Will Climate Change Cause Recessions in the Future?

Bitcoins and U.S Dollar Bills, Photo by David McBee on Pixels
Bitcoins and US Dollar Bills, Photo by David McBee on Pixels

Several recent events have coincided globally to shake the world economy, prompting inflation in many countries, some of which are at the brink of recession and some of which are facing severe food crises. First, as most countries emerged from COVID-19 lockdowns of the last two years, the demand for goods and for travel has been on the rise, leaving the supply side lagging behind. One example of the imbalance between supply and demand is the current chaos in the aviation market, as thousands of flights have been cancelled just in the last months. Second, the war in Ukraine has caused global shortages in many natural resources such as oil, gas, metals, wheat, and corn, driving the prices of these and other commodities up sharply. Third, the recent COVID-19 lockdowns in multiple cities in China have had a disrupting effect on the Chinese economy and on international trade, also leading to shortages of raw materials and adding to the inflation caused by the War in Ukraine. One other economic development has been the drop of equity prices, especially in the US stock markets, caused either by the tightening of monetary policies because of inflation or due to the popping of the speculative bubble.

When looking at what is happening now in the world from a climate change point of view, many observers emphasize how many of the countries that have been dependent on Russian fossil fuels now understand the need to move quicker to renewable energy. Another point widely heard is the fact that the limited availability of fossil fuels and the resulting soring energy prices have placed climate policies at a crossroads as governments need to urgently choose between energy security and energy transition. The choice between the two, to date, has seen the defeat of climate change by security issues as more and more countries search for alternative supplies of oil and gas to meet their needs.

According to the BBC, Russia supplies 40% of the EU’s natural gas and 27% of its imported oil. The EU’s dependency on Russian energy sources has made the countries of the EU realize they need to shift to green energy. But since implementing these renewable energy projects takes several years, for the interim period, the EU plans to invest in pipelines and Liquified Natural Gas (LNG) terminals from countries such as Israel and Egypt, to diversify from Russian fossil fuels. This is one of the reasons why Israeli Minister of National Infrastructures, Energy and Water Resources Karine Elharrar has recently announced the opening of a new tenders for natural gas exploration licenses in Israel’s territorial waters in the Mediterranean Sea.

When countries and corporations invest in fossil fuel infrastructure, they create carbon lock-ins and the consequence is that the world’s ability to meet the Paris Agreement’s targets for reducing global greenhouse gas (GHG) emissions is receding. This technological lock-in means that fossil fuel use will persist for more time than what might have been expected, the cumulative GHG concentration in the atmosphere will continue to rise, and the physical effects of climate change will become more and more pronounced in the future. Eventually, the increase in the frequency of extreme events will probably lead countries in a few years’ time to make faster changes to mitigate the effects of global warming. This is what is known in the climate change discourse as a disorderly transition to the low-carbon economy.

It is no wonder that the World Economic Forum, in its 2022 Global Risk Report has placed climate action failure and extreme weather in first and second places respectively, as the most severe risks on a global scale over the next 10 years and has dedicated a chapter in the report to the disorderly climate transition. In a disorderly transition to the low-carbon economy, according to the Network for Greening the Financial System (NGFS), climate policies to curb climate change are taken relatively late, hence, emissions reductions need to be sharper than in an orderly scenario to limit global warming to the same target. This scenario suggests transition risks will be high. Possible causes of transition risks include abrupt changes in policy and regulation, for instance, carbon pricing or regulations for limiting the use of fossil fuels; technological development, making current technologies obsolete, and changes in consumer preferences. All of these can cause supply shocks, shifts in prices, labor market frictions, and can impact international trade, government revenues, interest rates and exchange rates.

I believe what we are witnessing in today’s markets, is what we can expect to see when transition risks of climate change start to materialize in a disorderly transition. Whether it be tighter regulations on fossil fuel use, carbon taxation or consumer preference, without a wide rollout of alternatives to fossil fuels and other strategies to mitigate climate change, the global economy will see future waves of supply chain disruptions, energy shortages with soring energy prices, and food shortages. All of these are expected to cause inflation and the intervention of central banks, just as we are witnessing today. And I should add that these transition risks are only half of the bigger picture which includes the physical risks of climate change.

Though we still don’t know the outcome of these economic developments on the the global economy, the result can range from being relatively mild with minimal effects to the world GDP to causing a state of economic recession in many countries. How economies cope with the current economic situation can indicate their levels of economic resilience to future shocks, including climate transition risks. Nevertheless, it is important to remember that due to the complex nature and interconnectedness of climate policy, technological progress and consumer preferences, according to the NGFS, transition risks may materialize in ways that are difficult to foresee. And the disorderly transition the world is heading towards, might create, as Mark Carney, the former governor of the Bank of England, called it, a climate Minsky moment whereby a sudden change in investors’ expectations of future climate policies could lead to fire sales of assets and a widespread repricing of risk. Such a Minsky moment may affect not only direct stakeholders but also second and third circles of influence and has the potential to destabilize the financial system and the real economy.

In any case, it is not necessary to reach a climate Minsky moment, which is considered an extreme scenario, in order to understand that the effects of climate change risks will not remain specific to one or two sectors such as the carbon-intensive sectors which have been the focus of a recent Bank of Israel publication, but rather, they will encompass the economy as a whole. It is enough to look at the effects of the war in Ukraine and the other recent events around the globe, to understand that the effects of such shocks are relevant to every one of us as individuals and, for policy makers, to make use of the current events, which are unrelated to climate change, in their stress tests and scenario analysis for climate risks.

About the Author
Galit Palzur is an economist, specializing in corporate risk management of natural disasters and extreme events. Previously, she was the Director of the Economics and Standards Division at the Ministry of Environmental Protection; Chairman of the Bureau of the OECD Working Party on Climate, Investment and Development; economist at the Budgets Division at the Ministry of Finance, and served as board-member of several government-owned companies and statutory bodies.
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