premium may rise, pushing down on R*. The long-run productivity
growth may also differ; if green technologies have higher productivity, this would raise the
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marginal productivity of capital, raising firm investment, and with it, R*. Finally, transition to net
zero may have large up-front costs, including requiring updated infrastructure (such as
decarbonising buildings, subsidising the move away from gas boilers), and so it may require a
rise in public debt levels (Office for Budget Responsibility (2021) ). This would raise the
supply of government bonds, which, all else equal, leaves less wealth to finance firm investment,
therefore pushing up on R* (NGFS (2020) ).
Key takeaways
There are a large number of potential channels through which both physical impacts from
climate change and the transition to net zero may affect the long-run trend equilibrium interest
rate, R*.
Some forces could put upward pressure on R*, such as an increase in trend productivity
growth or additional green investment. Other forces could work in the opposite direction, such
as an increase in the risk premium.
More work is needed to understand and quantify these various channels, in particular to
understand their net effect and whether their relative importance is different at different
horizons. Most importantly, we will learn over time how the risks associated with climate
change are priced into returns, how productivity develops both in the face of climate events
and the transition towards a green economy, and how governments, corporates and
households respond to these changes.
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4: Monetary policy considerations
Monetary policy clearly cannot solve climate change, but climate change may have
macroeconomic implications that could be relevant for monetary policy makers. This section
explores how the macroeconomic effects of climate change as discussed may have implications
for the conduct of monetary policy, both in the short and long term. As described above, climate
change is likely to be a source of shocks to inflation and activity, lead to structural changes in the
economy and to reshape the longer-term macroeconomic landscape in which the MPC operates.
This section considers climate and monetary policy strategy, monetary policy trade-offs and
possible changes to the transmission mechanism of monetary policy.
Climate and monetary policy strategy
The remit for the MPC, as set out by the government, outlines its objectives and provides
guidance for its strategy. As discussed in the Introduction, it requires the MPC to set monetary
policy to meet the inflation target of 2%, and, subject to that, to support the economic policy of the
government, including its objectives for growth and jobs. In March 2021 HM Government updated
the MPC remit to ‘reflect the government’s economic strategy for achieving strong, sustainable
and balanced growth that is also environmentally sustainable and consistent with the transition to
a net zero economy’.
The primacy of the price stability objective remains at all times. In 2016, as part of a broader
stimulus package, the MPC launched the Corporate Bond Purchase Scheme (CBPS). It is a
monetary policy tool: the MPC judged it was necessary at the time to impart sufficient stimulus to
the economy to meet its inflation target. However, the structure of CBPS holdings provided an
opportunity in which monetary policy could further support the Government’s net-zero objectives.
As such, in 2021 the MPC announced plans to ‘green’ the CBPS portfolio to incentivise
companies to reduce emissions by adjusting the composition of CBPS investments, for example
requiring firms to satisfy climate-related eligibility criteria for their bonds to be purchased by the
CBPS. As the macroeconomic conditions changed, the MPC decided to run down the CBPS
holdings in its February 2022 meeting. The primacy of the inflation target in the MPC’s remit
meant that, despite the benefits of the CBPS from the perspective of climate change mitigation,
this did not prevent or delay the decision to reduce the stock of corporate bonds in order to meet
the inflation target.
Insofar as investments into green capital and R&D that facilitate the transition to net zero tend to
pay off over a long horizon, an important mechanism through which monetary policy can facilitate
the transition to the green economy is ensuring the continuation of price stability and credibility of
the monetary regime. This minimises the inflation risk premia component of interest rates, and
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therefore, reducing the financing costs of long-horizon green investments.
Monetary policy trade-offs
The MPC’s remit also allows consideration to be placed on the variability of output. The
implications for monetary policy of climate change can therefore be seen in the context of the
MPC’s remit and guidance around trade-off management.
Over the short run, the MPC adjusts its policy instruments in response to macroeconomic
developments, depending on their effects on inflation and activity. Some economic developments
push inflation and activity in the same direction, such in a rise in green investment which would
tend to push up on both activity and inflation. In this case, monetary policy can adjust its
instruments to bring inflation back to target and restore activity to equilibrium at the same time.
Other economic developments push inflation and activity in different directions. As discussed in
Section 2, the transition to net zero will make carbon-based energy sources more expensive.
