Climate insurance policies in all probability extra inflationary than anticipated, says Bank of England deputy

Policies designed to fight climate change ‘probably’ had a bigger impact on the inflationary upheaval of recent years than expected, the Bank of England’s deputy governor has said.

Sarah Breeden, who is in charge of the bank’s financial stability efforts and sits on its Monetary Policy Committee, said in a speech on Friday that a sudden sharp rise in the cost of carbon resulting from UK policies could make inflation higher for longer.

Russia’s invasion of Ukraine in 2022 was the crucial catalyst in an inflationary spiral led by energy prices, driving Britain’s consumer price index as high as 11.1 per cent by October of that year.

Breeden told an audience at the University of Edinburgh Business School that the rise in wholesale gas prices coincided with a ‘material’ increase in the cost of carbon.

This, she said, was driven by a reduction in the supply of carbon permits, a falling share of permits given out for free and ‘an expansion of sectoral coverage’ under the UK’s emissions trading scheme.

Carbon permits, also known as carbon credits, can be bought by firms and individuals to offset carbon emitting activity.  

The ETS sets a cap on the total amount of certain greenhouse gases that can be emitted by covered sectors.

It meant carbon prices roughly doubled in price to around £100 per tonne of carbon dioxide equivalent by the summer of 2022.

Breedon said: ‘These carbon costs are non-trivial in the sectors most exposed to the scheme, like the power sector.’

She explained that while wholesale gas prices were the dominant driver of high electricity prices in 2022, carbon costs amounting to roughly 50 per cent of the fuel costs for gas-fired electricity producers were ‘a major driver of prices’.

Breeden said: ‘The source of an energy price shock might affect its impact on inflation.

‘Specifically, if energy prices rise due to a carbon permit supply shock, the impact on non-energy price inflation could be about 1.5x as large at its peak – and last several months longer – than if the rise were driven by a gas supply shock.

‘That seems plausible if shocks of this kind are expected to be longer lasting given the stringency and scope of the carbon permits scheme might be expected to increase over time.’

‘New shocks’ to the economy not as bad 

Breeden added that the BoE needs to ‘build more sophisticated analysis of climate policy into out bread-and-butter monetary policy works’, highlighting ‘mounting evidence that it matters for price stability’.

It came as the deputy governor, who is planning a broader speech on the impact of climate policy ‘later in the year’, outlined her near-term economic outlook.

Breeden, who has been with the bank since 1991, said she expects ‘a continued unwind of past shocks, as lower headline inflation translates gradually into lower wage growth and this eases the pressure on price setters to pass on higher labour costs into prices’.

She cautioned that there are ‘new shocks’ hitting the economy, such as the labour market impact of the Autumn Budget, but said ‘they are likely to be considerably smaller than the large shocks of the recent past’.

This suggests the BofE is willing to consider resuming interest rate cuts if inflation moderates, having paused at 4.75 per cent amid fears of a resurgence in price pressures. 

Breeden said: ‘The recent evidence further supports the case to withdraw policy restrictiveness and I expect to continue to remove restrictiveness gradually over time.

‘The important questions as I look ahead are what combination of shocks explains the recent slowdown in activity and how will employers respond to higher employment costs.

‘The answers to those questions will affect the outlook for medium-term inflation and so the speed at which restrictiveness needs to be removed.’