Carbon pricing and inflation expectations

Putting a price on carbon emissions helps mitigate climate change but may also raise overall price inflation—sometimes called “greenflation.” Using high-frequency event studies based on regulatory news in the European Emissions Trading System, one of the world’s largest carbon markets, the authors find that carbon price surprises—regulatory announcements that affect the future supply of emissions allowances—generate significant increases not only in energy futures prices, but also in inflation expectations (measured by inflation swap prices and breakeven inflation rates) across short- and long-term horizons. Even a decade ahead, market participants do not view carbon policy shocks as temporary surprises, but as more persistent shifts in the inflationary environment. These findings contrast with previous literature which generally found only small or short-lived effects on inflation expectations.

Despite the sustained increases in market-based inflation expectations, forward-looking nominal interest rates show no meaningful response to the carbon policy shocks, suggesting that investors do not anticipate that the European Central Bank will lean against the inflationary effects of higher carbon prices. If greenflation is incorporated into longer-run inflation expectations, maintaining price stability becomes much more challenging for central banks. The results underscore the need for central banks to account for the expectations channel when assessing the macroeconomic trade-offs of climate policies.

The paper makes both methodological and empirical contributions to climate economics. On the methodological side, the authors implement high-frequency financial market event studies using a novel set of plausibly exogenous policy shocks. The paper is the first to apply this methodology to bond and derivative markets, estimating the term structure response of inflation and monetary policy expectations. On the empirical side, the paper provides new evidence of pass-through and spillover effects of carbon prices to energy markets, and of the wider impacts on expected inflation and interest rates.

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