That could push overall energy prices up, depending on how much and at what speed that is
compensated for by cheaper renewable energy sources. But it may reduce activity. By pushing up
on inflation and down on activity, that creates a ‘trade-off’ for monetary policy, given monetary
policy instruments typically push on both activity and inflation in the same direction. The remit
provides flexibility for the MPC to allow inflation to deviate from the target temporarily, in order to
avoid undesirable volatility in output in some circumstances so that the MPC is able to manage
trade-offs (Carney (2017)).
Climate change and the transition to net zero is an example of a ‘relative price shock’, which the
MPC has faced in the past. Section 1 mentions one previous example: the globalisation following
China’s accession to the World Trade Organization in 2001, which led to low tradeable goods
inflation rates (Spange and Young (2007) ). Ultimately, monetary policy must allow the
economy to adjust to such shocks. It should respond only where the shocks exert a generalised
and persistent effect on inflation. For example, following the depreciation in sterling that followed
the UK’s EU referendum, the MPC traded-off the associated inflationary pressure against
undesirable volatility in output, and there was a temporary deviation in inflation from target, as
allowed for under the MPC’s remit.
On the other hand, the relative price shocks associated with the transition to net zero may be
different to the types of shocks that the MPC has faced in the past. In particular, in transition
scenarios, the price of carbon (whether set via a tax, emissions trading scheme, or other means)
rises steadily over time. Therefore, it is possible that the impact on inflation may become
generalised and persistent.[14] In that case, there would likely need to be an adjustment in
monetary policy in order to meet the inflation target.
A related consideration in achieving the inflation target is the speed of the structural adjustment in
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the economy. For example, in a paper presented at the Jackson Hole Symposium in 2021,
Guerrieri et al (2021) argue that in the face of reallocation of resources across different
sectors of the economy and downward wage rigidities, monetary policy may need to be looser
than otherwise in the absence of this reallocation. Although this paper focused on sectoral
reallocation due to the Covid pandemic, Bartsch et al (2022) have drawn a parallel between
its findings and the reallocation required for transition to net zero.
Another monetary policy strategy consideration relates to the trend equilibrium real interest rate.
As discussed in Section 3, this can act as a long-run guide to monetary policy. To the extent that
climate change affects the trend real rate, we would expect this to influence the medium to longrun path the MPC set for Bank Rate. Therefore, it would be important for central banks to monitor
and understand possible changes in the trend equilibrium real interest rate.
More generally, there are many open questions and further research and analysis is required to
help guide policymakers to achieving their mandates for price stability in the face of the
challenges posed by climate transition and physical risks.
Possible changes in the transmission mechanism of monetary policy
Monetary policy affects the economy via the so-called ‘monetary transmission mechanism.’ This
can be thought of as a set of channels through which changes in Bank Rate or the stock of asset
purchases ultimately affect inflation. The nature of the monetary transmission mechanism is
ultimately determined by the structure of the economy – how production is organised, the structure
of capital and labour markets, the economy’s interaction with the rest of the world, and so on.
As discussed above, it is likely that climate change and its mitigation policies will result in
structural changes to the UK and world economies. These in turn would have implications for the
monetary transmission mechanism. Monetary policy works largely via the impact of interest rates
on aggregate demand in the economy. In particular, policy rates work their way into spending,
saving and investment decisions through several of channels, including market interest rates,
asset prices, credit supply, expectations and exchange rates.[15]
One of the channels runs through market interest rates. Interest rates in the broader economy are
affected when the MPC make changes to Bank Rate, as Bank Rate serves as the benchmark
interest rate for the broader economy. When market interest rates change, they alter firms’ and
households’ incentives to save or invest, which in turn directly affects aggregate demand in the
economy. The market interest rate channel could be affected by climate change, for example if
households increased saving and firms delayed investments during the transition in response to
uncertainty about the nature and the timing of the structural transformation (see Section 2). Such
behaviours could reduce the sensitivity of aggregate demand to interest rate movements.
Another channel through which monetary policy operates is via asset prices. Particularly if there is
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a ‘delayed adjustment’ rather than a smooth transition to net zero, there could be sharp
revaluations of a wide range of assets in the economy. This could be triggered by a sudden shift
in government policy or an extreme weather event. Such asset revaluations could affect the value
of firms’ and households’ collateral, changing their ability to borrow. Asset revaluations may affect
the capital and liquidity positions of banks and financial intermediaries, which may also affect
their ability to lend to the wider economy.
Understanding how such changes in the structure of the economy may affect the monetary
transmission mechanism is important for understanding the implications of climate change for
monetary policy, as emphasised by the NGFS (2020) and ECB (2021) .
