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Over the next decade, a significant increase in climate-related government expenditure will, we believe, help sustain demand in developed markets after their initial COVID recovery, lifting nominal growth, inflation and real interest rates in the coming years. But that investment drive alone will not achieve the targeted carbon emission reductions. Energy and carbon emissions prices will need to rise sharply to achieve that. Those rises and a higher cost of capital will eventually trigger declines in carbon-intensive investment and consumption, reinforcing the shift towards (in particular digital) services and intangible capital, such as software, intellectual property and networks.
What actions are necessary to hit climate targets? The climate commitments that developed-market governments either have made or are likely to make require a large increase in “green capex” combined with higher carbon and energy prices to encourage a rotation in economic activity. That means shifting away from carbon-intensive capex and goods consumption towards green infrastructure, labour-intensive services and increasingly intangible capital.
What is likely to happen? We predict we will see a sustained rise in government and private-sector investment even if the capacity to implement the plans is constrained by resources. Carbon taxes and energy prices are unlikely to increase as fast as they need to and the resulting drop-off in carbon-intensive capex and consumption is likely to be delayed.
How much spending is needed and how much is actually likely to materialise? Much of the analysis we have read suggests the required level of investment spending is about 1.5% – 2% of GDP per year. Some of that is spending that might have happened anyway (for instance, in replacement spend) but that probably still leaves about 1% – 1.5% of GDP of additional spend per year. In Europe (the 27 European Union countries and the UK), that would equate to about €250 – €350 billion total or €150 – €250 billion additional spend, per year. Given the political focus on economic stimulus and strong electoral support for additional investment spending, we believe that this investment is likely to materialise.
Specifically, who is going to spend and when? Here it’s difficult to be precise; while we have an idea of what needs doing, the actual plans for spending and policy are still in flux. In many cases, policies needed to incentivise the step-up in investment (for instance, housing renovation schemes) are still in development.
So, when will we know? We are likely to learn a lot over the coming months. The upcoming Climate Summit COP26 in Glasgow may trigger more commitments and specific plans. The Biden administration is working on an infrastructure spending plan. In the European Union (EU), governments must submit National Recovery Plans to the EU Commission by the end of April — those plans will contain specific spending commitments. More broadly, we are likely to see a step change in incentive schemes and in regulations that will have lasting impact. Keeping track of this spending will be an important research task.
How is the capex likely to be split? Most of the plans split the required capex across five categories: investment in power grids and power plants; residential real estate; commercial/public real estate; industry/agriculture and transport. The exact split will depend on individual country circumstances. Data from the European Commission’s assessment of EU members National Energy and Climate Plans is roughly consistent with the estimates we mentioned earlier.
Is this all going to be traditional capex? Some of it will be traditional infrastructure spending, yes —such as the electricity infrastructure conversion and the step-up in renewable energy provision. But much of the spending will be on things like housing/buildings upgrades, efficiency measures and replacing car fleets that would not normally be classified as capex but rather consumer durables.
What is the offset — where will capex decline and what spending will recede? Most of the studies we have seen are consistent in saying that green investment activities are not enough to reduce emissions. A steep rise in the price of emission/energy and a higher cost of capital for carbon-intensive business are required to create the incentives to rotate economic activity. Eventually, capex in oil, coal and gas will decline sharply, and consumption will turn towards less energy-intensive services.
How big will that decline be and when will it happen? Most studies suggest that the decline in activity is of roughly the same order of magnitude as the increase in activities — the rotation creates major winners and losers. The politics of implementing that switch about is difficult — it means losses of jobs and income. It will happen, but we think it will happen later in this decade. That difference in timing is critical.
What will be the macro economic effects?
- In the next decade, the impact on GDP and employment is likely to be positive, dominated by the rise in capex. In the longer term, higher energy prices will depress energy-intensive capex and consumption.
- The sustained rise in investment will have strong multiplier effects, lifting investment and income in the economy more broadly.
- Rising energy/carbon prices will have a sustained, direct impact on inflation. But in the first decade, the direct impact of strong demand is also likely to lift inflation.
- That should lead to stronger nominal growth and higher real and nominal interest rates.
- Within developed markets, Europe, which has a small fossil-fuel extraction sector and extensive investment in renewables, is set to be a relative winner at first, compared to the US and other developed markets with large extraction sectors.
How big are these effects likely to be? We don’t yet know enough to provide a precise estimate. But the most important immediate point is that this is a sizeable and durable increase in investment spending that will extend the COVID recovery. The contrast is with the post-Global Financial Crisis recovery, which was characterised by shrinking public and private investments, public- and private-sector balance-sheet repair and low interest rates. Green spending will contribute to making the recovery in GDP and earnings more durable.