Climate Change is a Growing and Persistent Driver of Inflation
By Roger Mortimer, Portfolio Manager
After a forty-year period of falling interest rates, central banks around the world are struggling to contain inflation. Triggered by the Russian invasion of Ukraine and the resulting energy shock, inflationary pressures can also be attributed to the labor force disruption caused by COVID, and to years of underinvestment in commodity industries prompted by the trend to ESG investing and calls for greater capital discipline.
Investors may be tempted to think of the inflation we are now experiencing as transitory, something that central banks can stamp out with decisive policy action. After such a lengthy disinflationary period, this perspective is understandable. It may not, however, prove to be accurate - and if the inflationary trends acting on the global economy are the new normal, then the growth investing playbook of the past few decades may be less effective in the environment we are moving into.
Much of the inflationary focus in the media has been on energy, with oil reaching $120 in the wake of western sanctions on Russia, and European gas prices trading at unforeseen levels as Russian supplies (typically 40% of the European total) are withheld. In the United States, academic research on previous big moves in gasoline prices has found an almost one-to-one relationship between spending on gasoline and spending on other consumption.1 The Federal Reserve watches energy prices as an indication of future demand and sees falling energy prices as potentially indicative of a slowing economy.
While recent higher energy prices have been largely a result of geopolitics and investor influence, climate change is also playing a role. Renewables will eventually deliver power at lower and more stable costs than the fossil-based inputs we use today, but in the medium term, during the transition, higher carbon taxes on conventional fuels will add to inflationary pressures. As carbon taxes become more pervasive across industries and geographies and their prices ratchet higher, this inflationary effect will persist.
A second area where consumers feel inflationary pressure is in the price of food. According to the UN Food and Agriculture Organization (FAO), global food prices reached their highest level ever in March 2022.2 While they were slightly lower in April, down 0.8% from the peak, the cost of the reference basket of commonly traded food commodities was 29.8% higher than a year earlier.3
Source: UN Food and Agriculture Organization
Food and energy costs are highly correlated as the supply chain for food production is energy intensive. In 2018, about 10% of total US energy consumption was used in food production4, but food production is more fossil-fuel intensive than other parts of the economy, accounting for about 20% of US fossil fuel consumption.5 This is a function of the mechanized equipment used to grow, harvest and transport food to market, which currently is highly gasoline and diesel-intensive, and the fossil inputs in fertilizer.
While the inflationary impact of energy prices on food costs is readily apparent, it is becoming clear that climate issues are also a growing inflationary force and one that is likely to intensify.
At its most simplistic, climate change, resulting in rising global temperatures and environmental degradation, is eroding agricultural productivity, driving up the cost of food. While the study of this idea is relatively new, the conclusions are consistent and seem logical. As the planet is placed under greater stress, its productivity will fall. Some factors, like crop yields and labor efficiency, may see the linear impact, whereas others, like the complex balance between systems, may be less easy to predict.
According to the IPCC WGII Sixth Assessment Report, published in October 20216, global warming is affecting agricultural productivity in both land and ocean-based systems. Crop yields are impacted by degrading soil conditions; rising temperatures affect crop developments, and extreme weather impacts crop harvests. Rising temperatures directly affect animals and people, with both dairy production and animal mortality (affecting beef production) impacted. More difficult working conditions and heat stress to farm workers reduce productivity with the resulting lower yields and higher costs directly impacting the end cost to the consumer.
The increasing incidence of climate extremes is also affecting crop yields and harvest stability. Both drought and flooding - two sides of the climate change impact - result in longer-term inflationary pressures. The events can reduce the amount of arable farmland, disrupt productivity for long periods of time, and increase the costs of operating the land, including necessary infrastructure improvements, higher insurance, and financing costs.
In 2018, England experienced what it called a "once-in-a-lifetime drought", but it is facing even worse conditions this summer, with crop yields down 10-50%.7 The month of July was the driest in England since 1935, and the record high temperatures this summer have been materially higher than in 2018. As noted by professor Richard P. Allan of the University of Reading, "the higher temperatures and thirstier atmosphere due to human-caused climate change will have intensified the rate at which soils dry out and hence speed up the development of drought.”8
Unprecedented flooding in Pakistan, where a third of the country is currently underwater, impacts not only the nation's ability to feed its own people but also its neighbor Afghanistan, which relies on imports over now-flooded Pakistani roads to meet its needs.
In the United States, insurance payments to farmers for crop losses due to drought and flooding have tripled over the past 25 years. Since 1995, of the $143 billion paid out to US farmers, more than 60% of the cost is attributed to climate change.9 These costs are expected to rise further.
Drought has second-order impacts also. In Argentina, Brazil, and Paraguay, low river water levels on key transport routes have forced barges to reduce capacities to avoid grounding, raising the cost of corn and soybean products to the end export markets.
More difficult to assess are the risks of systemic failure; the impact that climate change has on pollination, and the natural balance of delicate insect systems that are critical to plant growth. Scientists have noted declines in pollinator abundance, diversity, and resilience and have urged greater study of this area.10 Current research is not clear on the likelihood of 'tipping points' or 'cascading failures,' but the scientific community's confidence that environmental change is accelerating makes this an area where further research is warranted.
In summary, climate change affects the cost of food in multiple ways - some like straightforward pass-throughs of higher conventional energy costs related to rising carbon taxes, but others that are more progressive as a result of falling agricultural productivity and extreme weather disruption. Deeply entrenched climate trends suggest that food cost inflation will be a long-term theme. With the cost of necessities rising, consumers will have less to spend in discretionary areas, affecting the valuations of companies exposed to these areas, many of which have been market favorites. As investors become more aware of both the negative effects of inflation on high terminal value growth stocks and the opportunities presented in climate mitigation, we believe that the re-rating process of energy transition leaders will accelerate.
The KraneShares Global Carbon Transformation ETF (Ticker: KGHG) seeks to invest in companies that are emerging as decarbonization leaders and believes that a valuation arbitrage is available for capture as incumbent industry players increasingly migrate capital investment plans towards greener growth areas within their industries. We believe that large incumbent energy and industrial players have many of the qualities required to succeed in the energy transition (see "The Orsted Effect"), including large existing operations and customer bases; the relevant project management skills; and adjacencies to emerging areas. A targeted strategy of investing in these companies, where management is committed to the energy transition, offers, in our opinion, the potential not only for significant environmental impact but also for superior growth and revaluation among the leading participants.
- Simon Moore. " Rocketing Gas Prices Hurt Consumers - Study Shows How Much." Forbes, March 11, 2022
- World Economic Forum. "Why are food prices near an all-time high?". May 12, 2022
- Save On Energy, " American food production requires more energy than you’d think". Updated June 16, 2022
- IPCC Report
- Karen Gilchrist, "There’s no sign of any rain coming to us’: Europe’s extreme weather risks smaller harvests and higher prices". cnbc.com, August 31, 2022
- Catherine Clifford, "England just had its driest July since 1935", cnbc.com, August 1, 2022
- Jena Brooker, "Extreme weather is destroying more crops. Taxpayers are footing the bill", Grist.org, January 28, 2022
- Tanya Latty, Vasilis Dakos, "The risk of threshold responses, tipping points, and cascading failures in pollination systems". Biodiversity and Conservation. September 3, 2019