Key takeaways
Climate change may involve new sources of trade-offs for monetary policy. For instance, the
relative price shocks associated with the transition to net zero may exert a generalised and
persistent effect on inflation, making it different from the average shock that the MPC has
faced in the past.
By leading to structural changes in the economy, climate change may also alter the channels
through which the instruments of monetary policy affect inflation and economic activity.
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5: Conclusion
Monetary policy clearly cannot solve climate change, but climate change may have
macroeconomic implications that could be relevant for monetary policy makers.
In some sense, climate change comprises another set of economic shocks and structural
changes for monetary policy makers to assess and monitor in order to achieve the inflation target.
However, climate change presents new challenges to monetary policy makers in a number of
respects, including its global dimension, its very long time horizon and the degree of uncertainty
about both climate policy and how economic agents will respond. That is particularly so given the
non-linear nature of climate change leading to irreversible effects (‘tipping points’).
It is too early to tell the potential impact of climate change on the economy. Many of the effects will
only become clear over time. That applies both to the manifestations of climate change and the
evolution of official policies to mitigate it, including via regulation and economic incentives to
reduce carbon intensive activity. It is for governments to set out a pathway to net zero and the
policy levers that will be used to deliver it; while monetary policy cannot solve climate change,
monetary policy makers need to monitor and understand its macroeconomic implications in order
to achieve the inflation target.
Different pathways to net zero will involve different mixes of taxation, subsidies, regulation etc. In
some transition scenarios, the price of carbon (whether set via a tax or other means) rises
significantly, steadily and over a multi-year period. That may push up on aggregate inflation, other
things equal, requiring a tighter stance of monetary policy to achieve the 2% inflation target. The
scale of the impact on investment, including in new technologies, and on the capital stock, as
some less energy-efficient capital depreciates, is uncertain. As a result, there are different
possible paths for the long-term equilibrium interest rate. A credible path for future policy for the
transition is vital to reduce uncertainty and enable economic agents to react smoothly and
appropriately.
In response to macroeconomic developments in the UK, including spillovers from the rest of the
world, the MPC adjusts its policy instruments in order to meet the HM Government’s 2% inflation
target and, subject to that, to support the economic policy of the Government, including its
objectives for growth and employment. Further analysis, research and monitoring will be needed
to assess how climate change and the transition to net zero will impact the macroeconomy and
what that might mean for monetary policy.
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Annex
Adaptation policies – Policies designed to prevent or minimise the anticipated adverse effects
of climate change.
Business Insights and Conditions Survey (BICS) survey – A survey that asks businesses
from various industrial sectors and regions in the UK, run by the Office for National Statistics.
Capital – One of the factors of production used by firms, including tangible assets – such as plant
or machinery – and intangible assets – such as software and knowledge. In equilibrium, these
assets act as a store of wealth for households.
Carbon pricing – Various schemes that ensure emitters of greenhouse gases pay for each
tonne of their carbon-equivalent emissions.
Climate Biennial Exploratory Scenario (CBES) – Illustrations of possible paths for climate
policy and global warming (not forecasts), and ran by the Bank of England to explore the effects
of climate risk in the largest UK banks and insurers.
Collateral constraints – Refers to the effect that housing wealth as collateral has on the
relationship between housing prices and economic activity. For instance, in periods where house
prices increase, the value of collateral increases as well, leading to higher household borrowing,
which boosts consumption.
Corporate shares and bonds – Sources of funding typically used by firms to finance investment
into capital, which pay a return either through dividends (shares) or interest payments (bonds). In
the standard framework, households are the ultimate holders of all shares and bonds, either
directly or indirectly through deposits with a financial intermediary that invests in the firm.
Decision Maker Panel (DMP) survey – A survey that asks small to large private sector
businesses across all industries, run by the Bank of England, Stanford University and the
University of Nottingham.
Downward wage rigidities – Resistance against a reduction in wages when a
negative/adverse economic event takes place.
Emissions Trading Scheme – An example of a ‘cap-and-trade’ scheme, where a limit is set on
quantity of the total greenhouse gas emissions, which ‘permits’ are then traded in a market.
Glossary
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Equilibrium real interest rate – The interest rate, adjusted to remove the effect of inflation, that
brings the actual output level of the economy in line with its potential and sustains inflation at
target. Over the long run, this fluctuates around a global trend component, referred to as global R*.
Forward guidance – A monetary policy tool that works by providing information about the likely
path or behaviour of monetary policy in the future, based on its current assessment of the outlook
for the economy and inflation.
Global value chains (GVCs) – The linkages of firms that source intermediate inputs for
production from firms in another country.
Government bonds – Bonds issued by governments to finance any expenditure in excess of
revenue. As with capital, the households buy these bonds as a store of wealth. Government
bonds are considered to be safe assets, which pay a certain return with no risk.
Gross Value Added (GVA) – The value generated by any economic unit engaged in the
production of goods and services, which is one measure of economic activity.
Human capital – Measures the economic value of intangible assets such as knowledge or
experience.
Intergovernmental Panel on Climate Change (IPCC) – The United Nations body for
assessing the science related to climate change.
Intermediate inputs of production – Intermediate goods and services, such as energy, and
raw materials, are used as inputs in the manufacturing process of other goods and services.
Labour force – The number of working age people, both employed and unemployed, who are
currently willing and able to work.
Mitigation policies – Policies designed to lessen the impacts of climate change by preventing
or reducing the emission of greenhouse gases.
Network of central banks and supervisors for Greening the Financial System (NGFS) – A
group of central banks and supervisors willing, on a voluntary basis, to share best practices and
contribute to the development of environment and climate risk management in the financial sector
and to mobilise finance to support the transition toward a sustainable economy.
Net zero – When greenhouse gas emissions are cut as close to zero as possible, with any
remaining emissions reabsorbed from the atmosphere.
Potential output – The level of output consistent with keeping inflation on target over a long
horizon.
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Price stability – Low and stable inflation.
Productivity – Measures how effectively the inputs of production are used in order to
manufacture a given level of output.
Relative price shock – An unexpected change in the price of one or more goods and or
services compared with the price of other good and or services. For example, an unexpected
change in the price of commodities relative to the price of other goods and services in the
economy.
Risk premium – The excess return on a risky asset over and above the return on risk-free
assets, which compensates the holder for risk or volatility in the return of the former.
Solvency position – A characterisation of a firm’s ability to meet its long-term debts and other
financial obligations.
Transmission mechanism/monetary policy transmission – The way in which changes in
monetary policy flow through to the real economy and inflation.
Trend equilibrium real rate – The global trend component of the equilibrium real interest rate
(see Bailey (2022)), also known as global R*.
1. The authors would like to thank Jessica Murray, Lee Robinson and Ivan Yotzov for their help in producing this article.
2. See for example the Bank’s Climate Biennial Exploratory Scenario and the Bank’s Climate Change Adaptation
Report.
3. Batten et al (2016), Batten (2018).
4. Elgie and McClay (2013) , Bernard et al (2018) , Metcalf (2019) , Metcalf and Stock (2020) , Moessner
(2022) and Konradt and Weder di Mauro (2022) .
5. Notable exceptions are Switzerland and Sweden, with carbon taxes at US$100.90 and US$139.11 per tonne,
respectively (Konradt and Weder di Mauro (2022) ).
6. The Bank’s Agents have twelve locations across the UK and meet hundreds of contacts each year, ranging from small
businesses to large global companies. Similarly, the DMP survey covers small to large private sector businesses
across all industries, surveying (typically) the Chief Financial Officer (CFO) of around 3,000 firms each month.
7. Note that the DMP question includes firm investment in response to physical impacts (eg adaptation), as well as the
transition.
8. The BICS was conducted between 21 March and 3 April 2022.
9. See also Apel (2022) .
10. Flood Re is a joint initiative between the Government and insurers which aims to make the flood cover part of
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household insurance policies more affordable. Flood Re is in place until 2039, as per current legislation.
11. The Climate Change Committee (2020) estimates the UK electricity supply must reduce emissions from 2019
levels by more than 50% by 2035, to reach net zero by 2050.
12. See Brunnermeier et al (2013) for a survey.
13. A profit-maximising firm will continue to employ additional units of capital until the marginal benefit (the marginal output
of each additional unit of capital) equals the marginal cost (the rate at which they can borrow to finance this
investment).
14. One estimate is the IMF’s (2022) World Economic Outlook chapter that finds limited inflationary impacts of carbonpricing initiatives. However, this particular model simulates only a 25% reduction in emissions and contains highly
forward-looking firms and households that reduce their demand (offsetting the inflationary impacts).
15. See The transmission mechanism of monetary policy for a more detailed discussion of these channels.
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